There’s more than one strategy for determining a property’s value, and there are multiple factors that can impact the value of a property. Keep reading to learn what they are, as well as why property valuation really matters
Factors That Determine Property Valuation
Property valuation is a means of determining the financial value of a property. It’s not an exact science, and it’s based on a variety of different factors. There are also different types of valuations, such as the assessed value for tax purposes and the fair market value for sale purposes. Some of the most important factors for determining property valuation are a building’s internal characteristics. In other words, what’s going on inside? The internal factors will include the square footage, the number of rooms, the quality of the construction, any appliances, aesthetics, and more. Property valuation also depends on the building’s external characteristics. These factors could generally be described as curb appeal. What does the outside look like? How big is the lot? What sort of landscaping is there? Are the outside and lot both well maintained? The location of a building is also a major factor in determining property valuation. You could have two identical buildings with two identical lots. But if one is in a better location, it’s likely to be worth more. First, consider the characteristics of the neighborhood. Neighborhoods with easy access to public transportation, hospitals, schools, parks, and more may generally appraise better than those in an area with fewer amenities. Crime rates, such as a high or low number of burglaries, may also impact a property’s value. Having desirable grocery stores nearby may increase a property’s value, too. In one analysis, homes located near a Trader Joe’s or Whole Foods had higher property valuations than those located near an ALDI, according to ATTOM Data Solutions. Property values are also significantly impacted by the current real estate market and local supply and demand. In general, when the demand for homes exceeds the current supply, property values increase. When the supply exceeds the demand, homes tend to sell for less. Between 2020 and 2021, the housing market in the US was a clear example of the impact that outside market forces can have on home prices. Data from the Federal Reserve showed that the supply of homes for sale fell to some of its lowest levels in 20 years during the pandemic. Demand grew and prices were driven up. Home prices were also driven up by bidding wars, just like in the past, but the rise in home prices seen during the pandemic was also the highest it’s been in years. Between August 2020 and August 2021, the median home price increased 17.7%, from about $257,000 in August 2021 to about $303,000 in August 2021, according to Zillow’s Home Value Index. One year before that, between August 2019 and August 2020, the median home price only increased by about 5%.
Property Valuation Methods
There are a few different methods for finding the value of a property. Each of these methods is likely to be used in different situations.
Sales Comparison Approach
The sales comparison approach is the one most often used in determining the value of a property for sale. Using this approach, a realtor or appraiser compares a property to similar nearby properties, sometimes called “comps.” For example, if you’re planning to sell a 2,000-square-foot home with three bedrooms and two bathrooms, your realtor is likely to look at other 2,000-square-foot homes in the neighborhood with the same number of rooms and price yours accordingly. If your home is in better condition than those, they will likely price them higher. If yours is in worse condition, they’ll likely price it slightly lower than the comparables.
Income Approach
The income approach to property valuation is most commonly used with investment properties that result in a stream of income. Using the income approach, an appraiser will examine expense statements, rental rates, vacancy rates, market conditions, and more to determine the property’s income. The income and cash flow projections are then used to determine the property’s value.
Cost Approach
Using the cost approach to property valuation, the value of a property is based on its replacement cost. In other words, how much would it cost to replace or reproduce the existing building on its current plot of land? Once you know the replacement cost, subtract depreciation and add the value of the site to determine the property value.
Why Property Values Matter
The value of a property is critical information for current owners, your local taxing authority, lenders, homebuyers, and more. Below are some examples of property value terms and when they are important.
Appraised Value
When you apply for a mortgage to buy a home, your lender will usually need to know the appraised value of the house you want to buy. The amount a bank, credit union, or lender will allow you to borrow is known as the maximum loan-to-value ratio and it is based on the appraised value of the home. It differs with each lender, bank, or credit union, but it’s usually no more than 80% of the home’s appraised value (a higher ratio typically comes with the need for mortgage insurance). However, there are some lenders and programs that may lend you up to 97%, such as Fannie Mae.
Assessed Value
State and local governments charge their residents property taxes on property they own. The assessed value of a home or other property is what determines how much you’ll pay in taxes. Property taxes vary by state, so the taxes on a home with an assessed value of $250,000 will result in a very different tax bill in New Jersey, where property taxes are notoriously high, versus Alabama, where property taxes are known to be very low.
Fair Market Value
The fair market value of a property is generally considered the price at which the property could sell for in an open market where both the buyer and seller are fully informed and not under any pressure. In other words, it’s the amount you could reasonably expect to buy or sell something for based on the current real estate market.
Actual Cash and Replacement Cost Value
Actual cash and replacement cost value are methods used in insurance to determine how much an insurance company will pay out when you file a claim. If you have actual cash insurance, the insurer will reimburse you for the depreciated value of your property and its contents. Replacement cost insurance, on the other hand, would reimburse you for the cost to repair or replace your property and its contents without accounting for depreciation.
Potential Future Value
If you’re planning to invest in a rental property, then it may be important to understand its potential future value. In most cases, determining the future value of a property has less to do with the amount you could sell it for and more to do with the expected future cash flows.
The Bottom Line
Property valuation is critical for determining the sale price of a property, how much your lender will give you for a mortgage, how much you’ll pay in property taxes, and more. While property valuation can be somewhat subjective, there are a few consistent factors that will help a realtor, appraiser, or assessor determine just how much a property is worth. And remember, property values change over time, especially as the real estate market changes.
