Appraising Income Properties
You've found the perfect deal. You've negotiated the sale price down. The
property inspection went well. Everything is ready to go. Then you approach the
bank for financing.
Suddenly they pull out a long list of things they want to see, one of which is
an independent appraisal of value. Why do they need this and what is an
appraisal?
An appraisal is nothing more than an estimation of the value of a property. The
lender requires it to ensure they do not 'over finance' the property with too
much debt. This is important because if the borrower defaults (doesn't make
their payments), and the lender is forced to sell the property, they want to
ensure they get all of their money back. If they can't sell the property for the
price it was appraised for, they may be forced to take a loss (which they
obviously don't want to do).
Most investors find out quickly that they can't just use any appraiser for their
deal. Most lenders have their own list of preferred ones they insist are used,
even though the investor is the one paying the bill. They do this to ensure the
appraiser has the proper credentials and is not just 'uncle Frank' who will
fudge the numbers a bit in the investor's favour.
There are 3 methods used to estimate the value of a property: Cost approach, Direct Comparison approach, and Income approach. An overview of each one is provided below.
- Cost approach - This method estimates the cost to replace or reproduce the property. This includes the value of the land, as well as materials and labour for the structure itself. It can be used in situations where there are no comparable properties, and the income method does not apply.
- Direct Comparison approach - This method compares the subject property to other property available for sale on the market or already sold. The comparison is quite detailed, describing items such as the age of the structure, square footage, number of rooms, heating and cooling systems, lot size, and more. Value adjustments are made based on the differences between these comparisons, and a final estimation of value is determined.
- Income approach - This method uses the income of the property to determine its value. This is typically done on multi-unit apartment buildings, especially the larger ones. The analysis looks at gross income, vacancies, operating expenses, net income, capitalization rates, yield, and more. The calculations are similar to the ones described in our previous newsletter issues titled 'Analyzing A Real Estate Deal' (parts 1 to 3 and ongoing). The analysis results are compared to market norms for similar property investments, and an estimation of value is determined.
Here are a few things to remember when dealing with appraisers:
- Appraising a property is not an exact science. That's why there are 3 different methods that can be used to determine the value.
- If the appraisal is for the bank, the appraiser will tend to be conservative in their estimation of value. This is to ensure they do not estimate too high to avoid the bank coming after them if they lose money on the property.
- If the appraisal is for you (ie. for the sale of the property), the appraiser will tend to be more aggresive in their estimation of value. This is to ensure a good sale price on the open market, and as a result, a happy client.
- Be sure to ask the lender for a copy of the appraisal. You paid for it, so you deserve a copy. It will provide land vs. building value for your accountant to help determine how much building depreciation to deduct on your tax return.
- Try to accompany the appraiser to the property during the appraisal process. They can be very helpful in suggesting areas to improve your property to increase its value.
To learn more about the appraisal process, take an appraiser to lunch, purchase this month's Recommended Read, or purchase an appraisal for your own property. You will learn a wealth of information just by reading an appraisal report.
This article is copyright © 2004-2010 Spirepoint Properties. All rights reserved.
Paul Blacquiere and Joanne Beehler are full time real estate investors and have been investing in Ottawa, Ontario, Canada since 2002. They are owners of Spirepoint Properties, a Canadian real estate investing company dedicated to making real estate investing easy.
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