There are three basic types of appraisals: sales comparison, cost, and income capitalization.

* Sales Comparison: the sales comparison method estimates a property's value by comparing it to similar properties that recently sold in the area. Those properties are called comparables, or "comps." An appraiser will compare "comps" to the subject property to help determine its value. Sales comparison appraisals are typically used to evaluate single family homes, townhouses, and duplexes.

Appraisers are generally required to compare the subject property to at least three comps. Since few houses are identical, the appraiser will adjust the values according to some standard formulas: for instance, if the subject property has a deck and a comp does not, the appraiser will adjust the value of the subject property upwards to compensate for the additional feature.

Sales comparison appraisals are part "art" and part "science": the appraiser has a fair amount of latitude within which to determine the value of the property. If two different appraisers evaluate a particular property, they'll rarely agree exactly on its value.

* Cost: the cost method determines a property's value by calculating how much it would cost to replace. The appraiser estimates the value of the property if it was new, then deducts an amount for depreciation (wear and tear) based on the property's current condition. The value of the land is determined by using recent sales of comps. (There is no way to estimate land value by the cost method since land can't be "replaced.")

Cost appraisals are more accurate when the property is fairly new, since it's easier to estimate the replacement cost. Cost appraisals are also useful when a property is somewhat unique and suitable comparables can't be found.

* Income capitalization: income capitalization appraisals place a value on a property based on its ability to produce income. Income capitalization appraisals are most commonly used to estimate the value of office buildings, commercial real estate, and other rental properties. Very seldom is an income capitalization appraisal done by an appraiser; they're done by investors. In effect the investor is determining how much they're willing to pay - which becomes what the property is worth (to them.) You'll see why investors perform this calculation in a moment.

Since determining value by the income capitalization method is something you'll need to be able to do, let's look at it more closely. The process is simple: first calculate the gross income (rent) for the property and then subtract an amount for typical operating expenses like loan payments, taxes, maintenance, insurance, and other costs. The result is the net income the property is expected to provide.

Let's use the following example:

Gross income $50,000

Expenses $40,000

Net income $10,000

You've calculated that the property will produce $10,000 per year in net income. Now you can decide how much you're willing to pay for the property.

You can calculate the value by using the formula:

Value = net income / capitalization rate

The capitalization rate is the expected rate of return. Let's say in this case you want to get at least a ten percent rate of return; if you don't, you'd rather invest your money elsewhere. The math is easy:

Value = $10,000 / 10%

So, the value of the property to you is $100,000. That's the most you can pay in order to get a ten percent rate of return. In effect, then, that's the property's value - to you, at least.

Say you're willing to accept a 7 percent rate of return. Here's the formula:

Value = $10,000 / 8%

The value of the property is now $125,000. That's the most you can pay in order to receive the seven percent rate of return you want.

As you can see, an appraiser isn't the right person to perform an income capitalization appraisal - the appraiser doesn't know what rate of return you are seeking. The appraiser can perform a cost approach appraisal to provide a different view of the property's value, but if you're investing for income, the income capitalization approach is the only way to be sure you'll get the rate of return you seek.

Appraisals are important to buyers, sellers, and lenders. Lenders use appraisals to make sure they don't loan more than the property is worth. Sellers use appraisals to make sure they aren't over-paying for a property and buyers use appraisals to help them properly value their properties for sale. Understanding appraisals will make you a better real estate investor.

Mark Sumpter is a national speaker, author and full-time real estate investor. He is the founder of The Wealth College Inc, which develops comprehensive, systematic approaches to securing financial freedom through real estate investment.
Mark offers a FREE audio CD on "Building Wealth Through Real Estate" by logging onto www.therealestateinvestortoday.com.
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