There are three methods of residential appraisal. These are the cost approach, the comparative sales approach, and the income approach. The cost approach sets the market value of a property by calculating how much an identical structure to the property will cost to replace it and also how much the land on which the house would be built would cost. In comparative sales method, the recent sales of comparable property in the market are taken into consideration. This is because the comparable sales show the typical behavior of buyers in the prevailing market conditions. In the income approach, the value of a property is determined by comparing and analyzing the current rents in the market and the expected future gross rents.
When determining the value of a property, most lenders prefer using the comparable sales approach before they accept your property as security for a loan. The income approach is mainly used to determine the value of non-owner occupied homes. The three methods should not be simultaneously used to determine the market value of a property as they will give conflicting results.
The comparative method is irrational when we consider the amount of money other comparable properties are being sold at. When the method is used as a base of advancing a loan, the money advanced will be at a greater risk in the market when prices of comparable properties start falling.
The cost approach is riskier than the comparative method since the value of the house may be relatively small than the value of the land on which it is built. It becomes difficult to independently establish the value of the land since a house is built on it. For this method to be effective, the market value of the property must be established using the comparative or income approach methods before the value of the land is established.
The income approach is the only reliable method of residential appraisal, and it is unfortunately the most ignored by lenders. It has been found out that the value of property is affected by the amount of rent that buyers are paying for comparable property in the market. When house prices fall, rent also falls and buyers would only purchase house when they are sure the will save money.