What Is the Appraisal Approach?

The appraisal approach describes the process of estimating an asset's value, based on factors such as its cost, the income it generates, and its fair market value (FMW) compared to that of similar assets. The resulting appraisal figure is essentially an educated guess that attempts to forecast the price an asset would likely fetch in a free market. While appraisals are typically performed in conjunction with a sale of an item, they may also be conducted for insurance or taxation purposes.

Key Takeaways

  • The appraisal approach is a procedure for determining an asset's value using an appraisal, rather than relying on market transaction pricing.
  • It is usually performed in conjunction with a sale of an asset, or for insurance or taxation purposes.
  • A dollar value is assigned based on factors such as the asset’s cost, the income it generates, and its fair market value compared with that of similar assets.
  • Appraisals are essentially educated guesses as to the price assets would fetch in a free market.

Understanding the Appraisal Approach

The appraisal approach is used to determine the worth of high-value assets such as real estate properties, objects of art, jewelry, vehicles, financial interests in oil fields, and other alternative assets. The values of these items are difficult to quantify because they don't change hands often enough to reliably generate current market prices the way publicly-traded stocks and other securities do. Consequently, the value of such items must be estimated by qualified individuals known as appraisers.

Appraisal Approach Requirements

Appraisals are only deemed legitimate if conducted by disinterested parties who are certified and licensed by state regulatory boards. Appraisers must meet the Universal Standards of Professional Appraisal Practice (USPAP) guidelines and pass the relevant academic courses. Appraisers must possess expert knowledge in their given areas of specialty. Case in point: a diamond ring should only be evaluated by an experienced jeweler, and not by a real estate analyst.

The Three Appraisal Approaches For Real Estate

Real estate is typically appraised if it's being sold or if the owner seeks to refinance the existing mortgage on his property. An appraisal aims to determine a property's value that reflects its condition, age, location, and other relevant characteristics. This action helps discourage banks from loaning more money to borrowers than the properties are worth.

Estimating the value of real estate is necessary for several endeavors, including financing, investment analysis, property insurance, sales listings, and taxation.

Appraisers rely on the following three methods of establishing real estate property values:

  1. Sales comparison. This is the most common method, where appraisers value a property based on the recent selling prices of similar properties in the same neighborhood. To accomplish this, at least three comparable properties must be reported within the last year, in an open and competitive market.
  2. Cost approach. This practice operates under the premise that a property’s value should equal the cost of building an equivalent building, taking into account the cost of the land and construction expenses, less depreciation. After all, it would be economically illogical for a home buyer to pay more for a property than it would cost to build a similar structure from scratch. 
  3. Income approach. Sometimes referred to as the "income capitalization approach," this estimates the value of a property based on the income it generates. It’s calculated by taking the net operating income (revenue the property generates minus operating expenses), and dividing it by the capitalization rate — the expected rate of return.