A few days ago, a friend of mine came to me with some very exciting news. The exchange went something like this:
Him: "I'm about to make a $50,000 paper profit on my house! We are scheduled to close next week!"
Me: "That's amazing! Congratulations! What's your secret?"
Him: "The seller accepted my offer for $150,000. I just got off the phone with my insurance agent, and he told me the value of the house is actually $200,000!"
At this point, my heart sank. My friend had not stumbled into the deal of a lifetime. He just didn't understand the difference between two common appraisal methods: the cost approach versus the sales comparable approach.
The sales comparable approach
The sales "comp" approach, as its known, is the backbone of valuation. Its principles are used across industries -- from the stock market, to the real estate market, to fine art. It is about as close to tangibly measuring supply and demand as we can get. And it's the predominate method used by banks, buyers and sellers, real estate agents, and economists.
The theory is also very straightforward. Imagine two identical houses sit on identical lots directly beside each other. There are no discernible differences between them whatsoever.
Yesterday, one of the house sold for $200,000. Can you guess what the other house's value is? Its a very fair guess to say its $200,000 as well, because the two houses are identical. This is the basis of the sales comp approach: to determine the value of a home, find other homes in the area that have recently sold and are as identical to the property in question as possible.
How do appraisers determine what makes one home comparable to another? Location, square footage, age, materials, lot size, finishings, demographics, and every other discernible feature of the property. The skill of the appraiser is to assess the differences between the two homes and adjust the value appropriately.
This process is as much art as it is science, particularly in areas with dramatically changing market dynamics (i.e., 2008-2011 across the U.S.) or with a limited sample of home sales to choose from.
The beauty of this method is that the value is determined from actual sales from real sellers to real buyers. The appraiser has a certifiable and reliable data point to work from; the challenge is, again, knowing the market well enough to quantify the dollar value difference of similar homes with slight differences.
And, even more importantly, if a buyer and seller have agreed on a given price for a comparable house, it's highly likely that another buyer and seller will do the same for about the same price.
The cost approach
The cost approach is another common method for determining the value of a home, and it must be acknowledged up front that the usefulness of this method is quite limited. Sometimes called the "replacement value" of the home, this method is what confused my friend into thinking he netted $50k overnight.
The cost approach takes into account the value of the lot, the cost of the materials, the floor plan of the home, the likely labor costs to build the house from scratch, and even includes a 10%-20% profit incentive for the builder.
So, what is the point of this method? For insurance companies, it provides the actual dollar value that needs to be insured. If the house burns down, the homeowner (and bank) will want to rebuild the house. If the replacement cost is more than the market value, then without the additional insurance money, the homeowner (and bank) will be stuck funding the difference.
For builders, investors, and homeowners considering building a home, the cost approach can also be useful in assessing the prospects for the new construction project. If there are preexisting homes in the area very comparable to the home to be built, then it makes more sense to build only if the home can be built for less than the existing homes.
But why would replacement cost differ from market value? For newer homes, the variance will generally be less, but for older homes, it can be great. A home built in the 1960s, for example, may have hardwood floors, a brick exterior, and other upgrades that have depreciated over time. The money needed to replace all of these higher-end treatments could push the replacement cost well above the market value, which is depressed because of the home's age.
All appraisals are not created equally
Deep inside the doldrums of the Appraisal Institute's 1,000+ page Uniform Standards of Professional Appraisal Practices guide book are too many definitions of "market value" to count. Expert appraisers can rattle off dozens of variations, each with a different purpose, and each resulting in a different value. For you and me, that much nuance is just not worth it.
Don't let the complexity of modern appraisal theory trick you into thinking your home is worth more or less than it really is. At the end of the day, all that really matters in assessing the value of your home is what you're willing to sell it for, and what a buyer is willing to pay for it.
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