Of the three main types of real estate appraisals – cost, sales-comparison, and income capitalization – you’ll more than likely be dealing with values based on the sales comparison approach as a residential real estate investor.
What Is The Sales Comparison Approach?
The sales comparison approach is what it says, the value of the subject property is determined by what similar properties recently sold for in the surrounding area.
Now, let’s say your property (the subject property) is a five bedroom home with three bathrooms, but there are no comparable homes that have sold recently that have five bedrooms and three bathrooms. What then?
Well, an appraiser will use what are called “adjustments.” Adjustments are simply value added or subtracted from a comparable property to bring it more in line with the size, condition, etc. of the subject property.
So, if your property is five bedrooms but the comparables (comps) are all four bedrooms, then the appraiser would likely add value to the comps to compensate for the one less bedroom. Similar adjustments would apply to differences in square footage, lot size, and any other differences that the appraiser feels necessitate an adjustment.
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Similarly, if, let’s say, a comparable property had a garage and your property didn’t, the appraiser would remove value from the comparable.
Note: adjustments are always made to the comps; never to the subject property. Here is how adjustments may appear on an appraisal (I’ve blocked out the addresses).
Notice, for example, in comparable sale #1, that $1,000 was added because the subject property has a privacy fence and a shed, but comparable sale #1 does not. This is just one example.
Don’t Overdo It
Now, this is where you need to be careful. Just because an appraiser will do adjustments, they are not going to adjust for everything, and there’s only so much value you’re going to get out of your property.
You can gold plate the floors of your property if you want, but an appraiser will never adjust enough for you you recoup your investment. While that’s a wild example, the point is a valid one.
So, before you starting gutting your investment property and remodeling it from the ground up, you need to know what your property will likely appraise for after your improvements.
Ask your Realtor to run what’s called a comparable market analysis. A comparable market analysis (CMA) is similar to what an appraiser would do. Your Realtor will pull comps for your property and adjust according to the repairs you’re planning on doing.
If your Realtor is fairly good with pulling CMAs, this will give you in indication of what your property will likely appraise for when you’ve completed your improvements. It’s ideal to run a CMA even before you purchase a property to know if its a deal worth pursuing.
If you’re looking to recoup all your money (purchase price + renovation costs), you need to remember that most banks will only loan you 80% of the appraised value. So, your formula for recouping all your money would look like this:
(After Repair Value (ARV) x 80%) – (purchase price + renovation costs) = NEEDS TO EQUAL AT LEAST ZERO.
Additionally, I like to subtract another $1,000 for bank fees, cost of appraisal, etc.
Next, I suggest you check out my post, “How To Lower Your Home Renovation Costs.”