AMA - Appraisal or Comp Analysis?
Julien in Cambridge Mass asks, "Should I get a real estate appraisal or a comparative market analysis?"
Julien, that’s a great question.
The simple answer is it depends on what you need it for. A comparable market analysis, or what is sometimes called a broker opinion of value is a quick and simple approximation of the market value of a property. However, it’s not of high enough quality for some purposes. Nor will it give you an accurate enough answer in all cases.
Let’s look at the different types of appraisals that can be ordered. Depending on how you constrain the appraisal, you can get a dramatically different result. So it’s important to understand the details of what you are getting.
Generally speaking, appraisers determine the value of a property using one of three methods.
- Replacement Cost
- Comaparable Sales
- Multiples of net income
The problem exists when the three methods don’t agree, which of the three do you select? Generally, the appraiser will choose the lowest of the three. But here too they need to apply judgement and discard the one that doesn’t apply.
The biggest problem in particular for commercial real estate is that in many cases there are no truly comparable properties in the same area. In those cases, a like for like comparison is truly impossible.
If your property is a 10 unit building, there may not be any other 10 unit buildings in the area. There might a 12 unit, a 16 unit, a 20 unit. So what do you compare? Do you compare price per unit? Do you compare price per square foot? Are the properties truly comparable meaning are they of a similar vintage with similar levels of finish and attracting a similar tenant base? If not, then they’re not true comps.
The appraiser will then look at replacement cost. They will look at the finishes of the building, and make a cost per square foot estimate construct the a new version of the same building today. Often times, buildings are trading below construction cost because they might have been built some number of years ago and the increase in value has not kept pace with the rising cost of new construction.
Finally, the third method is multiples of net income. This is where a property is valued on its ability to generate profit. That is, after all why we real estate investors are in this business altogether. The appraiser will look at what, say, B class apartment buildings are trading for in the area. It might be 6.5% cap rate. They will then analyze the financials for your building and determine the income and the expenses for the property based on a bank approved model for properties in the local area.
But here is where things get tricky. Not all appraisals are created equal. They’re not equal if they serve different purposes.
Imagine if a bank asks for an appraisal to value a property under fire sale conditions. What would this property sell for if the bank had to dump it and get its money in under 30 days? That would be a very different result than if the bank asked the appraiser to allow it to list for 6 months.
Sometimes the appraisal is to justify the purchase price for a lender who is about to lend against a property. In that case, the buyer may have got a real bargain. But the appraiser will likely list the purchase price as the appraised value even if the market value was higher than the purchase price. Why would they do that? You guessed it, the client for the appraisal was the bank, and that’s what the bank instructed the appraiser to do.
By now you’re probably getting the idea that the process of determining value is somewhat fluid. If that’s your conclusion, you’d be correct.