When new investors decide to do their first fix & flips, they typically get hung up on how appraisals work with renovated properties. Do appraisers look at “as-is” conditions? After-rehab conditions? Bottom line, these people want to know, how many comps do you need for an appraisal when purchasing a property?
For a typical, non-renovated home, appraisers ask for 3 to 4 comps. These should be within a mile of the property and 20% of gross living space. With ARV appraisals, appraisers want to see 3 to 4 “as-is” comps and 3 to 4 comps for sold properties with a similar amount of completed renovation work.
In this article, I’ll cover additional considerations around comps, appraisals, and renovated properties. Specifically, I’ll review the following topics:
- What is a Home Appraisal?
- What are Comps in Real Estate?
- How Many Comps Do You Need for a Standard Appraisal?
- How Many Comps Do You Need for an ARV Appraisal?
- My Rule of Thumb for Comps
- Final Thoughts
What is a Home Appraisal
If you’ve purchased a home, chances are you’ve dealt with an appraisal—whether you knew it at the time or not. In technical terms, a home appraisal serves as a formal valuation of a property. In non-technical terms, an appraisal tells you how much your home is currently worth.
Why do you need an appraisal?
Anytime a real estate transaction—purchase, sale, or refinance—involves a lender, that lender will require an appraisal. To understand this, it’s important to understand how mortgages work. When a bank extends you a mortgage, they loan you money backed by real estate (the house) as collateral. If you stop making mortgage payments, the lender can then seize your home and sell it to pay off the outstanding loan balance, a process known as foreclosure.
However, if your home value is less than the amount you owe, a lender wouldn’t be able to recover the entire loan balance during a foreclosure. For this reason, lenders mandate appraisals prior to any loan closing. Put simply, they want to make sure the collateral will cover the entire loan balance in the event of a foreclosure.
How do appraisals work?
Due to the amount of money on the line with home mortgages, lenders require qualified appraisers, meaning they need to be licensed or certified. Additionally, they must be A) familiar with the local area, and B) have no direct or indirect financial interest in the associated transaction.
Broadly speaking, three different appraisal methods exist:
The cost approach
With this method, appraisers base their valuations on the construction costs associated with a given property improvement. In theory, an unrelated buyer will not pay more for Property A than he would pay to build identical Property B right next door. This method is generally used for rarely sold, non-income properties like schools.
The income approach
Typically reserved for income-producing commercial properties, this method uses a property’s net operating income (NOI) to derive value. If you divide NOI by a property’s capitalization, or cap, rate (the rate of return if purchased for cash), you arrive at value. For example, if a property has an annual NOI of $100,000 and a 5% cap rate, it would have a $2,000,000 valuation ($100,000 divided by 5%).
Sales comparison approach
Sales comparison approach: Residential investors rely on this final appraisal, and I’ll focus on this for the remainder of the article. In a sales comparison approach, appraisers look at the market “comps” to determine how high—or low—they should value your house.
What are Comps in Real Estate?
As with a lot of real estate terms, investors tend to casually throw around “comps” and assume everyone knows what they are. But, to adequately explain the sales comparison approach to appraisals, I need to provide a detailed overview of what comps actually are.
At a basic level, sales comps—short for comparables—represent recent property sales A) in your neighborhood, and B) similar to your own property. In theory, if you can confirm what other properties sold for, you can confirm your own home’s value. In a market-based economy, these real estate transactions dictate value with residential properties. You may think your home is worth $500,000, but if similar properties on your block just sold for $300,000, the market doesn’t agree with you.
On the other hand, if a home on the other side of town that looks nothing like yours just sold, should that sales price affect yours? No, probably not. Appraisers want to find properties as similar to your own as possible, which is why these are called comps. More precisely, appraisers look at the following factors to determine comps for your home:
- Location: While the exact distances can vary with population density (urban vs. suburban vs. rural), most appraisers rely on a half-mile rule of thumb. That is, geographically, they consider comps to be properties located within a half-mile radius of the home.
- Home size: Appraisers also want to find houses as close to the same size as possible. If listing a 3,000 sq. ft. home, the sales price of a 1,500 sq. ft. or 5,000 sq. ft. won’t give you an accurate parallel. In reality, appraisers typically accept a 20 percent plus/minus in gross living space when looking for comps.
- Parcel size: For single-family homes, you don’t just need to look at home size—you should also find comparable parcel sizes. A half-acre corner lot will likely command a higher asking price than a quarter-acre lot in the middle of a street.
- Bedrooms/bathrooms: In addition to size, appraisers also look for comparable properties in terms of number of bedrooms and bathrooms. This breakdown will affect the utility of properties. For example, a couple with two little kids likely prefers a 2,000 sq. ft. home with three bedrooms and three bathrooms, not a similarly sized home with one master bedroom and bath with a huge living room for entertaining.
- Sales date: Housing prices can change from month to month (and sometimes even week to week). Consequently, the older a property sale, the less relevant it is to your own home’s current value. Simply put, a home that sold on your block two weeks ago will more accurately reflect the current value than if that same home sold two years ago.
- Style: If you’ve ever driven around a neighborhood looking for properties, there’s a good chance you’ve had a “what were they thinking!?” reaction to a certain home’s style. While some designs remain timeless, some clearly belong in a different era. As a result, a home’s general style and aesthetics should be considered. For instance, appraisers ideally avoid using an art deco sales comp for a colonial property.
How Many Comps Do You Need for a Standard Appraisal?
Now that I’ve explained comps, the question remains: how many do you need for a sales comparison appraisal? I need to caveat this answer, as it depends on the type of appraisal. Generally speaking, two types of sales comparison appraisal exist: 1) standard, and 2) after-rehab value, or ARV.
A standard appraisal pertains to a home for sale that’s essentially ready to be occupied—not a distressed property that needs to be completely renovated. A potential buyer may still want to make improvements to these homes, but a baseline level of habitability exists.
For these appraisals, the appraiser will typically want to see three to four comps. Ideally, they’ll be within a half-mile to mile of the property—the closer the better—and within at least 20% of the gross living space. As discussed above, like-for-like comps represent the absolute gold standard, but some neighborhoods just don’t have enough recent transactions for near-identical comps.
With single-family homes, appraisers use Fannie Mae’s Uniform Residential Appraisal Report. This standardized document requires a general description of a property’s interior and exterior, the neighborhood, and comparable sales in the area. Using this information, the appraiser then provides his or her analysis and a conclusion about the property’s value.
This final value plays a huge role in closing a transaction. If it comes in below contract price, the lender will not provide a loan for the full amount, meaning A) contract price needs to be lowered, B) the buyer needs to put extra cash into the deal, or C) the deal falls apart.
How Many Comps Do You Need for an ARV Appraisal?
The process gets a little more complicated with after-repair value, or ARV, appraisals. With these, an investor asks for two separate appraisals on the same property, typically a distressed home in need of significant repairs.
First, appraisers complete an “as-is” condition appraisal, determining value in the current, distressed state. Next, appraisers do a projected valuation to determine what they believe the value will be after the planned repairs have been completed. As this asks appraisers to look into the future you’ll need to provide far more detailed information.
For the “as-is” appraisal, the appraiser will treat it essentially as any other one, requiring three to four comps that as closely as possible replicate the location and current condition of the distressed property.
For the ARV appraisal, you’ll need to provide the full scope of the work that you plan on doing to rehab the property. Prior to actually completing their analysis, appraisers will require a detailed contractor’s bid outlining this full scope of work and associated costs. That way, when they look for rehabbed comps in the area, they can look for properties that had a similar level of work completed during their own renovations.
Basically, appraisers want to know how you’ll rehab a property, and how much it’ll cost. Once they have this, they’ll look for another three to four after-rehab comps in your neighborhood that had similar work completed. With these comps, appraisers arm themselves with the necessary information to value a property in the future.
Due to the fact that ARV appraisals require these two different appraisals, they’re much more expensive than standard appraisals. As an investor, you’re asking an appraiser A) what the property’s worth as it sits, and B) what it’s going to be worth after the rehab. But, returning to the primary question, you’ll need three to four comps for both the “as-is” and ARV appraisals.
My Rule of Thumb for Comps
As with many areas of real estate, I’ve used my experience dealing with appraisals to develop a rule of thumb for comps. More precisely, I use this rule of thumb as an investor when I’m considering how to price a property for sale. Price too high, and you won’t get any offers. Price too low, and you could cut into your profits. Recognizing this reality, I like to do my own analysis of comps—separate from the actual appraiser’s analysis—when putting a fix & flip home on the market.
Here’s my rule of thumb: using the above characteristics of quality comps, find three to four active comps and find three to four sold comps. Formal appraisals only use sold comps. Appraisers know that a sold property reflects the market, as the property actually sold. Conversely, a home currently on the market (i.e. an active comp) will not reflect the market if it never sells. For instance, if a seller lists a property at $300,000, but it sits unsold for a year, that price clearly doesn’t reflect the market.
However, I see active comps as an outstanding indicator of market trends. Specifically, I like to look at active comps relative to sold comps to determine whether a market is improving or declining, that is, whether I’m working with a buyer’s or seller’s market:
- Active comps greater than sold comps: This means that the market is generally heating up, as it demonstrates seller confidence that they can command higher prices than recently sold, comparable properties. As an investor, this suggests that you can price a home more aggressively.
- Active comps lower than sold comps: If people are listing their properties for lower prices than recently sold properties, this means that the market is likely slowing down. Either due to an oversupply of properties or some other macroeconomic factors, prices are weakening. From an investor’s perspective, this means you should price your home more conservatively.
After conducting this comparison of active and sold comps, I typically price my properties at the lower of the actives or solds. Here’s my rationale: if I price a home too low, I can always sell for more than the initial listing price (e.g. increase the listing price, get multiple offers, etc.). But, if I overprice a property, one of the below two negative outcomes will occur:
- The property will sit on the market for an extended period, forcing me to pay more holding costs than initially factored into my budget.
- A buyer will sign a contract, but the deal will fall apart when the formal appraisal comes in under the contract price.
From a practical perspective, I broadly look at the active versus sold comps, selecting the lower of the two categories. Then, within that category, I start with the lowest comp. From there, I work my way up the pricing ladder until I find three comps as similar as possible to the property I’d like to sell. With these comps, I can comfortably price my property, confident that it will neither sit on the market for an extended period nor fail to appraise once under contract.
Ultimately, when pricing properties as an investor, you want to find the intersection between the realistic market and your profit goals. You may want to net $50,000 on a deal, but ignoring comps that suggest closer to $25,000 profit will lead to deal failure. Put slightly differently, prior to pricing a property for sale, make sure that market comps realistically support your profit goals. If comps don’t support your asking price, any potential deal will likely fall apart.
When it comes to comps, your unique situation will dictate the number you need for an appraisal. For a standard appraisal, you’ll need three to four comps, and these comps should be as similar to the property as possible. On the other hand, ARV appraisals require more effort and, accordingly, cost far more to complete. These appraisals require three to four “as-is” comps, and three to four ARV comps, with the latter supported by a detailed scope of work.
For investors, I also hope you take this away from the above article: comps have two primary uses. First, comps should be used to inform your own market analysis and pricing decisions. Second, sold comps dictate success or failure in most deals. If comps don’t support your sales price, buyers won’t receive the financing necessary to close. If buyers don’t receive financing to close, most simply won’t have the cash on hand to cover the difference between the appraised value and the contract price. This means investors will need to either cut their sales price or step away from the deal—both undesirable outcomes.
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