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Basic Appraisal Principles you Should Know About

JANUARY 23, 2025
House appraisal

An appraisal in real estate is an estimate of a property’s market value. That value is determined by a professional called an appraiser based on their expert opinion after an in-person inspection and various methods, such as research of market trends and similar properties’ prices.

The appraisal is used for transactions like sales, purchases, and mortgages. For example, it’s important information to settle a house’s final price and helps lenders decide whether to give a mortgage loan.

In real estate, basic appraisal principles guide the process and understanding of the market value of a property. So, if you were wondering what influences a house’s “price tag,” this is your blog.

Understanding Market Value

Market value represents a property’s worth under normal market conditions. It’s different from market price, which is the actual selling price. Market price can deviate from market value due to unique circumstances like seller pressure (e.g., foreclosure) or emotional bidding during private sales.

To estimate market value, appraisers rely on:

  • Comparable property sales: Reviewing recent sales of similar properties and adjusting for differences in features, size, and location.
  • Economic factors: Assessing market trends, supply and demand, and economic conditions that influence property values.
  • Unique property characteristics: Evaluating specific property traits such as layout, amenities, and condition.

Why market value matters

Appraisals and market value influence every corner of the real estate process:

  • Lenders depend on appraised market value to determine appropriate loan amounts.
  • Insurance providers use it to calculate coverage levels.
  • Local governments base property taxes on appraised values.

Understanding market value ensures fair transactions and protects all parties involved. For real estate exam students, it’s crucial to differentiate between value, cost, and price—terms that often appear in test questions.

To determine market value accurately, appraisers apply a set of established principles that guide their evaluation process. These principles are foundational for real estate professionals and licensing exam success. Let’s explore the basic principles of real estate appraisals next.

Principles of real estate appraisals

Appraisal Principles of Progression and Regression

Progression states that the value of a less expensive property is increased by its association with more expensive properties. It’s as if the influence of some houses rubs off on the others, like a high school thing.

Let’s say that houses that are more expensive than yours have recently been built in your neighborhood. Now, your house’s value will increase due to its association with these new and more expensive houses.

On the other hand, regression means the value of a more expensive property is brought down by its proximity to less expensive homes. The opposite example applies here: if less costly houses have been built next to yours, the value of your house will decrease.

Why is that? A property’s value depends on where it is and how desirable the houses are. So, if people want a more valuable house in the future, they should buy it in an area with expensive houses. That way, their home value will increase over time.

A row of modern townhouses under a clear blue sky. Each home features a symmetrical gable roof design, neutral-colored siding, and white trim around windows and eaves.

How Progression / Regression Affects Your Property Value

Appraisal Principle of Contribution

This appraisal principle assesses the value added by a specific improvement. It’s not the cost of the improvement that matters but how much worth it adds (contributes) to the property’s market value.

Sometimes, improvements won’t add a value greater than their cost to the property; swimming pools are a perfect example. If you built a pool in your home, the value of your house will be the value it had before you added the pool, plus the value of the pool.

Remember that the pool’s value is not necessarily the cost of adding it. An improvement could have cost $10,000, but when appraisers do their research, they can add an extra value to the house of only $3000. To know how much value an addition or improvement gives the property, appraisers compare it to similar properties and use various appraisal approaches.

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Appraisal Principle of Conformity

Properties that follow the general neighborhood standards regarding size, style, and condition tend to hold their value better. It’s about blending in rather than standing out. That is the principle of conformity.

Conformity is not only necessary in residential properties but also in commercial areas. Stores in the same area must attract the same kind of people to succeed. That being said, conformity should not be taken too far. Imagine an area with three mechanical workshops or a residential neighborhood with identical houses. The first one will not increase the value; the second one will look a little creepy.

Appraisal Principle of Substitution

This principle is the backbone of the appraisal process. It establishes that a property’s maximum value is the equivalent of the cost of buying a similar one compared to design, use, income, and where it is. In other words, a savvy buyer would not pay more for a property than the cost of acquiring a similar substitute property. Why would you pay $250,000 for a house when an identical one sells for $200,000 in the same neighborhood?

That’s why the sales comparison approach is so valuable for appraisal. It does explicitly that: estimates the value of a property by comparing it to similar properties recently sold in the same area. It is primarily used for residential properties in active markets with many recent comparable sales.

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Appraisal Principle of Highest and Best Use

Highest and best use is the principle that determines the highest value a real estate can have. The highest and best value is considered the most profitable, legally allowable, physically possible, and financially feasible use of a property:

  • Legally allowable: It must be allowed in the building codes and zoning ordinances of the property’s area and, of course, never illegal.
  • Physically possible: Depending on the real estate characteristics and where it is, it is the highest and best use it can have. It cannot be a massive warehouse if it’s a small house in a mountain town.
  • Financially feasible: It means it has to be financially viable and that can generate a positive return on investment. If there are many coffee shops in the area, building another one is not a good idea.
  • Maximum profitability / Utility: The use most generate the highest profit. All the possible uses that follow the other aspects (legally allowable, physically possible, and financially feasible) are compared, and then the appraiser decides which one is the highest and best use.

The highest and best use is all about maximizing the property’s potential within the constraints above.

Study Tip 💡

Remember the highest and best value concept with this question: What use can bring the highest value to a property?

These aspects are vital in determining the highest and best use of a property:

  • Legally Allowable: Is the use allowed by law?
  • Physically Possible: Can the property physically support this use?
  • Financially Feasible: Will the use generate more revenue than cost?
  • Maximum Utility/Profitability: Is the use the most profitable option?

Summing-up

In conclusion, appraisal principles are a crucial aspect of the real estate industry, impacting sales, purchases, and mortgages. Mastering these principles will not only help you understand how market values are determined but also enable you to answer related questions on your licensing test confidently. So, gear up, study hard, and get ready to conquer that real estate exam!

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