What are Appraisal-based Indices?
Appraisal-based indices are the most common form of rating the performance of the commercial real estate industry. The appraisal-based method can also be referred to as a valuation-based method. Unlike transaction-based indices, the data is readily available from recent valuations of properties. Although the data is not centrally placed (based on a common point for the collection), the data can be more easily obtained than from transaction-based indices.
However, appraisal-based indices are criticized for being based on the recent past rather than being real-time. The commercial real estate industry is rampant and changes within a short period. Therefore, the appraisal-based indices method is considered outdated as compared to the transaction-based method.
The valuation-based approach determines a property’s value by checking on several factors. The factors that are important in the valuation process include the potential income generated from the property and the value at acquisition for similar properties. Similar properties to be considered should qualify for having almost identical features with the comparable property. Similarity should also match in the location since different locations can be subject to different valuations.
- Appraisal-based indices help in calculating the value of an asset in the real estate market.
- Appraisal-based indices are determined from various factors, ranging from income from the property and cost of the property, in comparison with other comparable similar properties.
- The indices should be based on three or more comparable properties with similar characteristics with the subject property.
Appraisal Smoothing in Appraisal-based Indices
Property information such as transaction data and prices of acquired commercial properties are sometimes difficult to access, and the indices are developed from data on the valuations done on a regular basis and in the recent past to give credibility to the results. The appraisal values obtained can deviate a little from the real market values due to bias in the valuation method.
Appraisal smoothing states that appraisers evaluate the valuation values by obtaining the most recent data available in the market and incorporating property values from the recent past. It shows that the appraisal-based indices are based on the recent past rather than the present.
Appraisal-based Indices Correction Procedures
The correction procedures can be categorized into two groups, the multivariate and the univariate procedures.
1. Multivariate procedures
Multivariate procedures depend on several time-series data to obtain an estimated value for real estate market returns. Time-series data is data collected over a significant amount of time.
2. Univariate procedures
Univariate procedures use only one series of data to evaluate the result.
Thus, multivariate procedures come with the element of comparability over time, which can strengthen their argument compared to univariate methods. However, univariate methods can be objective in showing more precise estimations for a particular period. Hence, the multivariate and univariate methods are complementary procedures, not substitutes.
Appraised Value vs. Market Value
Both the appraised and market values are a representative estimation of the market prices in the real estate industry. The appraised value is a figure generated by real estate experts based on the features of a given property. On the other hand, the market value is consumer-driven, where experts check the prevailing conditions of the property and the current prices in the industry for similar properties. Both the property owner and the client pull the rope towards their side.
The owner wants to reap the highest possible benefits from their investment on the acquisition. The client also needs to acquire the property at the fairest value possible. Both can hire professionals to negotiate the acquisition transaction. Both the appraised and the market values should lie around the same amount for an easy consensus.
The appraised value is based on the features, location, and the value of recently sold similar properties, and it represents the true value of the property according to experts. However, a buyer also determines the value of a property since the investment is only worth what the buyer is willing and able to offer. The buyer then gives a counteroffer based on the seller’s offer, and a consensus is reached for the acquisition to proceed.
There are three major procedures used in property valuation: the cost approach, the sales comparison approach, and the income approach.
1. Cost approach
The cost approach considers the amount it would cost to build a house from scratch. The accrued depreciation will be deducted to determine the financial impact of the wear and tear over a period of time.
2. Sales comparison approach
The sales comparison approach involves calculating the value of a property by comparing it with other recently-sold assets similar to the subject property.
3. Income approach
The income approach involves calculating the value of a property on the income that a property generates.
Examples of properties suitable for appraising using the income approach are apartment buildings and office duplexes. The market value determined by the three appraisal methods above provides the market value offered by the investor to a buyer. The buyer then poses a counter-offer where they sit down with the seller before they reach a consensus on the acquisition process.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: