By Freddie Taylor
The longer you are in the real estate industry, the more you realize the importance of property valuation and real estate comps. As many real estate agents, loan officers, buyers, and sellers can attest, a closing can fall apart if the value isn’t there.
Everyone has a story about a deal dying on the desk of an appraiser. Everyone involved in the deal believes the property is worth $200,000 and the contract is written up at that value, but the appraisal comes in at $175,000. Immediately, everyone believes something is wrong with the appraisal and it should be higher. Believe it or not, sometimes the value just isn’t there. The real estate comps just are not available.
To avoid these costly errors, you must understand three fundamental concepts of residential property valuation and the appraisal profession. These three concepts are Comps, Proximity, and Condition.
Concept #1 – Real Estate Comps
What are comps? A comp, or comparable property, is a similar property sale used for comparison in the appraisal valuation process. A real estate appraiser utilizes comparable properties to support an opinion of value in an appraisal. Comparable properties are central to value conclusions based on the sales comparison approach to value.
The sales comparison approach to value is a set of procedures in which a value indication is derived by (1) comparing the property being appraised to similar properties that have been sold recently, (2) applying appropriate units of comparison and (3) making adjust-ments to the sale prices of the comparable properties based on the elements of comparison.
The sales comparison approach is the best method to find value for residential real estate appraisers. It is also the most common and preferred method of residential real estate valuation when an adequate supply of comparable sales is available. (Source: Dictionary of Real Estate Appraisal, Fourth Edition)
Comps are the essence of property value. Appraisers use them to support their value conclusions. Comps are like evidence to an attorney. Court cases are built on evidence. Values are built on comps and it is the availability of comps that determine value. You may think a property is logically worth $200,000 but if there are no recent comps available, then the value cannot be supported.
Concept #2 – Proximity
Proximity is the name of the game in real estate. Location. Location. Location. The number one factor in selecting a quality comp is proximity to the subject. The comp must be close in proximity in reference to time (the date the comparable property sold) and physical location (distance to the subject property).
The general rule is that property sales must have occurred within six months of the date of the appraisal. Obviously, the more recent the comps have sold, the better. Most appraisers and reviewers will allow sales that have occurred six to twelve months. Sometimes this is not always possible. The critical thing to remember is that comps are closed sales, not pending or active sales. Why? Think about it. How many times have you seen a property listed for say $200,000 that actually sold for $185,000? This occurs often. Therefore, value conclusions cannot be dependent on active or pending sales.
As far as physical location, the radius used by an appraiser is one mile and within the subject property’s neighborhood. These are not mutually exclusive. A comparable property could be within one mile, but not inside the subject’s neighborhood. Similarly, a property can be within the neighborhood, but not within a mile of the subject property. (Remember: The appraisal is subjective and each appraisal is bound by the assumptions made by each appraiser.)
A neighborhood is a geographic area in which similar properties effectively compete with a subject property in the minds of probable, potential purchasers and users. These limitations increase the likelihood of several factors that influence value. There are similar social, economic, governmental, and environmental factors. In addition, similar land value and quality of construction can be expected.
By definition, comparable properties can be substituted for the subject property. Therefore, they have similar access to highways, shopping, schools, employment, parks, and Houses of Worship, while being affected by the same crime rates and statistics. All of these elements are important when determining value.
Land value is a critical element to consider when choosing comparable properties. Limiting comparable properties to those within one mile and inside neighborhood boundaries increases the likelihood of similar land values. Homes that are similar in almost all features but differ in land value could upset the appraisal valuation dramatically.
Finally, quality of construction is a very important element in locating comparable properties. Utilizing comparable properties within one-mile and inside neighborhood boundaries is useful in narrowing the number of potential comparable properties. Of course, there are exceptions to the rule where these factors may be drastically different from one street to another, but the appraiser will do his/her best to select comparables that are similar to the subject property.
It is crucial for investors to get intimate with the areas in which they are investing and further understand the neighborhood boundaries of these areas. As an example, brick row houses in Pullman sell at different values than those in Pullman’s Historic District. This can be as large as a five figure difference in value.
As an example of a street being an important boundary, take the Chicago Lawn neighborhood and West Englewood where Western Avenue is the dividing street. Comps should not be selected from across this street as values dramatically change here. On the West Side of Chicago, North Avenue in the Austin area provides another significant boundary. Investors should perform their own research and notice the difference in values by crossing these streets. There are many more examples like this in the Chicagoland area. Finally, entering into a different city is typically out of the question, except for extreme circumstances, but not likely to be well received by an underwriter of an appraisal.
Concept #3 – Condition
Condition is the critical step in selecting real estate comps, or comparable properties. Property condition refers to its state of maintenance. The property condition is an estimate based on property inspection, observation, knowledge, and the quality and workmanship of recent improvements.
If the subject property is in average condition, it should be compared to properties in average condition. Bad comparables lead to bad appraisals. Often times, bad comparables are chosen in this phase of analysis by real estate agents, investors, buyers, and sellers. Subject properties in average condition are appraised using comparable properties of superior condition. This is not a problem if noted and the appropriate adjustments are made for the differences. But in bad appraisals, they typically are omitted.
It is important to understand that the real estate appraisal is not a science, but a subjective opinion based on research, experience, and inferences. However, there are some basics that should be applied by everyone.
The condition of the subject property is important because this is what determines which comparable properties will be used to determine value. If a property is wrecked, beat up, damaged, a handyman special, a distressed property, or generally in bad condition, you cannot compare it to properties that have been completely rehabbed. Properties that have been rehabbed and are in good condition sell for more than properties that need repairs. This creates the opportunities for investors.
These are a few things to consider:
- Overall condition is rated on a continuum: Poor, Fair, Average, or Good.
- The condition rating determines which grouping of comparables your property will be measured against or adjusted.
- Higher priced sales have a good rating and lower priced sales have a poor rating.
- This Condition rating is based on how well the home is maintained, the list of home improvements over the last two years, and the workmanship of the properties improvements.
- A home that was fully rehabbed four years ago will compare to average plus rated homes, not rehabbed homes in good condition.
- The visual condition is not the rating. What matters is the age of the improvements. Homes that have not been remodeled in 10 years can look good visually with regular maintenance. Yet, homes that have been remodeled two years ago may look the same but have a better rating.
Here is a common condition error: A home has been lived in the last 15 years, yet is very well maintained. The property owners were fanatical about taking care of the home. The furnace was replaced seven years ago, the roof is nine years old, the carpet is five years old, the kitchen is fairly modern, and everything shines like new. The home looks great.
Despite this home looking like new and being very well maintained, it wouldn’t be considered to be in “Good Condition.” The appraiser would not compare this home to houses that are at the top of the market. The reason is because these homes have been rehabbed and they are like new. The appraiser would consider these homes in Good Condition, not the home in the example. That home would be considered Average and, therefore, not be compared to homes at the top of the market.
They both are apples, but one is red and one green.
Many investors and homeowners think differently from the appraiser. This distorts the numbers that they use in the beginning of a purchase, sale, or investment decision.
Understanding property values prior to purchasing or selling property can save investors money and valuable time. Next time you are considering a property, consider the comps that are available. Understand the subject’s neighborhood, the sale date of recent real estate comps, and the condition of the property. May your investments be sunny, bright, and profitable.
Freddie E. Taylor II is the owner and certified appraiser with Appraisals By Taylor, Ltd., a real estate appraisal firm serving the Chicagoland market since 2002. He may be contacted at ftaylor@ABTChciago.com.
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