Taking a Deep Dive into Understanding Appraisals

Like so many other professions, the valuation world has its own terminology that is important to understand before you dive into understanding your real estate appraisal. In this blog, we’ll help you make a splash into the world of assessments by explaining the difference between market value, fair market value and insurance value. These are important terms to understand before you swim in the deep end of the appraisal pool.

Know your worth: market value

Market value is the estimated price at which a property would be sold on the open market. Being the dominant measure of value in the real estate industry, market value is the term most well-known by those outside of the appraisal industry. The market value of a property may fluctuate year-to-year because of the factors used to determine market value and the various economic factors which influence value are not static. Market value represents the value to the real estate (the land, structures and improvements – buildings) and sometimes personal property and intangible assets. Keep in mind that market value is a stated opinion.

When determining the market value of a property, there are three approaches an appraiser can use. The Sales Comparison Approach is useful when several similar properties have recently been sold or are currently for sale in the subject property’s market. The Cost Approach is useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. The Income Capitalization Approach is used when income-producing real estate is purchased as an investment and the property’s earning power and expected yield is the critical element affecting value from an investor’s point of view.

know the nuances: fair market value

Fair market value is the price at which buyers and sellers with a reasonable knowledge of pertinent facts and not acting under any compulsion are willing to do business. Fair market value is a term and value definition used in place of market value when valuing businesses in situations like estate, gift or inheritance transactions, IRS filings or other transfers that are IRS controlled, or the sale of an entity at an auction or on the open market. The fair market value is not always equal to the sale price because of the different determinants used to find each.

Fair market value, like market value, is determined by considering desire, utility, scarcity and effective purchasing power. Scarcity and utility are supply factors, while desire and effective purchasing power are demand factors. For a property to have value, all four factors must be present. Utility is the ability of the real estate to satisfy the use or need of the purchaser. Properties must have utility that satisfies specific needs and desires. For instance, basic shelter if it will serve as a residential property. If it is a commercial retail property, the building must have the ability to generate income.

Design features, called amenities, also affect utility. Two types of amenities can be found on a property and include natural amenities, like a waterfront property or one with a scenic view or man-made amenities such as swimming pools, community buildings and other recreational facilities. In most cases, the greater the utility, the greater its fair market value.

Scarcity is the present or anticipated undersupply of an item relative to the demand for it. Simply, if there is a high demand for a commodity, the scarcity increases its value.

Perhaps most familiar is desire or simply the purchaser’s wish for an item to satisfy human needs or individual wants beyond essential life-support needs. This can be anything from shelter to clothing to food. Understandably, perception plays a huge role in desire. How a prospective buyer perceives the value of a commodity can determine how strong his/her wish for it is. The ability of a buyer to participate in the market is the effective purchasing power, or the extent to which buyers acquire goods and services with cash or its equivalent (loan).

know the costs: insurance value

Insurance value is simply the cost needed to construct or replace/reproduce a structure if it is damaged or destroyed. The insurance value is calculated using two main factors: cost of building materials and cost of reconstruction labor. As you read above, when an appraiser is looking at market value or fair market value, he/she has many different considerations. Appraisers also take into consideration the property location, size, use and quality of materials. Hence, those values may be markedly different than insurance value. The insurance value focuses on costs associated with reproducing a structure that is constructed to be exactly the same as it was before its destruction.

One important note for those new to the appraisal pool is to understand that insurance value and market or fair market value should not be expected to be the same. Replacement costs are associated with the market value or the fair market value and reproduction costs are associated with the insurance value.

Imagine you own a vintage 1700’s castle complete with flag and that castle burns down. You’re going to want a new castle but what kind of castle will it be? If you want it to be an exact replica of the original castle, then you’ll need those custom stained-glass windows depicting your rise to power. Don’t forget about the special doors by the wood maker from that small village in France! And you can’t just hire any ol’ construction company, it has to be one well-versed in construction of vintage castles! As you can imagine, these costs start to add up. These are reproduction costs – when everything needs to be the same down to the very last detail. Let’s estimate that your reproduction costs total around $300 million. That would be the insurance value of your castle. But the value of your vintage 1700’s castle was only $175 million. This would be what someone is willing to pay to purchase the castle because you can buy something that looks like a castle without spending the castle budget.  Fair market value/market value and insurance value are usually very different. Knowing why they are different can help you better understand the scope and purpose of your what your appraiser will do.

Are you looking for help diving into the world of Chicago commercial real estate appraisals? The team at Argianas & Associates is ready to put our real estate appraisal experience to work for you. Do not hesitate to give us a call at 630.390.0113 or complete this form.  Stay in the know and join our mailing list to receive our e-newsletter featuring case studies, industry events and news, and informational real estate valuation topics.