When buying a property, buyers often wonder if they are paying too much. Sellers have similar doubts, usually that they are selling too cheaply.
Until a property is sold by a willing seller to a willing buyer, estimating that property's fair market value is just an opinion. If that opinion is rendered by a skilled professional appraiser, chances are the appraised value will be close to the property's true market value.
But even the best appraiser is rarely 100 percent accurate. For example, in today's slow home sale market it's difficult to obtain new mortgages due to high interest rates and the shortage of mortgage money. So a property may be appraised for $100,000, but if a buyer won't pay $100,000 for it then there is no confirmation of its appraised value.
There are three basic approaches to appraising value of a property. All depend on the appraiser's skill because each method requires subjective evaluations.
1. Market data approach: Using the market data method, sometimes called the competitive market analysis approach, a property's market value is determined from recent sales prices of similar nearby properties. This method is most widely used to estimate market value of homes and vacant land.
Value adjustments, up or down, are made to the recent sales prices of similar properties to arrive at a value estimate of the property being appraised.
But if your home is in bad condition, or lacks amenities common to those in your area, then its value will be less. If its condition is superior, then it will be worth more unless it is vastly overimproved for the general price range of the neighborhood. The value of overimproved property is held down by the average sale price in the adjacent area.
2. Replacement cost approach: Another appraisal technique, based on the replacement cost of a property, is used either as a double-check on the market data method or by itself if the property is unique or if there have been no recent comparable sales. For example, this technique is useful for appraising unique buildings such as churches, unusual homes and very old structures. Fire insurance agents use this method for estimating necessary insurance policy coverage.
This method requires three steps: (a) the cost of rebuilding the structure is estimated at today's costs; (b) estimated depreciation (loss of value due to wear, tear and obsolescence) is subtracted, and (c) land value is added. The result is the estimated replacement cost of the property.
3. Income capitalization approach: If the property is income-producing, such as an office building or an apartment house, the income capitalization appraisal method is used.
To use this method: (a) Subtract from the building's gross income its operating expenses to arrive at its net operating income (mortgage interest and depreciation are not considered because these vary with each owner). Then (b) capitalize this net income by dividing by the "cap rate" percentage determined from recent sales of similar nearby income properties.