How do you appraise a property for proper valuation?
New homeowners, landlords, and real estate investors looking to purchase insurance policies on their real estate assets are left with one glaring question: what should they pay for their property taxes and insurance based on the value of their property or properties?
In order to find out how much you should spend on a homeowners insurance policy or commercial real estate insurance policy, you first have to determine the worth of your property or properties in question, also known as “property valuation.”
Property valuations are necessary in many aspects of life, from home mortgage loan applications to divorce settlements, real estate settlements, and lawsuits.
While many homeowners entrust their property valuation to an official property appraiser, it’s important to know the basics yourself before you decide how much insurance you need to buy to protect your investments.
There are three common methods of appraisal used in property valuations: the sales comparison approach, the cost approach, and the income approach.
Let’s review these methods of appraisal so you can determine how much insurance you’ll need based on the value of your property.
- The Sales Comparison Approach
The most common method of property appraisal is the “sales comparison approach.”
This method compares properties that are similar in characteristics, style, location, and included amenities that have sold concurrently or within the same period of time.
The purpose of the sales comparison approach is to allow the homebuyer or real estate investor to compare the sales prices of similar properties before buying.
This forms the basis of “comparative market analysis,” which analyzes and compares the prices of recently-sold homes within the same area.
The sales comparison approach is not an official appraisal of a property, but rather a rough idea of a property’s worth.
It bases property valuation on shared characteristics between properties, otherwise known as “comparables” or “comps.”
Properties are compared based on the number of bedrooms and bathrooms they include as well as special amenities like swimming pools, garages, and tennis courts.
So what are the “comparables” that influence a property’s valuation on the market? They are mainly the characteristics of the property, its location, and other conveniences.
In the sales comparison approach, a property is valued for the sum of its comparables, which are appraised on their separate flaws and merits.
It’s often been said that real estate is “location, location, location.” This is largely true in the sales comparison approach, which looks at a property’s proximity to schools, stores, water features (including lakes and rivers), common areas (including state and local parks), highways and overapasses, and industrial facilities when establishing an appraisal.
Factors like exposure to pollution, whether from industrial runoff or crumbling infrastructure, also play a factor in a property’s valuation through the sales comparison approach.
If a property is near abandoned buildings, for example, leaching contaminants can make it impossible to grow a garden or lead to a poisoned pet.
Recently-sold listings are also valued through the sales comparison approach based on their size, which is measured in square footage. A home’s sale price, for example, is divided by its total size in square footage. This enables the homebuyer to value a property based on size alone.
The price of the property being appraised is compared to other properties of similar size on the market. A median price on properties within the same comparative market is then established and multiplied by the square footage of the property being appraised, allowing homeowners to get an idea of what their home is worth in terms of raw space.
While a sales comparison approach can provide a fairly accurate idea of a property’s worth, the true value of a property is ultimately subjective. One family might be willing to pay more for access to a lake, for example, while another might prioritize quick access to downtown.
2. The Cost Approach
Let’s say you’re shopping for a home in a new development. You’re not sure if you want to build an entirely new home on a purchased plot of land or buy one of the prefabricated homes that are being built by the developer.
The cost approach examines how much it would cost to replace a structure given certain variables including a property’s location, type of structure, and accrued depreciation (reduction in value) over time.
The point of the cost approach is to determine if it’s cheaper to build a new structure or buy an existing one given the comparable costs of newly-built real estate.
Market value is calculated using the cost approach by adding the cost of land and construction while subtracting losses incurred through accrued depreciation.
In some cases, the cost approach is used to create an exact or augmented replica of a historical structure, commonly referred to as a “reproduction cost.”
One of the most famous examples of a historical replica is Nashville’s full-scale replica of the Athenian Parthenon constructed in 1897. The structure is built exactly as it would have appeared in 438 B.C. and even includes a 42-foot statue of the Goddess Athena.
The cost approach is also used in “replacement cost” valuations, which are used when historical structures are replaced but updated using modern construction methods and building materials.
Interestingly, the cost approach is the only method of appraisal appropriate for valuations on properties not traded on the open market, including churches, schools, libraries, government buildings, and hospitals.
3. The Income Comparison Approach
If your property generates passive income, you’ll need to use the income comparison approach to perform your property valuation.
The income comparison approach is the most common method of appraisal for real estate and rental properties, calculating the amount of Net Operating Income (NOI) a property produces compared to its asset value. This is what’s referred to as the property’s “capitalization rate” or “cap rate.”
If a property sells for $150,000 and has NOI of $15,000, the cap rate on the property is 10%.
The point of the income comparison approach is to substantiate a property’s market value based on its gross income potential minus its fixed and variable expenses.
The income comparison approach is used in nearly all large-scale commercial real estate property valuations from small apartment complexes and duplexes to huge office skyscrapers.
Insurance plays a crucial role in property valuation. Investors should always consider how much a property will cost to insure before signing on the dotted line.
Once a purchase has been made, property valuations determine how much coverage is necessary to buy.
Indemnities and assurances guarantees are usually included in property valuations performed by official appraisers but often use outdated information.
As your property changes, so should your policy. Expanding, remodeling, or furnishing your property can change the amount of insurance you need.
Review your property valuation with us. Our friendly Frontlight insurance brokers help you determine what kind of insurance coverage you need whether you’re purchasing a new home or a new hotel.
As the needs of your property or business change, we’ll be there to help you get the proper value from your property valuations. Your future’s bright, with Frontlight.