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The secrets of estimating real estate values
With skyrocketing home prices over the past two years, it's harder than ever to put a realistic price tag on your home, sweet home. FOX 5 real estate expert John Adams talks to Buck Lanford about how you can set a price without leaving money on the table.
ATLANTA - With skyrocketing home prices over the past two years, it's harder than ever to put a realistic price tag on your home, sweet home. But if you hope to sell, you're literally forced to decide on an asking price. How do you set a price without leaving money on the table? FOX 5 real estate expert John Adams is sharing the secrets of estimating real estate values.
With the economy slowing down, real estate valuations are critically important. If you ask too much, your house will languish on the market, and be used by agents as an example of an overpriced house. On the other hand, no one wants to leave money on the table at closing.
The secret to real estate valuation is in the definition of the term "fair market value:" FMV is that price at which a typical seller agrees to sell, and a typical buyer agrees to buy. It sort of becomes a self-fulfilling prophecy.
The assumption here is that both the buyer and the seller are knowledgeable regarding the marketplace, and are not under any undue pressure to agree to a sale. And the final price does not actually need to be fair. In fact, the appraiser's governing body, the AIREA, actually removed the word fair from the definition a few years ago, since the word fair is largely subjective in nature.
Licensed appraisers use a three-step approach to estimate what a typical buyer might be willing to pay for a particular piece of real estate. Let’s look at each one:
1. Replacement Approach
The replacement approach assumes that your house is burnt all the way down to the soil. There is nothing left but the land itself. So now we have two questions to answer: What is the land worth? And what would it cost to build back an equivalent house in today’s dollars?
The value of the land is a function of its location. A half acre lot in Buckhead might cost half a million dollars by itself. That same half acre in rural Georgia might cost much less. We typically think of land value as about 20% to 25% of the typical home value in that same neighborhood.
Now comes the tricky part. What would it cost to rebuild the house that has burnt to the ground? The answer is usually quoted in dollars per square foot of completed construction. But the appraiser knows that it is impossible to build back the exact same house. Codes have changed, materials have changed, professional labor has changed. So in the end, this is simply an educated guess.
A current typical cost for good, standard grade houses in Georgia is about $150 per square foot. So a 3-bedroom 2-bath frame house with 2000 square foot might cost about $300,000 to build. Add maybe 25% for the land ($75,000) and we are looking at a replacement approach valuation of $375,000.
2. Income Approach:
A totally different way of estimating value is to try to determine the income that a particular piece of real estate might generate over its lifetime.
This approach is particularly helpful when looking at a property built primarily for investment purposes, such as an apartment building or a shopping center. Unfortunately, when it comes to a single family home, it is harder to draw a correlation between potential monthly rent and value. That’s because the vast majority of homes are purchased for owner-occupancy, not for rental. And owner-occupants often value many less tangible factors to a high degree. For example, are the schools good? Is the house located near the family church? Is there a creek in the backyard?
So if the house above might rent for $2,400 a month, it could generate $28,800 annually in gross rent. Industry experts use a number called a gross rent multiplier (GRM) to estimate value from the rental income. The current average GRM in the US is 14.77, so if we multiply 28.8k x 14.77, we get an estimated value of about $425,000.
3. Comparable Sale Approach
The Comparable Sale Approach uses recent nearby sales of similar homes to try to predict what a typical buyer might be willing to based on past transactions.
So if every home in the subdivision is almost identical, and three or four homes sold in the past 12 months for $395,000 each, then the picture becomes much clearer. The house is worth $395.
However, if there is a lot of diversity in home styles and sizes, this process becomes much more difficult.
For example, in the Druid Hills section of metro Atlanta, there are many historic homes, and no two are exactly alike. Some are older mansions, others are modest bungalows. To make matters worse, there is almost no new construction except in the case of a teardown.
Since the Comparable Sale Method is thought to most closely reflect typical buyer behavior, this approach usually is considered the most indicative of market value, and carries the most weight in the appraiser’s final estimate of value. That being said, appraisers will often utilize all three approaches to give them an overall feel for valuation.
The bottom line is an appraiser is hired to bring some level of consistency and professionalism to real property valuation. They blend knowledge, skills, and experience into their craft. But the bottom line is that any appraisal is an estimate of value on a certain day. It will likely be a different number, high or lower, tomorrow and the next day and so on.