When financing a real estate purchase or refinancing a farm, residence, or rural property, the appraisal is an important part of the loan process. We find many people have questions about how the appraisal is completed. This is the first of two articles that will explain the valuation process and appraisal approaches used to estimate Market Value.
Valuation Methods
The application of the appraisal process employs three basic approaches to value.
- Cost Approach
- Income Approach
- Sales Comparison Approach
Approaches an Appraiser Uses
Cost Approach
The Cost Approach is a method of valuation whereby the current reproduction/replacement cost of improvements, less accrued depreciation, plus the land value, may yield an indication of value. Depreciation consists of a loss of value from any source and includes:
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physical deterioration
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functional obsolescence
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external or economic obsolescence
In arriving at an estimate of value, the following steps are performed under the Cost Approach:
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an estimate of the value of the land is made “as if vacant”
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an estimate of reproduction or replacement cost of the improvements is made
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an estimate of a percentage of applied depreciation is made for the improvements
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percentage of depreciation of accrued depreciation is extended and subtracted from the costed value of the improvements
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the value of all improvements is added to find the net value
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the land and total depreciated improvement value is added to find the total value of the subject property.
The cost approach is structured on the idea that a person will not pay more for a piece of property than the cost of constructing a similar property with applicable depreciation.
This approach is also utilized for structurally improved properties. For example, if a 5-acre building site can be purchased for $20,000 and a 1,600 square foot home constructed for $150,000, this approach is based off the assumption the buyer would not pay more than $170,000 minus depreciation for a similar 1,600 square foot home on 5 acres. Again, the appraiser takes into account any differences in quality, size, utility, age, and location of properties and makes other adjustments for these differences. Land value is estimated within value ranges indicated by comparable sales with land mix and other appropriate adjustments made to estimate the land value.
Income Approach
The Income Approach is based on the assumption that there is a definite relationship between the amount of income a property is capable of producing and its value. In the Income Approach, the present value of the future benefits of property ownership is measured.
There are several methods and techniques that can be used to estimate income or the income stream. The method that is most appropriate may depend on the property type and the anticipated quality or durability of the income stream.
The process of converting net income into value is called capitalization. Direct capitalization is a method which converts an estimate of a single year’s income by dividing the net income by an appropriate capitalization rate. The appropriateness and selection of the capitalization rate is critical in arriving at an estimated value.
The income approach is based on the principle of anticipation – a property’s present value is a factor of its future potential income. The appraiser analyzes the relationship between future income and today’s values.
Sales Comparison Approach
The Sales Comparison Approach to value involves direct comparison of the property being appraised to similar properties that have sold in the subject area. Adjustments are made to the comparable sale to arrive at an indicated value for the subject. The Sales Comparison Approach is based on the application of the principle of substitution, which states that a prudent person will not pay more for a property than the amount for which a comparable substitute property can be bought.
Although the comparable sales selected are the most comparable available, further adjustments are made to account for differences between the sales and the subject property. These differences or adjustments may include:
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financing
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time
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land
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buildings
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size
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location
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condition
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or any other factors which may have an impact on real estate values in the market
Land mix adjustments account for differences in percentage of tillable or open land, as well as differences in quality or land uses. For example, the subject property may be 70% tillable and a comparable sale may be 90% tillable. The appraiser must make adjustments for this difference.
It is important to note that all three approaches are market-based approaches. All of the data used to analyze the subject is derived from bona fide sales that have occurred within the market. An estimate of market value indicated by each of these approaches comes from market analysis completed by the appraiser.
If you are interested in learning more about purchasing Missouri land or rural property, complete this form to contact one of our loan officers.
