When you’re buying a house or condo, or any other type of real estate, it is important to know not only what the seller is asking for the property and what you’re willing and able to pay, but what the property is worth to other people. If you need a loan to purchase the property, the lender will be interested in this as well. If you need to sell the property six months after you buy it, or if you quit making your payments and your lender forecloses and takes over the property, you both want to know that you will be able to sell the property and get what you paid for it (or more). You both want to know the current “market value” of the property.
A real estate appraisal provides the buyer and the lender with a systematic analysis of market value, to help the buyer decide whether they want to move forward with the purchase at a given price and to help the lender decide whether they want to make a loan on the property.
In our section called Key Documents, we’ve included a sample real estate appraisal from a property that one of us purchased in 1993. While the appraisal is produced on a form that is modified from year to year, this standard form is almost universally used by appraisers in presenting their analysis of a property’s value. If you pull up this document and look at the bottom of the second page, you’ll see a value statement just above the appraiser’s signature, indicating that he estimates the market value of the property as of 3/17/93 to be $220,000.
What’s the Role of the Appraisal in the Real Estate Purchase?
Later in this section, we’ll provide a more detailed explanation of the appraisal form and how the appraiser arrives at an estimate of the property’s value. But first a few comments on the role of the appraiser and the appraisal in the purchase process.
First, if you’re using your own cash to purchase the property, or if you’re obtaining your loan from a family member or friend, whether or not to have a formal appraisal of the property is your decision. If you’ve seen lots of comparable properties during the course of your home search, you may already have a good feel for how the pricing of the property you’re making an offer on compares with the pricing of other homes that are currently on the market. And by the time you’re ready to make an offer on a property, your real estate agent should have pulled up information on recent sales of comparable properties and helped you review those to get a clearer picture of whether the seller’s asking price is high or low compared to the prices at which these other properties sold. If the seller is asking $350,000 for a 1700 square foot house in a standard cookie cutter subdivision where comparable houses have sold for $340,000 to $370,000, it may not make a lot of sense to pay an appraiser $350 to tell you that she thinks the house is worth $355,000. You probably already know it’s worth somewhere in the $350,000 to $360,000 range.
But if you’re borrowing money from a mortgage lender to purchase the home, the lender will require that you pay for an appraisal whether you think you need it or not. The lender is not going to risk lending $300,000 on a property that’s only worth $270,000. The lender will require that an appraiser be done on the property that they are financing and they will choose the appraiser to do the job.
Second, if you do pay for a formal appraisal for the property, Section 6.2 of the standard Colorado purchase contract gives you the right to terminate the contract if the appraised value is lower than the purchase price you and the seller have agree to. It’s not only important to know that you have this right of termination, it’s important to keep in mind that your buyer will too when you put the property on the market to sell it. If there is some feature of the property that reduces the value in the appraiser’s eyes, even if that feature isn’t important to you, you need to be aware that this could limit the resale value of the property in the future.
Finally, while there are good reasons to pay for a formal appraisal of the property whether or not it is required, you should never rely solely on this appraisal in making a decision about what you’ll pay for the property. You need to make this decision based on your own knowledge of the market and your own review of the sales of comparable properties. Three points:
Fallibility: Though licensed appraisers have extensive training and take a highly systematic approach placing a value on a piece of real estate, their estimate of market value is just an estimate. When a property is being evaluated as part of an estate settlement, two or three appraisers will frequently be hired to value the property. If the property is the 1700 square foot house in the cookie cutter subdivision mentioned above, three appraisers will probably produce value estimates within $10,000 or each other. But then again, an educated home buyer’s estimate of value would probably have been within that same range. Send three appraisers to a more unusual property and you may get $100,000 variation on a $500,000 property. Appraiser’s estimate a properties value based on certain prescribed practices. They don’t know what it’s worth.
Buyer vs. Appraiser Value: Both buyers and appraisers consider issues like the size and condition of the home, and things like the setting and the views. But buyers and appraisers will often weight these factors differently. Buyers, for example, will often place more value on the condition of the property and the views than appraisers do. The appraisers valuation of the property is important. If for no other reason, the home you buy will probably be reviewed by an appraiser when you sell it, so it needs to meet the standards used by appraisers. Still, when you put your home on the market in the future, it will be other buyers (not appraisers) who will be making the decision of whether to make an offer on your home and at what price.
Rational Market Price: In an estate sale, an appraiser may be sent to the property to give the estate executor their best guess regarding the property’s value, but their job in a residential sale is different. When they are reviewing price for a mortgage lender in this context, the appraiser will be given the price that the buyer and seller have agreed upon. Their job is to determine whether prior sales in the market provide a rational basis for the sale price that’s already been determined. If you’re buying in a neighborhood where sales of 1700 square foot homes range from $400,000 to $500,000, and you’re under contract at $498,000, the appraiser will tend to pick the sales toward the $500,000 end of this scale for comps and affirm that there is a rational basis for the $498,000 price by appraising the home for $498,000. If you’d contracted at $460,000, the same appraiser might well select the comps that support that price and appraiser the property at $460,000.
How Does the Appraiser Determine the Property’s Value?
If you open the sample real estate appraisal that we’ve included in our Key Documents page and look at the bottom of the second page, you’ll see a value statement just above the appraiser’s signature, indicating that he estimated the market value of the property as of March 1993 to be $220,000. Just above that, you’ll see that the appraiser provided the same estimate of value using the “Sales Comparison Approach” but that he provided no estimate of value using the “Income Approach” or the “Cost Approach.”
It is important to understand that there are a variety of ways to determine the value of a property. If an appraisal is done on a multi-unit apartment building, or on a single family home that is being bought for rental purposes as an investment property, an appraiser will routinely look at the rental income that the property generates and provide an estimate of the property’s value given this “return on investment.” This is the basis for the “Income Approach” to property valuation. In a purchase of an investment property or standard residential purchase in an area where there is extensive new construction, the appraiser may also us the “Cost Approach” to produce an estimate of value. That is, the appraiser will estimate the value of the land that the home is built on and add that to the estimated cost of building that home to produce a value estimate.
In most residential real estate purchases, however, even where the appraiser provides an analysis of value based on the “Income Approach”or the “Cost Approach,” the results of the analysis the appraiser conducts using the “Sales Comparison Approach” will dominate their conclusion regarding the property’s market value.
If you look at the second page of the sample real estate appraisal, you’ll see the basis for the appraiser’s value estimate using the “Sales Comparison Approach.” The appraiser locates three recent sales of properties that are similar to the one that’s being purchased (the “subject property”) He then compares the subject property to each of these recent sales on 20-30 features and the makes price adjustments for the differences. In comparing the subject property to “Comparable Number 1” for example, the appraiser noted that Comparable Number 1 sold for $188,000, but he adds $5000 to this because the subject property was newer, $6000 because the subject property was larger, and $6000 because the subject property had a garage and Comparable Number 1 does not. In the end, the appraiser felt that $27,000 needed to be added to the $188,000 sales price of this comparable sale to make up for the differences between this property and the subject property, so he ended up with an adjusted value of $215,000 for Comparable Number 1. The final $220,000 appraised value that he ultimately placed on the subject property was the product of three such comparisons of comparable sales.