Real estate appraisal is a service performed by an appraiser that determines valuation (what property is worth) and legal use (highest and best use).
There are three approaches to determining the fair market value of a property, cost approach, sales comparison approach, and income approach. In theory, if all three approaches are utilized to appraise any given parcel, the resultant values will be the same. In practice, however, some properties and some situations lend themselves to the use of one approach over another.
The Cost Approach is sometimes called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. It is the land value, plus the cost to reconstruct any improvements, less the depreciation on those improvements. The value of the improvements is sometimes abbreviated to RCNLD—reproduction cost new less depreciation, or replacement cost new less deprecation. Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials.
In most instances, when the cost approach is involved, the overall methodology used is a hybrid of the cost and market data approaches. For instance, while the cost to construct a building can be determined by adding the labor and materials costs together, land values and depreciation must be derived from an analysis of the market data.
The Sales Comparison Approach looks at the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject
The Income Approach capitalizes an income stream into a present value. This can be done using revenue multipliers or single-year capitalization rates of the net operating income. Net operating income (NOI) is gross potential income (GPI) less vacancy (= Effective Gross Income) less operating expenses (excluding debt service or depreciation charges applied by accountants). Alternatively, multiple years of net operating income can be valued by a discount cash flow analysis (DCF) model.
Automated Valuation Models (AVMs) are growing in acceptance. These rely on statistical models such as multiple regression analysis and geographic information systems (GIS). There is growing evidence that AVMs are not accurate. This is most evident where there is a renewal or "revitalization" of a particular area or neighborhood. There can exist within a single city block homes that are in poor condition to homes that have been completely rehabilitated and in good to excellent condition. The differential of sales prices can be demonstrated to be from 50% to 125%. This can lead to an inaccurate model. Extreme caution should be exercised when relying on these AVMs.
"The Appraisal of Real Estate, 12th Edition," by The Appraisal Institute ([www.appraisalinstitute.org]) is an industry recognized textbook.