What is an Appraisal?
An appraisal, very simply, is an opinion of value of a specific property, as of a certain date. Reliable appraisals, of course, are those opinions supported by facts, logical conclusions, experience, knowledge and expertise. There are three principal approaches to estimating value described below.
Cost Approach
This approach to the appraisal process arrives at a value conclusion by assuming that a buyer will not pay more for a property than the cost of creating a comparable substitute.
It begins with an estimate of land value to which the depreciated value of the improvements is added. Improvement value is the cost to build a similar product in today’s market, less any accrued depreciation due to wear and tear, changes in styles, design, or utility (functional obsolescence), or changes affecting the property from outside its boundaries like general market conditions (external obsolescence).
The appraiser must be well informed regarding land value and current costs as well as market preferences.
Sales Comparison Approach
This method of appraising estimates value by examining sales of other properties that are similar or “comparable” to the property being appraised. It is rare when two properties are identical, so the comparable sales are usually adjusted for differences in the selling date, terms of sale, physical characteristics of the structure, land value, etc. Adjustments can be either quantitative or qualitative.
Understanding what is truly “comparable” is one of the keys to the properly employing this approach. Another key is determination of appropriate adjustments.
Income Approach
This process is usually applicable in the appraisal of income-producing properties like commercial real estate. It is not typically used in the appraisal of vacant land, single-family houses, or residential condominiums.
This approach arrives at a value estimate by gathering and analyzing income to price ratios reflected by sales of other similar income-producing properties. In other words, if a comparable property with a net annual income of $50,000 sells for $500,000, it reflects an income to price ratio (net income divided by sale price) of approximately 10%. Typically this is referred to as an Overall Rate, or capitalization rate. An Overall Rate derived from a broad spectrum of sales of similar properties is then applied to the projected net income of the property being appraised to arrive at a probable value estimate.
The theory behind the Income Approach is that buyers of income-producing properties are focused on the cash return, and that the property with the best cash flow should sell for the highest price. It turns out this is not always true.
One or all of these approaches may be pertinent to a particular valuation assignment depending upon the intended use of the appraisal, current market conditions, and the approaches to value employed by market participants.