How to Know Which Properties are Worth Buying as a Real Estate Investor

Understanding the techniques used by professional appraisers will help you make better investing decisions.
Seth Kniep
Nov 4, 2021
Real Estate Investing
Appraisals are an integral part of investing in real estate. They are required to obtain loans and insurance. Knowing how to read appraisal reports will make life easier if you ever need to dispute an appraisal. And learning about the cost approach and income approach will make you a better investor. But don’t get too bogged down with appraisal specifics—that’s what professional appraisers are for.

If you’re investing JOD-style, you’ll need to get a loan (here’s why we never recommend paying cash). A key part of getting your loan is the appraisal, where an appraiser analyzes the property to determine its worth. For the loan to close, the property needs to appraise for, at least, the amount of the loan. The lender wants to know that they can sell your house and cover the loan amount you owe if you fail to make payments.

You’ll also need an appraisal to get insurance on your investment properties. This is because insurers need an accurate estimate of the value of the property they are insuring.

Appraisers employ three methods to estimate property values—the cost approach, the sales comparison approach, and the income approach. But these methods aren’t just useful to appraisers. Learning and understanding these methods will make you a sharper investor, too. By learning how appraisers work, you’ll become adept at estimating a property’s true value. These skills will help you zero in on the best deals and avoid wasting your time on bad ones.

All that to say, appraisals are a crucial part of investing in short-term rentals. To help you fully understand appraisals from the perspective of a short-term rental investor, we’ll go over the appraisal process, look at various situations where appraisals are needed, and discuss how to read appraisal reports.

Wait…What is an Appraisal?

There are lots of ways to estimate the value of real estate. You can get a “broker opinion of value” (BOP), check Zillow for the Zestimate, or form an estimate based on your own gut instinct. None of these, however, would constitute an appraisal. So, what is an appraisal?

An appraisal is a fact-based estimate of a property’s value as determined by a licensed appraiser. An appraiser is a certified professional who estimates property values using a standardized system of appraisal approaches. 

Good appraisers are neither optimistic nor pessimistic. Their job is to be as honest and accurate as possible. 

Why are Appraisals Needed?

Appraisals are needed because real estate is inherently difficult to value. Every piece of real estate is different and has its own quirks that add or subtract from its value. Additionally, sellers and buyers are both biased as to what they think a property should be worth. For obvious reasons, sellers tend to believe their property is worth more, while buyers feel the same property is worth less. But other players in the real estate game have a vested interest in obtaining a neutral, honest estimation of a property’s value.

Lenders usually require an appraisal to make sure that the property value is high enough to cover the loan amount in the event of default. Basically: If you fail to make loan payments and the bank has to sell your property, they want assurance that they can sell it for at least the loan amount.

Insurance companies may also require an appraisal for home insurance policies. They may be satisfied with the data from the appraisal conducted by your lender, or they may send their own appraiser. Insurers need to know the replacement cost of your property (the cost to rebuild structures that are damaged or destroyed). If a fire or tornado levels your house and insurance kicks in, the insurance company uses this info to determine how much to pay out.

Appraisals may also be used in divorce proceedings, probate, or property tax appeals.

Three Approaches

An estimate of a property’s value can be found by an appraiser using one of three appraisal approaches:

  • The Cost Approach
  • The Income Approach
  • The Sales Comparison Approach

Note: From here forward, the property being appraised will be referred to as the “subject property.”

The Cost Approach

An appraiser using the cost approach estimates the value of the subject property by estimating the value of the land, estimating the value of the improvements (buildings and structures), then applying depreciation based on the property’s age. The cost approach is most useful for extraordinarily unique properties where using the sales comparison approach is difficult because of a lack of similar properties.

The Income Approach

This approach only applies to income-generating properties. This approach aims to calculate a value based on the income the property is expected to generate. An appraiser using this method starts by estimating monthly rental income for the subject property. Then, they calculate a “gross rent multiplier” (GRM) based on similar properties in the vicinity of the subject property. The GRM formula is 

GRM = Price/Gross Rent

A GRM is almost like a cap rate in reverse; it’s just another way to express the ratio of property value to expected income as a single number. 

After finding a reasonable GRM, simply multiplies the GRM by the estimated monthly rent for the subject property to find an estimated value for the subject property. Usually, monthly rent is estimated using something similar to the sales comparison approach, except the appraiser is comparing rents rather than property values.

The Sales Comparison Approach

The sales comparison approach is the most commonly used in residential real estate and the one we will focus on. Once you learn how it works, you can use the sales comparison approach to analyze your own deals.

For the sales comparison approach, an appraiser will look at recently sold homes in the vicinity of the subject property. Ideally, the appraiser will select three or four “comps”—nearby properties with similar size, age, and features to the subject property. Because no two properties are alike, the appraiser must make adjustments to the sale prices of the comps based on the superiority or inferiority of different features compared to the subject property. Features that appraisers usually adjust for include age, interior square footage, lot size, view, number of bedrooms, and garage size.

Let’s work through a simplified example so you can learn how the sales comparison approach works. In this example, we will look at two comps and make adjustments based on each comp’s interior square footage, lot size, number of bedrooms, and number of bathrooms.

First, we will lay out all pertinent information in a comp table, along with blanks that we will fill in later:


Note that the price for the subject property is left blank; that is the missing variable we are trying to solve for.

Next, we need to estimate the value of each feature so that we can make adjustments. For this example, we will value each additional interior square foot at $100, each additional square foot of land at $1, each additional bedroom at $10,000, and each additional bathroom at $5,000.

Then, we can calculate an adjustment for each feature. We’ll start by adjusting the interior square footage for Comp 1. Because Comp 1 has 200 square feet less interior space than the subject property, we need to adjust the price of Comp 1 up to compensate. To calculate the adjustment, we take the difference in square footage (200) and multiply it by our price per interior square foot ($100), giving us an adjustment of +$20,000. As you calculate adjustments, begin adding them to your comp table.

Comp 2 has 100 square feet more interior space than the subject property, so we need to adjust the price of Comp 2 down to compensate. Again, we follow the same procedure, multiplying the difference in square footage (-100) by our price per interior square foot ($100) to get an adjustment of -$10,000.

We adjust for lot size, bedrooms, and bathrooms similarly, using the values established in our adjustment table. To get the total for net adjustments, add together all of the adjustments you made for each comp. Then, add or subtract net adjustments from the price to get the adjusted price for that comp. Finally, average the two adjusted prices to get your final estimate of value for the subject property. The finished comp table should look like this:

This is a pretty basic example. In real life, an appraiser will make far more adjustments. Coming up, we’ll look at an appraisal report from one of our recent deals, and you’ll see just how detailed professional appraisers can be.


Interpreting Appraisal Reports

For this example, we’ll look at a hypothetical JOD transaction—the acquisition of 123 Main Street. This appraisal was done at our lender’s request. The full document submitted by our appraiser was a dense 38 pages, with a head-spinning level of detail. The format is not beginner-friendly, but you can make sense of these reports if you know what to look for. 

First, remember your goal: You’re trying to understand the appraiser’s thought process and how they arrived at their value estimate. It’s always smart to look over appraisal reports and understand the appraiser’s point of view. But understanding these reports is especially important if the appraisal came in low and you want to appeal the appraiser’s decision or renegotiate with the seller.

Skip to the page where the appraiser did the sales comparison approach. Appraisal forms may vary depending on what state you’re in, so look for a page that lists out a series of comps and adjustments in a grid format. Here’s what ours looked like:

You should be able to recognize that this table follows the same general logic of our simplified example from above—selecting several comps, analyzing how their various features compare to the features of the subject property, adjusting the price up or down accordingly, and arriving at a final adjusted sale price for each comp.

How Can Learning the Sales Comparison Appraisal Method Help Investors?

You don’t have to be an appraiser to use the sales comparison approach. You can find comps yourself and analyze them in the same manner as above. You might even consider doing your own appraisal of a property you’re buying at the same time as the professional appraiser. Then compare your results to see how your analysis compares to the appraiser’s analysis. If you practice this enough, you will improve your gut feel and develop an eye for lucrative deals. You’ll become adept at analyzing properties on a granular level (looking at age, location, condition, features) to get a precise idea of what a property is worth. You’ll also be able to make better offers. Perhaps most importantly, you’ll be able to tell which properties are unlikely to appraise and avoid putting effort into these time-wasting deals. (“To appraise” means that the appraiser’s value estimate is sufficient to satisfy the lender’s requirements. To “not appraise” means that the appraiser’s estimate came back “below value,” and the lender will not make the loan.) Remember, time is your biggest asset, and you want as many of your working hours as possible to go towards activities that grow your portfolio.

What to do if Your Appraisal Comes Back Below Value

Sometimes the appraisal ordered by your lender may come back “below value.” This means that the value as determined by the appraiser comes back too low to satisfy the lender. As a result, the lender does not make the loan, and you cannot close your deal. If this happens, you have several options.

The first is to bring extra cash to the table. By bringing extra cash, the loan amount is reduced. By reducing the loan amount sufficiently, the lender will be satisfied that the appraised value of the property will cover the loan amount in the event of a default. (Remember, a “default” means that a borrower misses multiple loan payments in a row, giving the bank the right to foreclose (take back or repossess the property.)

The second is to renegotiate the purchase price with the seller. Lowering the property’s total purchase price will also decrease the loan amount (provided the down payment percentage doesn’t change). For example, if you’re putting 20% down, the loan amount would be 80% of the property’s value. If you negotiated the purchase price from $1,000,000 down to $900,000, the loan amount would go from $800,000 to $720,000. You can try to negotiate the seller down to the appraised value, using the appraisal as justification. You may have to compromise with the seller and meet somewhere in the middle.

Your third option is to walk away from the deal. If you included an appraisal contingency in your purchase contract (and you definitely should have), this contingency enables you to walk away from the deal and have your earnest money deposit returned. You can also use a financing contingency to get out of the deal. If the lender will not make the loan, the financing contingency is not satisfied, and you will likely get your earnest money returned. 

If you do not include an appraisal and/or financing contingency, you will likely forfeit your earnest money deposit if you walk away from the deal. Still, if the appraisal indicates that the property is worth way less than you thought it was, walking away from the deal may still be the best long-term decision, even if you do lose that earnest money.

Remember: A “contingency” is a feature of a purchase contract that permits the buyer to exit the deal under certain circumstances without being penalized. When a contract contains an appraisal contingency, the buyer can exit the deal if the appraised value is below the purchase price. An “earnest money deposit” is a sum given by the buyer and held in escrow during the closing process to demonstrate good faith. In certain circumstances, the buyer may lose their earnest money deposit if they walk away from a deal. 

Conclusion

Appraisals are an essential part of investing in real estate. Whether you’re getting a loan, getting insurance, paying your taxes, or refinancing, you will interact with appraisals on some level. However, you are not an appraiser yourself, and your knowledge of these subjects does not have to be intimate. What’s most important is that you understand the principles of the sales comparison approach and the income approach because this knowledge will help you perform your analysis of investment opportunities making you a more competitive buyer and ultimately a better investor.

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Seth Kniep

Married a pearl. Fathered 4 miracles. Fired his boss. Turned a single dime into $104,857. Today, a self-made millionaire, Seth and his team of 8 badass coaches teach entrepreneurs how to build passive income on Amazon.

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