Ever notice on popular home improvement TV shows how the appraised value of the homes are seemingly pulled out of thin air? It seems, through the magic of TV, that the real estate agent, host, celebrity, or repairman can simply divine the exact dollar value of a home from the direction of the wind. Or maybe it's the smell of the grass on the lawn?
In the real world, there is a little bit more to the process. A proper appraisal will include market research, a little math, and also a little bit of gut feeling from the appraiser to determine the house's "market value."
But market value is not as straightforward as it may sound. Taking a little time now to understand exactly how this estimation works will go a long way toward winning the negotiation and maximizing the bang for your real estate buck.
Defining "market value"
Defining value for the purpose of an appraisal can be tricky. We all have some intuitive sense for the definition of value, but for many people, it's a hard concept to articulate. The Uniform Standards of Professional Appraisal Standards (called "USPAP" for short) is the Bible of the appraisal industry, and it does a very thorough job of defining market value.
Market Value means the most probable price which a property
should bring in a competitive and open market under all conditions
requisite to a fair sale, the buyer and seller each acting prudently and
knowledgeably, and assuming the price is not affected by undue stimulus.
Implicit in this definition are the consummation of a sale as of a specified
date and the passing of title from seller to buyer under conditions whereby:
1. Buyer and seller are typically motivated;
2. Both parties are well informed or well advised, and acting in
what they consider their own best interest;
3. A reasonable time is allowed for exposure in the open market;
4. Payment is made in terms of cash in U.S. dollars or in terms of
financial arrangements comparable thereto; and
5. The price represents the normal consideration for the property
sold unaffected by special or creative financing or sale
concessions granted by someone associated with the sale.
Catch all that? Summarily, the market value of a property is the price for which a buyer and a seller agree to do the transaction, assuming neither is under the gun (i.e., the house is about to go into foreclosure), the house has been on the open market for an adequate period of time, and it's a standard transaction with cash and/or a bank loan.
Think about the stock market for a moment. Every time you buy a share of a stock, someone must be selling it to you. You must be willing to pay the quoted price, and the seller must be willing to take that amount of cash in exchange for her share. It's exactly the same concept.
Please don't think I'm beating a dead horse, here. The nuance of this definition is critical for both buyers and sellers. Take the bank's perspective for a moment.
Banks typically require a down payment of 20% for a traditional mortgage loan. Then they take the house as collateral. Ever wonder where that 20% figure came from?
It's simple: in the event the bank must foreclose on the home, they will take ownership of the house to try to get their money back. If you were buying a home out of foreclosure, would you want to pay full price, or would you low-ball the bank for the deal of a lifetime?
Another example: Since the financial crisis, many large institutional investors have purchased thousands of single-family homes across the nation. Typically, these investors seek to rent out the property in the short term, then sell it for a handsome profit in a few years, when the market rebounds.
Who will pay more for a house, these investors, or that family of four moving to the area for their jobs who love the location, school district, and the recently updated "chef's kitchen"? The institutional investor cares about dollars and cents. The family cares about a whole lot more than that.
If you are a buyer or a seller, understanding these nuances can go a long way to getting the most bang for your buck. If you're selling, ask yourself who the most likely buyer for your home is. Is that buyer willing to pay more or less than another type of buyer? How will your real estate agent help you market your home to that higher-value buyer?
And for buyers, are you negotiating from a position of strength? Is the bank breathing down the sellers' neck? Who are you competing with to buy that dream home?
Just because a real estate agent tells you a house is worth some amount of money doesn't mean that's what you have pay. Understand the market, do your homework, and don't be afraid to play a mind game or two before signing on the dotted line.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.