When you buy a property and go to the lender to finance your purchase. One of the first things any lender wants to know is whether the property you are buying is worth the money you are borrowing to pay for it. Usually, the lender wants to make sure the property is worth more than the money you are borrowing. The reason is that there is high liquidity risk in the long-term loans and in property assets. The lender needs to make sure even you default the loan in the down market or even something bad happens. It has something of sufficient value to sell and realize its investment returns.
To access the value of a property, the lender will be in charge of picking an objective appraiser. As the value of the property is subject to the House value current market situations and future income expectation, the most-recent appraisal value will be used to underwrite the loan. There are four commonly used approaches when performing an appraisal:
Sales comparison: Sales comparison approach is the most-common form of appraisal for all kinds of properties. It is simple and straightforward. The subject property will be compared to the similar, recently sold properties in the same location. The appraiser then can adjust the estimate by accounting for differences between the comparable properties and depreciation.
Income approach: This method is used for income-producing properties, such as office buildings, shopping centers, apartments and so on. The appraiser collects the data of the rents of the subject property and estimates the value of the property according to a wide range of assumptions. The appraiser compares similar properties in the same market to determine the rental growth rate, capitalization rate, deprecation rate as well as other expenses associated with the property operation.
Cost approach: This method is commonly used to estimate the value of a unique property or properties in areas where few comparisons are available. The appraiser assumes an identical building will be built and estimate the costs of the construction of the building. As the costs are based on the current market prices of the materials and labor costs, the depreciation expenses will be subtracted to reflect the intrinsic value of the property.
Residual value approach: Residual value approach is commonly used to estimate the value of raw land. The appraiser hypothesizes a building will be built on the land and estimate its value according to the current costs of developing the building or the sale price of other similar properties in the same location. The value of the land is then the residual value of the sale price of the property net of the development costs and the profit to the developer.