How Do Banks Appraise The Value Of Real Estate In Regards To Financing?
If you are planning to purchase or sell a piece of real estate in the Commonwealth of Massachusetts, then you should be aware of something that can make or break the deal. If a bank or lender is providing financing in order to fund the transaction, they will typically want to appraise the value of the real estate. An appraisal determines the true market value of the property.
This holds true if the real estate is considered to be residential, such as a condominium, single-family house, or multi family house, or if the real estate is considered to be commercial, such as an apartment building, office building, or a storefront. In addition, the appraisal must come in around or above the sales price (depending on down payment) that was agreed upon by the buyer and seller.
What happens if the appraisal value is lower than the sales price?
If the appraisal is lower than the sales price there are a few things that can happen. First and foremost, the seller can lower the price. Obviously sellers do not like to do this because they feel as if they’re leaving money on the table. However, it may be the only way to save the sale and in some cases it’s worth it to the seller to lower their price to fit the appraisal value. Another option is for the buyer to make up the difference. The buyer would need to make up the difference between the appraised value of real estate and the sales price in cash (down payment). Most buyers are not willing or able to do this. First, the buyer needs to have the additional cash on hand in addition to the down payment, which can be difficult. Let’s take a look at the following example:
A buyer and seller agree to a $1,000,000 purchase price for a multi-family home in the Boston, MA area.
The bank requires a 10% down payment of $100,000 from the buyer in order to finance the transaction.
The appraisal value is $950,000.
If the buyer is going to make up the difference, he or she must pay $50,000 out of pocket, on top of the $100,000 down payment. Even if the buyer has the additional $50,000 to spend on the purchase, he or she may not want to purchase a property for more money than it is worth. That is why this method doesn’t usually work. If the seller doesn’t want to lower the purchase price, and the buyer doesn’t want to make up the difference, the buyer may be able to cancel the transaction depending on contingencies that were included in the offer to purchase. Most Purchase and Sales Agreements include this clause. So how do the real estate appraisers determine the value of the properties? They utilize the following methods….
The Sales Comparison Approach
Once the appraiser walks through the property in order to determine its overall condition he or she will typically utilized the Sale Comparison Approach for residential real estate. Residential real estate is a condo, single family home, or building with four (4) residential units or less. The Sales Comparison Approach determines a property’s fair market value by comparing it to similar homes that have recently sold in the neighborhood and nearby neighborhoods to the subject property. These similar real estate sales are called “comparables” or comps in the real estate industry.
The appraiser must also factor in price adjustments due to the fact that no two properties are exactly alike. Here’s a good example. The house that is being appraised, also referred to as the subject property, has a brand new kitchen and the bathrooms have been renovated. However, the comps all have their original kitchens and bathrooms. In this case, the appraiser will increase the value of the subject property accordingly. The appraiser will continue to make adjustments that raise or lower the value of the subject property based on various factors such as the amenities, fixtures, finishes, overall upkeep, and lot size to name a few.
The Cost Approach
Although the Sales Comparison Approach is the main method for appraising residential properties, appraisers may use the Cost Approach if there are not any comparable sales to compare to. In essence, the Cost Approach values the property based on how much money it will cost to replace the real estate using a combination of local labor and local materials. The appraiser begins the process by determining the value of the lot of land. He or she then estimates the cost of rebuilding the property.
The next step is to take the property’s age and overall condition into considerations in order to determine the depreciation. The depreciation amount is then subtracted from the replacement cost amount. Any external improvements made to the subject property are then added to the total. For example, decks, landscaping features, pools, and sheds all add value.
To summarize, the value of the lot of land is added to the cost of rebuilding the property based on local labor and material costs. The age and condition of the property determines the depreciation amount, which is subtracted from the lot of land value and cost of rebuilding figure. Any external improvements are added to the total. That is exactly how an appraiser arrives at an accurate replacement cost for the subject property.
The Income Approach
Appraisers typically utilize the Income Approach, also known as the Income Capitalization Approach, when appraising commercial real estate in order to determine the value based on the amount of income that the property produces. Commercial real estate includes any property that contains commercial businesses as tenants, and multifamily commercial buildings that house five (5) or more residential units. Although the Income Approach is considered to be the most complicated appraisal method, it is based on a simple formula as follows….
The net operating income (NOI) of the rent that is collected is divided by the capitalization rate.
The capitalization rate, or cap rate for short, specifies the rate of return that is forecasted if the investment in the real estate is realized. The Income Approach discounts the future value of the rents by the capitalization rate.
The bottom line is that the Income Approach is based on the net income that the property is expected to generate, and is then calculated by dividing the net operating income by the property asset value. The figure is expressed as a percentage that is utilized to estimate the real estate investor’s potential return on their investment. When utilizing the Income Approach the investor must consider the amount of income generated, along with other factors, such as the condition of the property, in order to determine how much the property is worth on the current real estate market. For example, any significant repairs or updates that must be made to the property could cut into the profit margin in a significant manner.
It’s an exciting time to buy and sell both residential and commercial real estate in Boston, MA and surrounding areas. If you have any questions about how properties are appraised/valued, have general questions about the current real estate market, or you are ready to buy or sell a property, please contact us now!