FAQ #11: Which Appraisal Method is the Best?

From time to time, we get questions from Realtors, homeowners, and builders asking us why we use certain approaches, or if we can only use one of the approaches to value.  In this FAQ post, we’ll look at the three commonly-used approaches to value when appraising a single family residential property.

The three approaches we’ll look at here are the Sales Comparison Approach, the Cost Approach, and the Income Approach.  At times, all three approaches to value discussed below will be employed, and other times only one or two are appropriate.  Let’s look at each now.

1.  Sales Comparison Approach. This method compares the property being appraised to other properties similar to the subject, that have recently sold and are located in the same market area. It’s usually a very good method when there are many similar properties available for comparison.

In the development of the Sales Comparison Approach, an appraiser will typically follow these steps:

1. 1. Identify comparable properties.  The appraiser will identify recently sold properties in the same area that are similar in size, condition, quality, and other amenities to the property being appraised.

   2. Adjust for differences.  Next, the appraiser will adjust the sale prices of the comparable properties to account for any differences between the properties and the property being appraised. For example, if a comparable property has a smaller lot size than the property being appraised, the appraiser will adjust the sale price of that comparable property upward to account for this difference.  Likewise, if a comparable is larger in square footage than the subject, a downward adjustment will be made to account for the difference in square footage.

   3. Estimate the value of the property: Once the appraiser has adjusted the sale prices of the comparable properties, the adjusted sale prices will be reconciled to estimate the value of the property being appraised.  Almost always, the value indicated by this approach will fall somewhere within the range of adjusted comparable sale prices.

2.  Cost Approach.  This method considers the cost of building a home from scratch, plus the value of the land, and finally adjusting for any depreciation. It’s a useful method when there are few comparable properties available for comparison, and/or when the home being appraised is new or fairly new.  For the purposes of this post, I’m not going to get into the difference between Replacement Cost and Reproduction Cost.  Just know there are two different types of cost that can be used, and usually, replacement cost is used by appraisers.

To determine the cost of rebuilding a property, an appraiser is going to consider several factors, including:

1. 1. Replacement cost of the building: The appraiser will estimate the cost of building a similar property from scratch, using current construction materials and methods.  The cost estimates are usually based on nationally-recognized Cost Estimators, as well as estimates provided by local builders.

   2. Depreciation: The appraiser will consider any physical, functional, or external factors that have caused the property to depreciate in value since it was built.  The total depreciation will be deducted from the estimated cost of construction.

   3. Land value: The appraiser will consider the value of the land on which the property is located.  This will be added to the cost of construction.

For example, if the cost estimates indicate a cost to construct the home of $500,000 and the property has depreciated approximately 10%, then the estimated cost to construct is $450,000 ($500,000 – $50,000).  If the lot on which the home sits is worth $75,000 then the total value indicated by the cost approach would be $525,000 ($500,000 – $50,000 + $75,000).

This approach is most often used when comparable properties for comparison are limited, or when the home is brand new.  If a home is significantly depreciated, this approach may not be the best method to use.  One thing to note is that most entities will not let an appraiser rely solely on the Cost Approach.  Much to a builder’s dismay, the Cost Approach – if developed – must be done so in conjunction with the Sales Comparison Analysis.

3.  Income Approach.  This approach is used when the property does – or can – generate rental income.  What this approach asserts is that the value of a property is directly related to the income it produces, either currently or in the future.

One simple way to use the Income Approach is to estimate the Gross Rent Multiplier, or GRM.  It’s an oversimplification, but GRM = the Property Value divided by the Gross Monthly Rent.  In this approach, the appraiser will look at recently sold rental properties and take the sale price divided by the gross monthly rent to produce a GRM.  The GRM is then applied to the gross market rent of the subject, which will result in an indicated value.  If the appraiser determines the GRM is 120, and the monthly rent is $1,100, then the indicated value is $132,000 ($1,100 x 120). 

Every property is unique, and every appraisal is unique and specific to that property.  Therefore, the appraisal method employed will depend on the specific property being appraised as well as the availability of data.  It’s important to know that it is up to the appraiser to determine and select the most appropriate method for the specific property being appraised.

If you have a question you’d like us to feature, email me at ryanbays@riverfrontappraisals.com

For more information on this and other topics related to the appraisal process, check out our Guide To Appraisals set of E-Books at https://riverfrontappraisals.com/guides/.