9 Steps in property appraisal process

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9 Steps to get your property appraisal report for valuation

Nowadays, getting a development loan approved without an appraisal report is impossible. The appraisal report provides multiple expectations of the project's future worth at completion and stabilisation using a variety of generally accepted methodologies. These anticipated values are then "reconciled" into a single value.

Stabilisation is the period during which a property reaches the degree of utility or usefulness that was anticipated. It typically happens in real estate when the property is leased and inhabited in a way that will last for the foreseeable future.

9-Step-Property-Appraisal-Process–Know-What-Your-Home-Is-Worth

What is an appraisal?

An appraisal of a home is a report prepared by a professional appraiser that estimates the value of a property. The estimate depends on recent sales of similar properties, current market trends, and other factors.  

Property appraisals are typically required when selling or refinancing a home.

9 Steps property appraisal process for valuation

9-Steps-property-appraisal-process-for-valuation

Step 1 - The choice of an appraisal firm

After contemplating making a loan, one of your first duties is selecting an appraiser. Then decide the appraiser's assignment (examine the property as a rental, a condominium, or a leasehold; indicate which existing structures will remain, etc.). 

The lending institution is in charge of selecting and employing the property appraisal company. The borrower cannot do it unless there are exceptional circumstances. 

It includes the loan is relatively small, it entails minimal risk, the lending institution is very familiar with the project from prior experience, or the lender is very familiar with the appraisal firm and is confident about its integrity and objectivity.  

Because most lending institutions have a small list of approved appraisers, choosing a property appraisal company shouldn't be challenging. 

It would help if you chose a qualified valuer with a lot of experience with properties like the one against which you anticipate borrowing, whether or not there is an institutional list of approved appraisers. It ensures the creation of a thorough and accurate review.  

For example, the evaluation may be drastically off if you're considering a warehouse loan and the approved appraisal firms have only evaluated residential and retail properties.  

For complex properties like hotels, it's essential to use a business with specific experience. 

The list of approved appraisals is frequently divided by speciality by lenders. You may not choose the best appraiser if top management restricts your options to a narrow group of companies.  

It might be risky to base financing choices on property appraisals created by companies with little experience appraising the sort of property under consideration.  

If there is an appraiser on a more qualified list than the one you have access to for a given assignment, you should recommend utilising them. 

You are responsible for using the appraisal when deciding whether to lend money.  

Given that an appraisal depends on an opinion, you should feel free to form your conclusions if you think it is inaccurate and use them to support your lending decision.  

A lender frequently disagrees with an appraisal if they can support it with solid justifications.

You are on record with your concerns if the appraised value or forecasted cash flow is more or lower than you think it is reasonable, and the loan is later jeopardised.

Step 2 - Hiring the appraiser

Many lenders merely give an appraiser a verbal assignment over the phone. That would be OK for a small, "simple" property, but an engagement letter of some kind is required for newly constructed or improved property appraisals.

Putting what is required of the appraiser in writing protects both parties—the appraiser and the lender—from misunderstandings. You can use a sample engagement letter for a commercial property development project with appropriate revisions to match an individual assignment.

Step 3 - Feasibility of the project

For the lender of new development, the project's feasibility can seem to be foregone. By the time a loan proposal reaches you, much labour and money have been invested in the project. 

The developer needs to be very knowledgeable about the surrounding area, the property, the logic behind the development, the demand and supply in the area, and any natural, market, or regulatory restrictions on the intended development, and the project's overall profitability.  

However, the developer's feasibility assumptions frequently turn out to be incorrect. Because of this, you, the lending officer, should constantly doubt a project's feasibility, especially if you are unfamiliar with the project's location or the kind of property being suggested.  

The property appraisal report contains many important factors to create an opinion and should help you rapidly develop a sense of the area.  

Once you have a better understanding of the developer's logic and how he arrived at the conclusion that their project makes sense, you can start to form your own opinions.

Take a smart move and start using Property Development Feasibility Suite to know your numbers well.

Step 4 - Report content

The appraisal report should include essential facts and figures to support its narrative, assumptions, and conclusions. A broad perspective might help build a foundation to arrange and base initial views.  

Nevertheless, it would be best to exercise caution when extrapolating too much meaning from the macro data and numbers.  

In order to derive helpful conclusions, a significant amount of the data is supplied as filler and frequently has little to no market value.

For instance, citywide statistics could not affect neighbourhood features and trends in crowded, economically diversified cities like Chicago, Los Angeles, San Francisco, and Montreal.

Citywide statistics could be quite deceptive. The feasibility of a project is typically directly impacted by local factors the most.

Step 5 - Find demand and supply

In the home appraisal report, you should anticipate finding a section on local analysis and data covering the future supply of comparable properties proposed for or under development.  

It is frequently discovered when the reporter looks at the quantity, nature, and location of accepted building permit applications. Those details are publicly available. 

You should carefully assess the site's attractiveness in light of the significant increase in supply if there is a lot of building around the neighbourhood.

Lenders and developers frequently recognise prospects in the exact location simultaneously.

When numerous developers complete properties of a similar type simultaneously, an imbalance may result where the supply exceeds the demand in the future. 

As a result, future revenues have a greater likelihood of declining, and future absorption periods have a greater likelihood of increasing compared to a completed project where absorption of space and income are at a set level immediately measurable today.

Step 6 - The loan proposal

Writing reports and loan presentations is a significant element of a lending officer's job. In those presentations, portions are devoted to describing the project's location.  

It is frequently quite helpful to incorporate this information in your loan write-up, regardless of how helpful the appraiser's data and narrative material are in forming your conclusions. 

You can use most of it in your analysis with very little modification. It gives the loan proposal more substance, is simple to copy and may be helpful to individuals who will read it and maybe approve the loan. 

If nothing else, these facts appear credible when used wisely.

Step 7 - Appraisal's conservative bias

There are various reasons why the appraiser favours conservatism. 

The main one is that, in contrast to completed properties, real estate improvements that are to be built present the appraiser with an additional obstacle because they must make assumptions about and assign a value to something that does not yet exist.  

As a result, the assessed value of a development project may differ from the established future value of the finished property. The appraiser will probably be conservative because of the greater uncertainty about the final value. 

The appraiser's awareness that their appraisal of the home may be the subject of criticism when a loan encounters difficulties is another factor contributing to their conservatism.  

They intentionally produce conservative values because it is usually their best course of action. Since they need to keep working for your lending institution, they must produce conservative values.

The loan will be repaid as intended, and nobody will give the appraisal any consideration if the property appraised value is less than the final real value of the completed project and interest and principal payments are made as anticipated.  

The evaluation's applicability will decline over time. However, the property's value at completion may be disappointingly lower than anticipated if the project or the property market performs below expectations.  

It can happen when loans are taken on properties in "pioneering" neighbourhoods where you can't test the market consistently. The appraised value can be close to the property's final genuine worth because the assessment was created cautiously. 

Other justifications have to do with appeasing the credit evaluation officer of the lending institution. Institutional credit review officers prefer appraisals that include lower-than-actual-value estimations.  

The credit officer and those who initially helped make the loan decision also want to be seen as conservative.  

When a conservative judgement of value is conveyed, the consequence is a smaller, more conservative loan since a problem loan is frequently the result of an over loan position, which involves lending too much money against the value or the cash flow from the property that serves as the loan's collateral.  

As a result, the risk of over lending is diminished. Furthermore, even unjustified guilt can harm or ruin a career regarding "poor" loans.  

Therefore, despite their history of continuously projecting values below actual values as determined at project completion, the credit officer will encourage the use of conservative appraisers through his influence over the loan approval process and potential control over an approved appraiser's list. 

Because of all these factors, the appraiser can quickly come up with value estimations that are lower than the developer's and possibly yours.  

The lending officer's primary responsibility is to create loan presentations, as opposed to the credit officer, whose primary duty is to assess loan presentations.  

A lending officer shouldn't overly avoid taking risks, but it never hurts to project a conservative aura.

Step 8 - Influencing the property appraisal

Because appraisers want to keep getting assignments, they typically strive to please you, their customer. You can occasionally manipulate the appraiser to produce a report with values slightly higher (or lower) than they would otherwise report.

It would be best if you delicately expressed your concern up front to ensure that the appraiser is not undervaluing the property. It is less probable that the appraisal will be altered once it has been produced and presented.

Influencing-the-property-appraisal

Greater values

Management favours the loan - Ask the appraiser to evaluate their report if you and top management favour the loan.

An assessment that results in a higher but entirely defensible value can eliminate an exemption rather than making a credit policy exception against a required loan-to-value or debt service coverage ratio.

Flexibility - Having flexibility for oneself is another motivation. Consider a situation where a lender, who thought he was responsible, makes a loan on a project that encounters difficulties during construction and then discovers that he has a loan on an incomplete, high-risk project.  

The borrower may request him to cover additional costs to complete the project, thereby lowering the risk. 

A loan amount increase may be the best option if the genuine, unbiased predicted value after completion is significantly higher than the suggested, increased aggregate loan amount. 

Consider a scenario in which the appraised value of a completed home is % of the existing loan commitment, which equals a loan-to-value ratio of 65% (the reciprocal value of 154% is 65%).  

There is a 35 percent margin of safety before the property value exceeds the loan amount, assuming that the property can achieve the value. 

There is less room or no margin to increase the loan amount when the home loan depends on an assessment that undervalues the property. 

In the example above, if the value of appraisal is overly cautious, resulting in an 80% loan-to-value (LTV) ratio, the lender has only a 20% margin of comfort before losing all its borrowed funds.  

A fake "over-loan" scenario is formed if the lending institution has a maximum LTV policy of 80% and the loan amount is increased.

Although this is not the case, the evaluation may have many unfavourable and expensive effects.  

In this instance, it might prevent or at the very least postpone the lender from providing further financing, which is likely the best course of action for home loan recovery.  

Even worse, it may lead to an incomplete project with a subpar exit strategy.

Market conditions - Market conditions and lending institution rivalry are a third reason to reject a conservative assessment. There is more competition for customers when there are more lenders available.  

Unless particular loan departments (and you) become more aggressive, this may limit market share and profitability. Higher appraised values allow loan officers to make larger loans more competitive. 

Larger loans help the lending institution become more competitive and boost its revenue. Of course, they also raise the risk.

The correct value

Regarding the discussion above, you, the loan officer, will typically seek a value that is as objective as possible. If there is a bias, you prefer a positive over a negative one.  

Because you almost definitely know the borrower and the transaction the best, a favourable bias provides you more personal control over the credit decision.

Low values may make it difficult for you to make a larger home loan that you fully believe in due to your institution's LTV ratio requirements. A higher value gives you more freedom to make a bigger loan.  

If you want, you can still make a smaller, more "conservative" loan with a lower LTV ratio.

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Step 9 - Appraisal evaluation

You can fill a decent-sized library with books and material about the property appraisal process.  

Fortunately, a typical narrative assessment will include the factual data, list every appraiser's assumption, and describe in-depth how each assumption was used to arrive at each result.  

You don't have to be an appraiser to comprehend how the appraiser arrived at their assessment of worth. You only need to read the property appraisal. 

Frequently, a junior non-designated appraiser completed all the work, which the professional appraiser then approved after a quick assessment. A lending officer cannot evaluate an appraisal report to determine its quality. 

Although you are responsible for reviewing the evaluation report, especially its approach and thoroughness, you could find it difficult to confirm its accuracy. 

It shouldn't be a significant concern because, by the Guide Notes to the Standards of Professional Appraisal Practice and the Uniform Standards of Professional Appraisal Practice promulgated by the Appraisal Standards Board of the Appraisal Foundation, a licenced appraiser will state all the facts as he knows them truthfully and accurately. 

The relevance, application, and interpretation of facts should and could be assessed.

The three crucial property valuation methods

The three fundamental valuation techniques are the market, income capitalisation, and cost approaches. 

The following is a brief overview of the essential property appraisal methods.

The-three-crucial-property-valuation-methods

1. Market approach (Sales comparison approach)

The market approach is the most well-known method, and if it is applied correctly and efficiently, it is the best measure of value for the needs of a construction lender.  

Since most real estate transactions are registered in the municipality where the property was transferred, the appraiser or real estate agents can get recent sales data from the local office of records. 

The market strategy requires that there be a reasonable number of recent sales of properties that are comparable to the ones you may borrow against in the immediate neighbourhood. Comparable sales, or comps, are the name given to these sales. 

The appraiser locates each property on a map, displays a photo of each with some notes, and uses the information gathered to build a table known as a similar sales grid. 

The substitution rule is then used when the data have been obtained: An investor won't spend more money on a specific property if he can get a better attractive property for less money elsewhere.  

The appraiser adjusts the comps on the grid (adjustments) by adding and subtracting percentages of the recorded sales price based on several variables, including the sale date, the location, size, configuration, and condition of recently sold homes. 

Adjustments essentially level the playing field by accounting for variations in relatively similar features.

A comparable sales grid includes the following adjustment categories -

Finance conditions - It must be considered if some comparable sales had advantageous financing circumstances, including a seller-provided mortgage with a low-interest rate.

Terms of the sale - Sales that aren't at arm's length, such as those to relatives, may have special terms that impact the real value of your property.

Market circumstances - The possibility that market conditions were different rises as the gap between comparable sales widens.

Location - Most property valuations account for local variations, such as the prestige of the immediate area, views, traffic, and the accessibility of transit.

Size - Smaller constructions may sell for more or less per square foot than more significant structures, depending on the property's location and type of land. 

Adjustments must be grounded in actual market data for the specific type of property, not merely gut feeling.

Utility - It measures the property's usefulness. For instance, a retail basement that is unfinished will be less functional than one that is.

Condition - Age, obsolescence, and wear can impact a property's state. Typically, a newly constructed property is worth more than an older one. However, there are several exceptions, especially if a historic building has attractive or desirable features.

Each sale is compared to the asset being valued in the grid-creation process. The fact that some persons may find the direction of modifications to be counterintuitive is a crucial consideration in this case.

The appraiser locates each property on a map, displays a photo of each with some notes, and uses the information gathered to build a table known as a similar sales grid.

2. Income capitalisation approach

The basis for the income capitalisation property valuation method is a simple formula:

Income-Capitalization-Formula

Knowing the property's net income and calculating a cap rate can evaluate its value using the income capitalisation approach.  

If the facility is built and functioning at or close to stability, the seller will give the appraiser the net operating income (NOI). Otherwise, the borrower will submit an estimate of whether the property is a construction site.  

On existing properties and almost always on projects that have yet to be built, you must assess gross rental income from tenants, vacancy rates, and running costs.  

Data on revenue and costs are gathered from previous evaluations, supporting documentation, and owners of comparable buildings in the study area.  

The appraiser compares each property's rentals and expenses to the one being appraised, called the subject. The appraiser uses a grid that considers elements including location, property size, and amenities, just like in the market approach. 

After calculating the NOI, the appraiser next attempts to calculate a cap rate based on recent local sales and NOI statements of comparable properties in the nearby area.  

You can determine the cap rate by dividing the NOI by the sales price.

Cap Rate = NOI/Purchase Price.   

The cap rate is typically entirely accurate when calculated directly from actual transactions. The value estimate should be highly accurate if the NOI is calculated correctly, excluding any unforeseen exogenous influences.

Here is an example of a cap rate calculation from actual sales transactions:

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Cap Rate Calculation

Property

NOI

Price

Cap Rate = NOI/Price

Office building 1

$600,000

$6,425,000

0.0933

Office building 2

$825,000

$14,030,612

0.0588

Office building 3

$320,000

$3,043,000

0.1051

Office building 4

$1,050,000

$12,529,000

0.08

Office building 5

$900,000

$12,153,000

0.074

The weighted average NOI/Price is 0.083. This equals the cap rate.

Like the market strategy, the appraiser places each property on a map, describes each in an image, creates a similar lease grid, and then adds and subtracts from it (adjustments). 

The appraiser adjusts the initial cap rate to arrive at the final cap rate. For instance, the appraiser might deduct an estimate of the percentage rise in the property's NOI from the initial cap rate. 

He might also include a percentage component for obsolescence and depreciation. A final adjusted cap rate is the outcome. The equation is

Final Capitalisation rate = Initial Rate - Expected Growth% + Obsolescence and Depreciation%

Be aware that the property's value increases when NOI is split by a lower cap rate and decreases when NOI is divided by a higher cap rate.  

If a potential investor needs a return of 10% and the property's NOI is $100,000, he will make an offer on the asset of no more than $1 million to earn at least a 10% return:

Cap-Rate-Formula

Cap Rate = $100,000/$1,000,000

= 10%

Method of discounted cash flows

The discounted cash flow technique is a variation of the income approach property valuation method that takes time into account. It only uses a property's stream of periodic NOIs and its residual value, representing the sale of the property that is anticipated to occur after the analysis.  

The present value is then calculated using a discount rate compared to a cap rate. This present value represents the property's value. The discounted cash flow approach is beneficial when NOI or sales activity is expected to fluctuate.

3. Cost approach

The cost approach of property valuation is predicated on the idea that anyone purchasing a finished property will not pay more than the land's or fee interest's worth plus the cost of any modifications made to it, adjusted by a depreciation and obsolescence allowance.  

It simply entails adding the complex expenses, the soft costs, the estimated financing charges, and the builder's profit to the land value

The cost approach is practical; however, the standard techniques used to determine hard costs is frequently imprecise.  

Fortunately, the construction lender can rely upon the inspecting engineer, who is more trained and experienced in predicting construction expenses than the appraiser.  

Additionally, you can create your top-down estimates if you have additional project proposals comparable in type and scope to the one you are concentrating on.  

As a result, the cost approach should often not be utilised as the central estimate of value in evaluating a property that will be developed. 

However, contrasting it with the developer's (and the inspecting engineers) cost estimate can offer a beneficial check. A significant variance should be questioned, mainly if the appraiser's cost estimate is significantly higher.

Bottom line

In a detailed report of the property appraisal, assumptions and conclusions depend on openly disclosed facts and data for the reader's consideration. 

It's crucial to remember that the property appraisal is never 100 percent accurate and objective. You have a chance to develop your own opinions. 

It's a prevalent misconception that lenders, especially seasoned financial professionals, review only an appraisal summary page. 

Those who have worked in lending environments where appraisal conclusions are considered absolute, no matter how properly or poorly expressed, can comprehend this notion.

FAQs

Why are property valuations important for a local real estate agent?

If you're a local real estate agent, then you know that property valuations are important when it comes to helping your clients buy or sell a home.

After all, the potential market value of a home is one of the most important factors in determining how much someone is willing to pay for it.
A property valuation report will give you an idea of what a property is worth, based on recent sales data and other factors.

This can be extremely helpful when it comes time to negotiate a price with a potential buyer or seller.

It's also a good way to stay up-to-date on changes in the market value of properties in your area.

How do home appraisals affect mortgage?

Home appraisals are a projection of property's estimated market value. It's used in the mortgage process to determine how much money a lender will give a borrower to purchase a home.

The appraisal is based on factors such as the size and condition of the property.

In case of low appraisal, the potential buyers may need to bring more money to closing or renegotiate the selling price.

If the appraisal comes in higher than the purchase price, it's possible that the lender may only lend up to the appraised amount, and any extra funds would have to come from the potential buyers.

What is the purpose of an appraisal in real estate?

After you've put an offer on a home, the next step is to get an appraisal. An appraisal is basically an estimate of how much the home is worth.

The lender wants to make sure that the loan amount they're giving you isn't more than the value of the home, so they'll order an appraisal.

Appraisals can sometimes be a bit controversial because different appraisers can come up with different values for the same property. Some appraisers may be more experienced than others, or may simply have different ways of valuing a property.

If you're really not happy with the appraised value, you could try to get a second opinion from another appraiser.

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