Wednesday, April 15, 2015

"How are home values determined?" . . . an appraiser's perspective

Every day, I'm challenged by home sale prices and determining a home's value.  As a Realtor for over 40 years, I was also one of the first certified appraisers in Texas, created after the failure of the "savings and loan industry" in the 1980's.  At that time, "appraisers" were only required to be licensed real estate agents with some extra training.  Since many S&L failures were attributed to faulty appraisals, laws were created to license/certify appraisers so that there would be some accountability for appraiser actions.

Most people -- including most Realtors -- don't really understand the appraisal process.  Realtors attempt to determine a home's value by a "price per square foot (ppf)" method; however, this is NOT an appraisal practice, per se.  Thus, the inaccuracies created by the "ppf" method are a source for controversy and argument among buyers, sellers, lenders, Realtors, and appraisers.

There is a theory that a home's value (or any parcel of real estate) is determined by "the highest price a willing buyer will pay and the lowest price a willing seller will take."  This is fine and dandy if the buyer is paying with cash.

However, if a lender is involved, the lender wants to ensure that they're not lending more than a "fair market value" for the home . . . enter "the appraiser."

The "Uniform Standards of Professional Appraisal Practice (USPAP)" -- a national set of "rules" for appraisers -- require an appraiser to consider three approaches to value in every appraisal assignment. However, a client can restrict or choose to limit the approaches to one or two of the approaches, or the appraiser can write in his/her report why an approach is not valid.  But at least it must be considered.  

The most common approach (especially in residential transactions) is called the "Sales Comparison Approach," wherein a subject property is "compared" to recent sales in the market area and adjusted for the differences in size, finishes, financing terms, garages, land, etc. etc. etc.

The "cost approach" is a method for determining the value of the land + its improvements, less any depreciation (which could be physical, functional or external).  These three areas of depreciation are not well-understood, except for maybe physical which consists of items needing repair or are simply worn.  The "functional" obsolescence refers to items that need updating or strange room configurations that don't fit today's lifestyles.  "External" (sometimes called "economic" obsolescence/depreciation) refer to items such as busy street locations, power lines in the back yard, and other annoyances from locational issues.

The third approach is called the "income" approach.  In this approach, the income that a property could produce (or does produce) is analyzed to determine a market value based on a particular expected "rate of return" sometimes called a "Capitalization Rate (or "Cap Rate")" or in more complex cases, an Internal Rate of Return or Discounted Cash Flow technique.

Sound complicated?  It is.  This is why -- when selling or buying -- a consumer should get the most competent advice available.  Many Realtors are highly qualified to help buyers and sellers, but some still don't understand these processes.  (Notice that the three approaches to value are NOT "price-per-square-foot.")

All Realtors and Appraisers are charged with a "competency provision" in their ethics and/or regulatory requirements.  This just means that they are required to disclose whether or not they have experience or "competency" in the type of property being asked to help with.  As a consumer, you should check the qualifications of a potential agent, broker, or appraiser before you hire them.

Questions?  Feel free to email . . . ask the Realtor/Appraiser.