Which appraisal method would an appraiser use to appraise a rental home?

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Appraisals are usually done to know the value of a particular property, whether for residential, commercial, or industrial use. Depending on where the appraisal report is needed for, they may be requested by the people who are planning to sell their property, buyers who want to know if the price of the property they want to buy is fair, and for lenders that are making the decision on whether to loan an amount to a borrower.

Because appraisals are very important and can be used as a legal document, it is extremely crucial for them to be done by the professionals that are called “appraisers.” Appraisers are the experts who will put a value on your property according to its condition, size, and other data. 

Are you an owner of a rental home who is planning to order an appraisal for your property? If this is the case, it is only normal for you to want to know how your home will be appraised. After all, if the appraisal report will be used for loans, mortgage, or selling, you would absolutely want to know how you can improve your home’s valuation. We will be here to explain the different appraisal methods and which one would be utilized for your property. 

What do “appraisal approaches” mean?

 

 

 

 

 

 

Appraisal approaches, also sometimes called appraisal methods, are the different procedures or techniques that are being used by professional appraisers to put value in your residential, commercial, or industrial property. In other words, the specific approach that will be done on your particular property will aid in determining the valuation of the asset in question.

There are three main approaches that are being used in appraisals that are done for Real Estate, and they are the Cost Approach, the Sales Comparison Approach, and the Income Approach. Each of these approaches is different from the other and is used in different situations.  Depending on the asset that needs to be appraised, the appraiser will use the approach that will fit the need and requirement of the specific property.

Among the three appraisal approaches, which would be used for your rental home?

To answer the question of which among the three main methods used for appraisal: the Cost Approach, the Sales Comparison Approach, and the Income Approach would be more likely used by the appraiser that is putting the valuation on your rental home, the answer would be the Income Approach

To understand why, the first thing we need to do is distinguish each method from the other. Doing so will greatly help in knowing why the Income approach will be used and will also help you achieve a closer valuation estimate you want for your rental home. 

We know that appraisals do not guarantee that your property will sell exactly the same as the value on the report, however, it will certainly help you in raising the value if that is your end goal. This can be done by doing necessary repairs and adding high ROI (Return of Investment) projects to your rental home. 

Understanding the Three Appraisal Methods

For us to know why appraisers use the Income Approach for most rental properties, let us go in depth about each method and where they would be commonly used.

The first approach: The Cost Appraisal Method

What it means: For the first approach, the valuation for the property will be estimated by considering how much money would be needed to build the same existing property. In this method, the price of the land, the materials that are needed, and labor that will be done for the construction of the building will be accounted for along with the estimated depreciation of the property after many years. 

There are two variations of Cost Appraisals:

  1. The reproduction method – Just like what its name suggests, this method is done by considering the cost of constructing the same exact building using the materials that were originally used when it was first made. For example, if the home was built in the year 1980, the reproduction method will take into account the costs of the material that was used and the price of the labor during that same year. 
  2. The replacement method – For this method, the cost appraisal will be done by considering the cost of constructing the same exact building, however, modern approaches and materials will be used. After all, many experts would say that it is unfair to do the reproduction method when the materials are no longer available at the present and if there are much better alternatives that will be more functional and efficient in the current year. For example, if the home that will be appraised was also built in the year 1980, the replacement method will consider the cost of building a likeness of the original one but will take into account the cost of modern materials, designs, and layouts at the present. 

Where it is commonly used: The cost appraisal method is often used in properties that only yield little income or no income at all, which is why it will be rarely used for appraising commercial properties that generate income such as rental homes. This method is usually utilized by appraisers for churches, schools, and other similar buildings. 

Pros of the method: Cost appraisals are great for putting a value on properties that are residential or assets that are not generating income. It can also be great for historical homes and buildings that were constructed using valuable and durable materials that are considered timeless. 

Cons of the method: It is not a secret that the use of cost appraisals in the present time by professionals such as appraisers has already dwindled, and this is because this method is known to be less reliable compared to the other approaches. The reason for this is because it can be very difficult to find similar properties that are identical to the asset that will be appraised. When there are no similar materials or land that can be used as a reference to the appraisal, there is a tendency that the estimate will be very challenging or will not be accurate.  

The second approach: The Sales Comparison Appraisal Method

What it means: Also called the Market Approach, the sales comparison method is an approach that is done by comparing the property that is being appraised to comparables or “comps”. These comparables are the properties that have similar characteristics with the asset that is being appraised and have recently been sold. This approach is often used by appraisers to determine the value of the property by using the current market data that is available through comparative market analysis or CMA.  

Where it is commonly used: This particular approach is very common as is it is considered to be very reliable. Sales comparison approaches are usually done in residential properties such as single-family homes. 

Pros of the method: As mentioned above, the sales comparison appraisal method or SCA is very reliable and is widely accepted and used in most states in the U.S. This is because the process is done to use comps that have things in common with the property that is being appraised yields to a more accurate estimate. The things that appraisers often look at to compare other properties to yours are the location, condition of the property, features, layout, and other important data that will help them in making an accurate estimate. 

Cons of the method: Because the act of appraisal is not an exact science and can also be called “art,” it can be impossible for two different appraisers to arrive at the same valuation. Although the sales comparison approach is very helpful in determining the value of two same properties, one might be valued at a lesser or bigger value than the other. This is often the case when two comps are appraised on different dates, as the value can also rely on the current market condition, although they are exactly the same to each other. 

Finally, the third approach: The Income Appraisal Method

What it means: Also called the income capitalization approach, this method is done by appraisers when they consider the income that can be generated by the particular property that is currently being appraised. This can be done in assets that are already generating income or properties that are seen to have income potential. 

Where it is commonly used: As mentioned above, this method is done in properties that already generate revenue or have the potential to earn revenue from its buyer. This is exactly the reason why the income appraisal method is applied by appraisers in putting value to rental homes and other similar properties such as office and apartment buildings that have a rentable area. This method can also be used in assets that will be appraised for mortgages or investment reasons to determine whether the lender or investor will get their money’s worth from guaranteeing a loan or investing in the property or franchise. 

Pros of the method: As long as the property that is currently being appraised is in great condition – meaning that it does not need any immediate and major repairs, there is a good chance that the appraisal value of the property will be high, which is what owners who are planning to sell would want. 

Cons of the method: This type of method is considered to be the most difficult type of appraisal approach as there are many factors to take into account, such as the potential vacancy and collection losses that come with properties such as rental homes. Also, the estimated gross annual income is just a guess backed up with some data, and will vary from what is actually earned. This can be a big issue for buyers, lenders, and investors. 

Can the appraiser use two appraisal methods to appraise a rental home?

Although it is established that most appraisers would use the Income Approach in determining the value of a rental home, it is very possible for these professionals to use and combine two or even all three of the most popular appraisal methods that are available. In fact, appraisers do not usually rely on using one method, depending on the property they are meant to assess. Doing this can help them arrive at a more accurate valuation estimate of your property.

There are also some instances where the appraiser that will determine the value of your rental home may prefer to use another method than the Income Approach.

How is each appraisal approach usually done for rental homes?

For the Income Appraisal Approach

This particular approach would often need to know the exact or estimated figure of the annual capitalization rate of the property – which is what is estimated to be the income of the rental home every year. This is calculated by getting the estimated gross rent multiplier and dividing it by the present value of the property.

As an example, if your rental home costs around $200,000 which is the median price of real estate properties in Fort Wayne, Indiana, and have an expected income of $1,500 every month, the annual capitalization rate of your property would be around 9%. For investments, a lower capitalization rate or cap rate is considered to be less risky, which would mean that the return of the invested funds is more bound to happen, when compared to cap rates that are higher in percentage that is seen to be risky.

For the Cost Appraisal Approach

This approach would determine the value of your rental home by putting into account the property’s land value along with the cost for the construction with the depreciated value. Because the cost appraisal approach heavily relies on deciding whether a property can be put into good use, this is more often used on land assets and less on existing rental properties. 

For the Sales Comparison Appraisal Approach

The sales comparison appraisal approach is very popular for many reasons. It can even be used in rental properties as it can also aid in determining whether a comp of similar characteristics has recently sold in the current market and for how much it was bought by the buyer. This can be very helpful in putting a value on a rental property as there is also a high chance that it would be around the same value as the comps around the area. 

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