How Much Does That House Cost?

October 20, 2008 at 3:41 pm | Posted in Uncategorized | Leave a comment
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… Well, it all depends on what you mean by “cost”.

As an Appraiser, it’s my job to determine market value of a home based on three “approaches” to value. And this is determined in most cases for the purpose of securing a mortgage on the home. Of course there are always unique situations, but this summary is pretty much the rule of thumb.

First and foremost, for mortgage purposes, estate planning, divorce settlements, etc., there’s the Sales Comparison Approach whereby you use recent similar sales to help narrow down what your house is worth. If a 3 bedroom, 2 bathroom, one story, 2 year old house with plain upgrades just sold next door for $200k, and you have the exact same house, then your house is worth about the same amount. Find a few more recent sales to show consistency and so much the better. What if your neighbor has the exact same house except he has a pool and his sold for $212k? Well, we’ve just established the approximate value of a pool in your neighborhood (and if you haven’t figured this one out yet, a pool is typically NOT a great idea for adding value to your house). As far as appraising goes for most homes- whether they be tract or ranch or custom estates, this approach to value is really all that matters.

Now if you live in California and you want to invest in rental property in Arizona, then your motivation is more driven by what your cash flow situation would be. That analysis is called the Income Approach. Why buy a rental home where your mortgage payment will be $2000 per month when you can only rent it out for $800? Well that’s not for me to determine- it’s all based on your individual situation as a borrower. Your lender will look at your personal financial situation and decide if they’d be willing to loan you money for such a purchase- even if your incoming rent would be less than your outgoing mortgage. If the rental income makes sense then an investor might buy the home and not really care too much about getting the best price. But besides verifying if there will be an acceptable cash flow, the lender still first and foremost wants to know if the house is priced appropriately, so we go back to the Sales Comparison Approach. The Income Approach in this case is there as very important supportive data.

The third approach to determining value is called the Cost Approach, and for appraisal purposes, that’s typically leaned on if we’re talking about a unique property- like a school, or a fire station, or a church. I’m not sure how many Crystal Cathedrals are in your neighborhood, but how exactly can you be expected to base value on recent sales of similar properties- which may be from 8 years ago, 10 states away. In these situations, the thing to do is figure out how much it would cost to build that property from scratch. Figure materials, labor, permits, land value, etc. and you’ve got an estimated cost. But if your property is 20 years old then you have to figure that it’s depreciated. But over the past 20 years, the current owners might have added new flooring, new paint, new appliances, etc. so it doesn’t look like a 20 year old house anymore. Let’s assume that the new Yankee stadium is the exact same dimensions and materials as the old one and built the EXACT same way. Take out the historical significance of the house that Ruth built along with sentimental value, and the new one is worth more than the old one because it’s new and hasn’t depreciated. How reliable is the Cost Approach? Well the older a house gets, the less accurate the cost estimate is because the degree of depreciation is an opinion- one appraiser might say that a house has depreciated by 10 years while another one might opine that it has depreciated by 20. That’s all a factor of the upkeep, improvements and estimate of how much longer the house has before it should be torn down. It’s a little confusing, hence not very reliable for houses.

It used to be that appraisers were required to apply two approaches to value so that one sort of substantiates the other, then he would explain which one was given the most consideration and why the third wasn’t developed. But in 2005 Fannie Mae (the one who approved the standard appraisal form requirements) decided that the Cost Approach really wasn’t that important when talking about single family homes- and they were absolutely correct. So they decided that the only approach that really mattered in these situations was the Sales Comparison Approach. However, individual lenders (and plenty of us appraisers) were a little leary of the fact that the Cost Approach section is still on the appraisal form that we use. So these individual lenders decided that it was still important for appraisers to work out the Cost Approach regardless of the situation and despite the fact that it is unreliable. So any good appraiser puts verbiage in the report that the Cost Approach was developed as a special request and that it’s unreliable and that it should not be relied upon fo stuff like insurance estimates. So now this takes us back to the original question… How much does a house cost?

As mentioned above, the cost value is the cost to rebuild the house from scratch minus depreciation. But arguably the biggest (variable) cost factor we’re talking about is the land that the home sits on. You put the exact home on two lots that are the exact same size, but one’s in Mesa and the other is in Scottsdale, and you have a difference in cost. And that takes us to real estate 101- location location location. But I digress.

So say a house cost $300,000 to build. There’s a boom in real estate, homes are being built like crazy and people are camping out to get on waiting lists for new homes. That house’s value is not $300,000. It’s whatever Dave and Wanda Homebuyer are willing to pay (as long as there are comparables that support the purchase price (Sales Comparison Approach) or they don’t get a loan and pay cash. But look at our market now- and I’m talking a large number of markets in America, but in particular places like Phoenix, Las Vegas and Orange County. We’re seeing home values declining by double digit percentages over the last 12 months (source, Freddie Mac Q1 2008 vs. Q1 2007) . Does that affect the cost to build a house? The answer is actually “yes”, but it’s not reflected directly in home values. It costs more to build because of fuel costs (to deliver materials, etc.), more (or less) to build because of materials costs, less to build because of labor (more workers to go around), less to build because of profit margins (or loses), but most importantly, less to build because of land values. Meanwhile, in this market buyers and banks who are now the sellers in many situations, don’t give a hoot how much it cost to build a house. They’re looking at the Sales Comparison Approach to determine how much is reasonable to list a house for or spend to buy a house based on recent activity. I’ve done plenty of recent appraisals where the purchase price was $160,000, but the Cost Approach calculated out to $325,000. So as you can see, nowadays, nobody really cares how much a house costs (unless you’re an insurance agent)

But the irony that I see all the time is that once the appraisal is complete on one of these distressed homes, the bank (who is simply checking the appraisal for completeness) ends up calling the appraiser to complain that the Cost Approach value is too high and that it should be “changed” to be closer to the Sales Comparison Approach value. They don’t say that it’s wrong, they just say that it’s not the same as the Sales Comparison Approach value. (Do you have wonder what good appraisers think about the people who review their work)

So in summary, there’s your appraisal lesson for now. It’s pretty complex, but not really. When you factor in those parties who look at the appraisal report, that’s when you get lots of “controversy”. The appraisal is done for a single purpose and that purpose is stated in the report whether it be for mortgage financing, estate settlement, or whatever else the client requests. When other “unintended users” start looking at an appraisal for their unrelated purposes, all bets are off.

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