Does your property tax assessor think you live in a mansion while your banker thinks you live in a hut? The appraised value is an important factor in determining mortgage amounts. Property valuations often seem arbitrary and different professionals can come up with different values. A great example of different opinions is that a seller often thinks their home is worth more than a potential buyer.
The true value of your home is the price you and an arms-length buyer freely negotiate. When you are buying your home the appraised value is easy. It’s simply the purchase price. The mortgage company will still want an appraisal to confirm that the property meets their guidelines and the appraiser will make every effort to support the purchase price. After all, it’s the free market that establishes the price.
So how does your mortgage lender come up with a value if you aren’t selling your home? Your mortgage lender will contract a professional appraiser. These appraisers are independent and unbiased when determining value. They can draw upon three basic methods. These are the Cost Approach, Income Approach and the Direct Comparison Approach.
The Cost Approach is the estimate of what it would cost to build your house on its current lot. Building costs are well established for most residential houses, but would not be easy to establish for apartment condominiums. This approach is most useful when the lot price is known or easily established. Most appraisers establish a Cost Approach valuation for reference, but give it little weight.
The Income Approach is only relevant for income producing properties, and could be used for rental properties. The premise is that rentals return a similar rate of return to landlords and that the condition/size/location of the property establishes market rent. This market (or actual) rent is then grossed up by the appropriate yield. For example if landlords are typically earning 5% return on their investments then a rental property receiving $20,000 per year in rent would assume to be worth $400,000 ($20,000 / 5%).
The Direct Comparison Approach is the most commonly used approach and is given the most weight by residential property appraisers. This approach is particularly effective in residential settings with many similar homes. If your neighbour had the exact same model home in the same condition and it sold yesterday, then your home would be appraised at the same value. In real life it’s not quite that easy. The appraiser will research recent sales of similar homes in your neighborhood and pick the 3 most relevant. Adjustments will then be made for any relevant differences, like square footage, condition and upgrades.
The real value of your home is theoretical until you decide sell it and the laws of supply and demand kick in. All in all professional appraisers do a good job in establishing a value. If it wasn’t for this unbiased determination, re-mortgaging your home would be difficult and in some cases impossible.