It’s helpful for potential homebuyers to have an idea of what their target properties are worth… but how do you figure that out? There are two tried-and-true approaches, and the art of valuation consists of blending them:
1. Historical Cost
This is how appraisers who are valuing a property for a mortgage bank traditionally value properties: If the house down the street just sold for $800,000 and your target house has exactly the same layout, chances are that it’s worth… $800,000. Of course, it’s unusual that there are enough similar properties to be able to convert apples to apples, so appraisers use the following adjustments:
If the house down the street sold for $800,000 but it had a brand-new kitchen—and your target house has exactly the same layout but an antiquated kitchen—chances are that the value of your target house is lower by the amount of a kitchen renovation. $750,000 might be a better valuation.
If a house down the street sold for $800,000 at the peak of the market, and prices have dropped roughly 20% since then, then an appraiser might guess that your target house with exactly the same layout is worth $640,000. Since appraisers value properties often, sometimes the time factor is expressed as a monthly percentage (“We’re seeing sales at the price levels of January, plus 1% a month to factor in the recovery.”)
If the house down the street sold for $800,000 and your target house is the same layout plus a screened-porch addition, the appraiser will add in a factor to raise the value of your target house by a certain amount per square foot to take into account the larger size.
2. On-Market Availabilities
It doesn’t matter if houses used to sell for $800,000 if everything that’s on the market is in the $1.2 million bracket. So, in addition to “historical cost,” agents look at everything else that’s available in the area at that time. That includes looking at different neighborhoods; if everything in a formerly $800,000 market is now for sale at $1,200,000, chances are that customers will simply discover a new neighborhood where houses are for sale for $800,000. (Or possibly an even newer neighborhood, where houses are for sale for $600,000.)
The key to measuring the effect of on-market availabilities is to look at the rental market. Economics 101 teaches us that rentals are, on some level, a substitute for houses and condos. So, if rentals are cheap, tenants will often stay put and not buy. If rentals are expensive, however, customers will begin to buy apartments. Use it as a guide while you are looking around, and as a way to figure out if this is the best time for you.