When you are looking to buy a home, the appraisal is one of the most important steps in the process. This is the step in the process where an expert will create a document that tells your lender how much the property is worth so that they can determine how much they can loan you for the purchase.
Appraisers use a variety of methods to determine the value of a home, however, these can vary greatly depending on the type of property; 1) single-family homes and, 2) multi-family rentals.
In this blog post, we will take a closer look at how appraisers determine home value for these two types of properties.
What is an appraisal?
In order to understand how appraisers determine value, it is first important to understand what an appraisal is. An appraisal is defined as "a professional opinion of value." In other words, an appraisal is an estimate of worth or value.
There are many different types of appraisals that can be performed on all sorts of different properties - from personal property like jewelry or art, to commercial property like office buildings or factories. The type of appraisal that will be performed depends on the purpose of the appraisal and the type of property being appraised.
That holds true in real estate as well. Although many people would assume that all appraisals are conducted in the same manner, the fact of the matter is that the process to determine value varies greatly between property types. Today, we will focus on residential real estate appraisal - specifically, appraisals for single family homes and multi-family rental properties.
How do appraisers value single-family homes?
Appraisers use a variety of different methods to determine value, but the most common method is the sales comparison approach. With this approach, the appraiser looks at comparable recent sales in order to determine what a subject property is worth. The appraiser will look at factors such as location, amenities, condition of the house, size, number of rooms, renovations, property size and market timing.
This approach is necessary for properties such as single-family homes where one family lives and there is no income generated from the property. Since there is nothing else playing into the value of the property, similar homes in the neighbourhood are used to determine what someone who reasonably spend to acquire this one.
Although there are a number of factors that play into the equation, the location of a home is arguably the most important. If a home is located in a desirable area with great schools, for example, it is likely to sell for much more than a comparable home that is located in a less desirable area. This often even holds true when the house is smaller, in a worse condition and may have a smaller property.
The other factors do plat a role, such as the condition which is also very important. If a home has been well-maintained and updated, it is likely to sell for more than a home that is in need of repair. Deferred maintenance can be one of the greatest deterrents to the appraisal value of a house because they can lead to future damages.
External factors also play a role in the value. At a time when there are fewer people looking for houses, the appraisal value will be lower to reflect the current selling environment. The same holds true during a strong market where there may be limited inventory and lots of buyers.
How do appraisers value multi-family rentals?
For multi-family rentals, on the other hand, appraisers will typically look at the financials to determine the net income and the cap rate for a property. Additionally, they could look at the location, condition of the building and other factors.
The net income of a property is determined by calculating the gross income and subtracting all operational costs. Rent, parking income, storage rentals, utility chargebacks, laundry income and all other sources of income are included in the calculation.
Operational expenses on the other hand include all expenses incurred as a result of owning the property other than mortgage costs and debt servicing expenses. This would include property taxes, utilities, equipment rentals, insurance and maintenance expenses.
Let's quickly look at an example.
Bob owns a fourplex located in downtown Ottawa. To make things simple for Bob, each one of the units is a one-bed one-bath that rents out for $1500/month. He makes no other money from the property.
GROSS MONTHLY INCOME = $1,500 x 4 units = $6,000
GROSS ANNUAL INCOME = $6,000 x 12 months = $72,000
Unfortunately, Bob does have expenses to keep the building running on top of his mortgage. The city collects $500/month for city services, the insurance company asks for $400/month to insure the building and finally his tenants expend $500 in utilities a month that Bob needs to cover. So how much is Bob grossing and netting.
MONTHLY OPERATIONAL EXPENSES = $500 + $400 + $500 = $1,400
ANNUAL OPERATIONAL EXPENSES = $1,400 x 12 months = $16,800
So Bob is actually only netting:
MONTHLY NET INCOME = $6,000 - $1,400 = $4,600
ANNUAL NET INCOME = $72,000 - $16,800 = $55,200
But that isn't really telling us all that much. How can we get the value of the house from here?
So that's where cap rates are used to figure out how much a property is worth. The cap rate is the percentage of the net income that it will earn each year. This number is then multiplied by the purchase price to get an idea of what the property is worth.
Cap rates can vary greatly from one city to the next, from one neighbourhood to the next and even from one property to the next. Smaller markets will typically have higher caps than say a city like New York, poorer and student neighbourhoods will have have higher cap rates compared to wealthier neighbourhoods and finally a brand new building will have a lower cap than a 40 year old one that is falling apart.
They are mostly influenced by the workload and risk associated with the property. More time and more risk means that the cap rate will be higher.
Now back to our example. Given that Bob's rental is in downtown Ottawa, the appraiser may choose to use a lower cap. It's a newer building as well and it's fully rented to young professionals. The appraiser looks at comparables and determines that an appropriate cap rate is 4.5%.
The appraiser will do the following calculation to find the final value of Bob's property.
PROPERTY VALUE = $55,200/4.5% = $1.23M
How to appeal an appraisal if you think it's too low
If you think your appraisal is too low, there are a few things you can do.
First, you can ask the appraiser to reconsider their value. This is called a reconsideration of value, and it's relatively common. The appraiser will usually take another look at the property and make adjustments if they find that they made any mistakes.
If you're still not happy with the appraisal after a reconsideration of value, you can ask for a review by another appraiser. This is called an appeal, and it's a bit more involved than a reconsideration of value.
To start an appeal, you'll need to submit a written request to the appraisal district. The request will include a description of why you think the appraisal is too low, as well as any evidence you have to support your case.
If the appraisal district agrees that the appraisal is too low, they'll order a review by another appraiser. The reviewer will look at all of the same information that the original appraiser did, and they may also talk to you about your property.
After the review, the reviewer will submit their report to the appraisal district. If they agree with the original appraiser, your property's value won't change. But if they think the appraisal is too low, they'll adjust the value accordingly.
Resources for learning more about appraisals
There are a number of resources that include information about the entire process:
The Appraisal Institute of Canada offers a variety of resources for those interested in learning more about appraisals and appraisal theory.
The Canadian Real Estate Association also has a number of resources available, including articles, videos, and webinars.
For more general information about real estate investing, the Real Estate Investment Association is a good resource.
So with all that in mind, how can this help you?
Well it's important to understand how appraisers professionally estimate a property's market value. Understanding the key factors that drive value to the appraiser can help you better estimate the value that the appraiser will provide as well as the ways that you can increase that price.
Leaving your home in bad condition can make it worth less money. Appraisers will look at how well you have taken care of your home and if it needs repairs, they might reduce the value because it will cost more to fix it. It is important to keep your home clean and in good condition so that you can get the most money for it if you ever sell.
As always, if you still have questions, please don't hesitate to contact us directly and one of our investment specialists will be more than happy to answer any of your questions or explain how ReDeal can help you reach your financial goals by investing on autopilot.