The ability to accurately determine the maximum retail value of a house after repairs is one of the key fundamental concepts in the real estate rehab business. As we learned in the last chapter, you never buy a house until you know how much it will be worth after it's fixed up! Maximum retail value (MRV) is essentially the after-repaired value. You need to know this value not only to sell the house after the rehab is done, but of equal importance, you need the value in order to calculate how much to pay for the house to begin with. Your strategy is to buy it wholesale, rehab it, and sell it retail.

The process of estimating MRV includes having a basic understanding of several fundamental concepts of real estate appraisal. Although I am a licensed real estate appraiser, I want to assure you that the concepts you need to know as a person in the rehab business are quite simple. The goal is to provide you with sufficient information so that you can intelligently discuss with your appraiser or real estate agent how they arrived at the MRV. It is well beyond the scope of this book to teach you precisely how to appraise a house and calculate MRV on your own.

However, with the help of your real estate agent or appraiser, a novice investor can accurately calculate MRV. Appraisal 101--The Basic Concepts A real estate appraisal is simply an estimate of value. Note the emphasis on the word estimate. This is not rocket science wherein precise mathematical calculations result in irrefutable facts. Rather, it is more correctly described as an art form because it depends heavily on the talent and judgment of the practitioner. The final outcome of the appraisal process is an opinion of value, not a fact of value. This opinion, while based on factual information derived from the marketplace, is always judgmental.

Modern appraisal practice uses three basic "approaches to value," or techniques, to arrive at a value conclusion. You will see all three approaches to value discussed, to some extent, on all standard appraisal reports. The cost approach develops the value of a property (house plus land) by estimating how much it would cost to build the structure today, subtracting depreciation due to age and condition, and then adding in the value of the land the house sits on. The income approach estimates value based on the rental income a property produces (based on market derived capitalization rates or gross rent multipliers). Finally, the sales comparison approach estimates value based on the evaluation of recent sales of similar properties.

I will focus exclusively on the sales comparison approach, because it is the most relevant and most accurate technique to use when dealing with the typical single-family house in need of repair. The cost approach is really accurate only when dealing with new construction because of the inherent problems in estimating depreciation on older homes. 

The income approach is usually more appropriate for larger income properties such as apartments or commercial buildings. The underlying theory behind the sales comparison approach to value is that the "subject" property, the one being appraised, should be worth about what similar properties have recently sold for. That makes sense, doesn't it? When you go to the supermarket to buy tomatoes, you expect to pay about what you paid last week, assuming the supply (availability) hasn't changed much and the quality (condition) of the tomatoes is the same. It's the same with houses-you would expect to pay (or sell) at about the same price as what similar houses recently sold for.

There are several concepts you need to understand about a "comparable sale." First of all, comparable sales are actual sales of properties
where the transaction has closed. Appraisals are never based on pending sales or on active listings. In the realm of real estate appraisal, the term recent sale means a sale that closed, preferably within the past six months (up to one year can be used, if absolutely necessary). In a fast changing market (either up or down), it's even more important to select sales that are truly recent (otherwise you get into the sticky issue of "time adjustments," which we will ignore in this discussion). Your task is to find at least three closed sales with which you can compare to the property under consideration. Once you have narrowed the field to recent closed sales, three primary criteria are used to select the comparable sales to be used in the appraisal.

Three Criteria for Selecting Comparable Sales

The three most important factors in picking out which closed sale to use in the appraisal are proximity; size of house; and age, condition and amenities.

1. Proximity. The comparable must be located close to the house you are evaluating. In other words, it needs to be in the same general neighborhood. This is to make sure that you are comparing apples to apples, in terms of external characteristics that might influence value. What does the "same general neighborhood" mean? Well, there is no magic formula for this. (Remember how judgment plays a big role in the appraisal process?) In some urban or even suburban areas, neighborhood characteristics could easily change within just a few blocks. In rural areas, it could be several miles. Just make sure the comparable is as close as possible and that the neighborhoods are very similar, if not identical.

2. Size of House. We all know that a 1,200-square-foot house ts going to be less valuable than a 2,000-square-foot house in the same neighborhood, all other factors being equal. So, you want to choose comparables that are as close as possible in square footage to that of the house you are evaluating (the "subject"). For example, if the subject is 1,500 square feet (above-ground heated living area-this does not include garages, workshops, basements, or the like), ideally you would like your comparables to be in the range of about 1,400 to 1,600 square feet. If you have comparables right at 1,500 square feet, so much the better.

3. Age, condition, and amenities. You would like your comparables to be similar in age, general condition (junker versus doll house), and have similar amenities such as bathroom count, garage, flooring, fireplace, security system, pool, hot tub, landscaping, and so forth. Adjustments--Correcting for Differences How in the world can you possibly find comparable sales that meet all of these three criteria? You want them to be in the same neighborhood; you want them to be the same square footage; and you want them to be the same age, same condition, and have the same features and amenities? Impossible!

To be Continue

 

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