A real estate appraisal is also commonly referred to as a“property valuation”.
It is important to note that the appraised value is different than the assessed value. The assessed value is determined by the municipality in which the property is located, and can be drastically lower than the appraised value.
When would you need an appraisal?
A real estate appraisal is needed whenever debt is being placed on a property or when an owner is looking to refinance. Someone might also have an appraisal done before listing their property for sale in order to help establish the listing price (this is particularly true if the property is unique and no local comps are available). Appraisals are also commonly required during estate sales, divorces, and can be used to determine tax liabilities.
Who conducts an appraisal?
Most states require appraisers to be licensed or certified. Appraisers have been specially trained to develop independent opinions of value. If an appraisal is required as a condition of your loan(purchase or refinance), the bank will initiate, hire and oversee the appraisal. New regulations prohibit Fannie Mae and Freddie Mac lenders from having direct contact with appraisers, so most banks will initiate the appraisal through an appraisal management company that has a pool of appraisers on which to draw.
If you’re getting an appraisal done to establish a property’s value prior to sale, you can hire the appraiser directly.
Residential vs. Commercial Appraisals
There’s an important distinction to make between residential and commercial properties. Typically, “residential” homes are considered those with 1-4 units. Anything with five or more units starts to fall into the realm of “commercial” property, even if the property type is housing. This is important to understand because appraisals, like financing, differ depending on whether a property is residential vs. commercial in nature.
The appraisal process is very different for residential and commercial properties, so even if you’ve purchased a home before and have been through an appraisal, the experience may not have prepared you for the commercial version. The main differences include how the properties are valued, the complexity of the appraisal, the cost, and how long the appraisals take to complete.
Residential Appraisals
Most residential appraisals are for single-family homes that will be owner-occupied.
Residential appraisals are pretty straightforward. Most use what’s known as the “sales comparison” approach (more on this below). This approach compares like-kind residential properties, generally in the same neighborhood. Most appraisers have access to MLS and will use this to find comps nearby. Most will look at four to five comparable homes that have sold within the past six months within a mile radius, as well as one or two current listings.
Determining residential home values is relatively easy to do. Appraisers look at similar homes and what they sold for, adjust for any differences, and then calculate the value.
Commercial Appraisals
Commercial real estate generally refers to revenue-generating property. Commercial appraisals are typically reserved for multifamily properties with five or more units, as well as any other commercial property types – such as office buildings, retail centers, hotels, and industrial properties.
Generally speaking, commercial real estate is valued based on the income it generates. There is less emphasis placed on the location, condition of the property, size and other factors that are analyzed when doing a residential appraisal. With commercial appraisals, the focus leans toward factors like income and rental prices, tenants with long-term leases, and the recent selling price of similar properties in the area.
Commercial real estate appraisals take longer and are more complex than residential appraisals. This is partially because commercial properties are more complex to build, operate, maintain and value. Commercial properties tend to be individually unique, which means that every appraisal must be customized for the property. Whereas a residential appraisal might take a week to complete, the commercial appraisal can take upwards of a month depending on the nature of the property.
Commercial appraisals are also more expensive than residential appraisals. A residential appraisal might cost between $300 to$500, whereas a commercial appraisal will cost anywhere from $1,500 to $5,000.
3 Ways Appraisers Value Property
There are three different approaches that appraisers use to determine a property’s value:
- The sales comparison Approach: As the name implies, this method compares a property characteristics with those of comparable properties that have recently sold in similar transactions. Because no two properties are exactly alike, the valuations of comparable properties are generally averaged to establish a fair market value for the property being appraised. Adjustments can be made as features vary. For instance, a property may be discounted if the units are smaller or if there is less parking. This approach is sometimes called the“market approach” and is considered the most widely used when evaluating residential real estate (assuming there are comps in the region).
- The Cost Approach: This method begins with an evaluation of the site’s value, as if vacant, and then calculates the replacement cost of any existing building structures, less depreciation. The cost approach assumes the buyer will not pay more for a property than it would cost to build an equivalent.
- The Income Capitalization Approach: Commonly referred to as the “income approach,” this method is often used when appraising investment property because it values a property based upon its rental history and revenue-generating potential. This approach is more complicated. A property’s direct capitalization discounted cash flow, and gross income multiplier are all factors commonly analyzed when using this approach.
Most appraisals will use some combination of two or more of these approaches. The values established through each approach are reconciled into one final opinion of market value.
What factors influence a property’s appraised value?
There are certain factors that influence a property’s appraised value, including local market conditions (basic supply and demand)and macroeconomic trends (e.g. a national recession). The principles of substitution, balance and externalities can also help explain shifts in value.
How is a real estate appraisal used in practice?
Lenders use real estate appraisals to determine how much a property is worth. They need an accurate picture of the property’s value in order to determine a mortgage’s loan-to-value ratio.
With owner-occupied residential real estate, a lender might be willing to go to 95% or more loan-to-value. For simplicity’s sake, this would mean on a home valued at $100,000 the bank would be willing to lend $95,000. The buyer would only need to come up with $5,000 as a down payment.
Commercial real estate usually has much lower loan-to-value ratios, usually closer to 60% or 70%. Using the same property as above, if the buyer was planning to use the property as a rental, the bank might only be willing to do a $70,000 mortgage, meaning the buyer would need to come up with a $30,000 down payment.
If that same property appraises for $120,000, the mortgage amounts and equity needed shift accordingly.
Sometimes appraisals come in lower than anticipated.
Let’s say you planned to purchase an investment property for $300,000 and planned to put down 25%. You would have been taking out a mortgage for $225,000 and would have needed $75,000 in equity. The appraisal comes back low. The property only appraises for $280,000.
There are a few strategies to mitigate a low appraisal.
The first strategy is to re-negotiate with the seller, trying to get them to bring the purchase price down to $280,000 from the previously agreed-upon $300,000. If the seller doesn’t agree but you still want to move forward with the deal, you’ll have to come up with additional equity to meet the bank’s 75% loan-to-value ratio. At a $280,000 valuation, the bank will lend $210,000. This means you now need to come up with $90,000 for a downpayment in order to purchase the property for $300,000.
What if you disagree with the appraisal?
If you feel that the appraisal is unduly low, you are well within your right to challenge the appraiser’s analysis. Grounds for a challenge may include information about the property that is incorrect, or your ability to produce comps from the area that are more recent, closer or more comparable overall than those used in the appraisal report. You might also challenge an appraisal if only one approach was used, and you feel that an alternative approach would have yielded a different result.
Ultimately, it is up to the bank to determine whether your challenge has merit. The bank may be willing to entertain a second appraisal, but that will be on your dime. The lender will then generally take the average of the two values.
CRE Appraisals vs. BOVs
Real estate investors may occasionally hear someone refer to as a “BOV” – or a broker’s opinion of value. On the surface, BOVs seem similar to appraisals. And to a large degree, they are similar.
In commercial real estate, a BOV is used to come up with an estimate of value for a specific commercial property. BOVs are used by many CRE professionals, including investors /property owners, lenders, CPAs and real estate attorneys. BOVs are most often used by commercial property owners looking to determine their property’s worth, and as such, whether to sell their property or not (and if so, for how much).
BOVs can be as simple as two or three pages, or as detailed as a 40-50+ page book. It depends on the purpose of the BOV, the property under analysis, and the requirements of the client.
There are a few distinctions to be made between BOVs and appraisals:
- BOVs are typically put together by commercial real estate brokers on behalf of their customers. Appraisals are put together by licensed third-party professionals who have no “skin” in the game, as it pertains to the deal at hand.
- A BOV is essentially a broker’s “best guess” at a property’s value, albeit a “best guess” backed by market data and other industry knowledge. The guidelines for appraisals are much more stringent, including more robust data collection and analysis. That said, a skilled broker with access to up-to-date market information can create a BOV as thorough as a commercial MAI-certified appraiser.
- Appraisers will always charge a fee for conducting an appraisal. BOVs are often put together by brokers for free, especially if trying to win over a client to get a listing.
- BOVs can be used to determine the value of an entire portfolio of CRE assets, whereas appraisals are generally property-specific.
Conclusion
In any real estate transaction, the real estate appraisal is one of the most important components—especially when intending to put debt on the property. To get the best results, be sure you understand the appraisal process, the data analyzed, and the parties involved in the decision-making. There are only so many factors you can control, so do your best to control those. And of course, challenge the appraisal if and when necessary.
Interested in learning more about how lenders utilize appraisals? Contact us today. We would be happy to share our experience withyou having worked with most of the nation’s leading CRE lenders.
