How to Think Like an Appraiser
In residential real estate investing one of the biggest factors on finding a good deal is determining the value of the property. If you plan to do renovations, repairs, additions, or new construction you want to figure the ARV (After Repaired Value). Getting that number correct will be the difference between a bad or ok deal to a good or great deal. Most investors establish value one of two ways. They run their own comparables (comps) of like-kind properties or they have a real estate agent provide them with a CMA (Comparable Market Analysis).
A quick guide to “running comps”, as we call it, is to find similar properties within a certain radius of the subject property that have sold recently. For residential homes in urban and suburban areas, generally you look for homes of similar size and condition within ½ mile that have sold in the last 6 months. You typically take the average and that is your value.
When obtaining financing for real estate, the lender hires an appraiser to determine the market value. If the property appraises for the same value or higher than you expected, you have a big sigh of relief. However, the appraised value could come in lower than the investors expected value. This can either kill the deal or require you to bring more cash to the closing. So, if you don’t want to have a cold sweat every time your lender sends an email with the appraisal attached, you should think like an appraiser.
To become an appraiser, you must first have a minimum of two years of training under a Senior licensed appraiser. This is challenging because most appraisers do not want to breed competition for themselves. You also need 2500 hours of report writing plus 120 hours of classroom time.
I met Joe Pat McGuigan (a licensed appraiser with McGuigan and Associates in Nashville, TN) years ago when I was rehabbing homes in West Nashville. I learned it was best to meet the appraiser at the property and go over my plan and even provide some comps I had found. The more properties I purchased over the years the more I would run into Joe Pat. Joe Pat’s father started McGuigan and Associates in 1988. Joe Pat has been a certified appraiser for almost 20 years. I considered him an expert so I would pick his brain on what he was seeing with the market and new trends and we have had some great conversations over the years.
Recently I reached out to Joe Pat and I asked him what is the most common mistake he sees from real estate investors and real estate agents when determining value? He said instantly, “looking only at price/sf.” What does that mean? From the method above, once you calculate the average value you have an average price/sf value. Joe Pat says most borrowers then just use this as a multiplier and that is a mistake. For example, if the average home sold is $100/sf and if the subject property is 2000sf. Then the value should be $200,000. Joe Pat says, not necessarily true. If this were the case would a similar home in the same neighborhood of 1500sf be valued at $150,000? Probably not. Typically, smaller homes sell for a higher price/sf.
You must also consider the floor plan. If the 2000sf home was 2-stories, that is different from a single-level 2000sf home with a basement. “A sale across the street may or may not be a comp”, said McGuigan.
Joe Pat said that in first day of appraisal class they teach the Law of Substitution. In summary, put yourself in the buyer/homeowner’s shoes and ask if that $200,000, 2000sf home they want to buy is not for sale, what would they buy instead?
McGuigan stressed the importance of major characteristics. Is the home across the street from a lake? Then a comp should not be lakefront. Does the home back up to an interstate? Then do not use a comp that is two streets from the interstate. Is the home in a favorable school zone? Then use comps that are also in that school zone. “You really need to understand location and know that market.”
What if you can not find comparables within a certain location or within a recent time such as, in more rural areas or in a down market? Again, you refer to the law of substitution and broaden your search or search a longer timeframe.
Determining an estimated value typically is not difficult if you use these tips and stay conservative. I will say after catching up with Joe Pat, I have the utmost respect for appraisers and the work they do for our industry. He said it is 8-10 years until an appraiser is truly confident with their work. I said, “Wow”.