This was a question I got asked today from a frustrated seller. She had called me to get my opinion of an appraisal that was done on her home that had appraised lower than the contract amount. I would like to share with you my answer to her as well as my thoughts on the cost approach to value and its relevance in an appraisal.
A little background is in order before we get into my response to her question. As I stated, she had just received a copy of the appraisal on her home which was under contract, and it had come up short of the contract price. She noted that the cost approach had come in very close to the contract amount but the sales comparison approach was much lower. She asked me why the cost approach couldn’t be given more emphasis in the appraisal since it was closer to the contract price.
The cost approach is one of the three approaches to value, along with the sales comparison and income approach, that an appraiser uses to estimate the value of a property. Unless a property is being rented, or is in a market with numerous rentals, the income approach does not provide a very reliable estimate of value. This leaves the cost approach and sales comparison approach as being the most commonly used approaches to value. The cost approach considers current construction costs while taking into consideration depreciation and then adds in the value of the land. This approach is typically more accurate on newer homes because it can be difficult to accurately estimate depreciation. The last approach to value considered is the well known sales comparison approach, where recent sales are compared to the home being appraised. After adjustments are made for value differences between the subject and sales a range of value is provided that the appraisers uses to reconcile a value estimate from the sales comparison approach.
After these two approaches to value are developed the appraiser must then determine which approach is the most appropriate for the subject. In the past several years an interesting scenario has developed where building costs have continued to rise and property values of existing homes have dropped due to the collapse of the real estate market. Large inventories of homes and an increase in foreclosures and short sales have driven prices down, widening the gap between the cost approach and the sales comparison approach. Sales statistics are showing that the market is in the process of recovering, however there can still be a significant difference between the cost and sales comparison approach to value.
The appraiser’s job is to determine which approach best reflects the market value of the home. Because a reasonable and well informed buyer will typically pick the least expensive alternative, the sales comparison approach is usually given the most emphasis in the final value reconciliation. This is why the cost approach cannot be given the most emphasis just because it is closer to the contract price. The approach that best reflects the actions and motivations of buyers in the market is the one that is given the most emphasis. So as you can see while the cost approach may be similar to the contract price the majority of home buyers will usually look at what other homes have sold for as well as what is available for sale and make an offer based on what they find. This would reflect the most accurate market value and the sales comparison approach would be given the most emphasis.
I hope my explanation has helped you understand how the appraiser would emphasize the sales comparison approach over the cost approach in their final opinion of value. If you have any further questions about how appraisers arrive at the appraisal value leave me a message below.