What is an appraisal?

View a tutorial video of a residential appraisal.

For many people, the purchase of real estate is the largest, single investment they will ever make.  Whether it's a primary residence, or an investment, the purchase of real property is a complex financial transaction that requires multiple parties to pull it off.

Most of the people involved are very familiar. The Realtor is the most common face of the transaction, the mortgage company provides the financial capital necessary and the title company ensures that all aspects of the transaction are completed so that a clear title passes from the seller to the buyer.

So who makes sure the value of the property is in line with the amount being paid?

This is where the appraisal comes in. An appraisal is an unbiased estimate of what a buyer might expect to pay - or a seller receives - for a parcel of real estate, where both buyer and seller are informed parties. To be an informed party, most people turn to a licensed, certified, professional appraiser to provide them with the most accurate estimate of the true value of their property.

Market Research
So what goes into a real estate appraisal? It all starts with the research of the market to which the property belongs.  In most cases, an appraiser is already keenly aware of local market behaviour but, as local economic factors change, it is important for the appraiser to remain abreast of characteristics that traditionally drive real estate prices such as employment rates, migration data, inflation, building starts and absorption rates.

Inspection
An appraiser's duty is to examine the property being appraised or the architectural drawings of a property being constructed that is to be valued on basis of completion.    He or she must actually see features, such as building layout, the location, and so on, to ensure that they exist and are in the condition a reasonable buyer would expect them to be. 

Once the property has been inspected, an appraiser may use multiple approaches to determining the value of real property including a cost approach, direct comparison and income approach.

Cost Approach
The cost approach is often the easiest to understand.  It is the estimated land value plus the estimated cost to construct the building less the estimated depreciation of the building.  The appraiser uses information on local building costs, labor rates and other factors to determine how much it would cost to construct a property similar to the one being appraised. The building depreciation can be estimated using cost estimation software or depreciation tables.   

Direct Comparison
Appraisers frequently rely on the direct comparison approach to value for most property types. It is often perceived by market participants as the most straight forward method towards property valuation.  Appraisers get to know the characteristics of the markets in which they work such as the traffic patterns and local supply and demand trends; and they use this information to determine which attributes of a property will make a difference in the value. Then, the appraiser researches recent sales or listings in the vicinity and finds properties which are ''comparable'' to the subject being appraised. The sales or list prices of these properties are used as a basis to begin the direct comparison approach.

Using knowledge of the value of certain items such as square footage, interior finishing, transportation access, or view lots (just to name a few), the appraiser adjusts the comparable properties to more accurately portray the subject property.

Income Approach
In the case of income producing properties, the appraiser may use an income approach to valuing the property. In this case, the amount of income the property produces is used to arrive at the current value of those revenues over the foreseeable future. 

In direct capitalization, the property value is reflected through a relationship between one year's stabilized net income and either a capitalization rate or an income multiplier.   In yield capitalization, the relationship between several years' stabilized income and a reversionary property value at the end of a designated period is reflected in a yield rate.  

Reconciliation
Combining information from all approaches, the appraiser is then ready to stipulate an estimated market value for the subject property. It is important to note that while this amount is probably the best indication of what a property is worth, it may not be the final sales price. There are always mitigating factors such as seller motivation, local supply and demand factors that may adjust the final price up or down. But the appraised value is often used as a guideline for lenders who don't want to loan a buyer more money than the property is actually worth. Using objectivity and a number of different approaches to research and valuation, an appraiser will help market participants make the most informed real estate decisions.