On a regular basis, I appraise homes that need some type of repair. It may be as simple as replacing an outlet, or as complicated as renovating a home. In the appraisal process, the appraiser has to estimate a cost to cure many types of repairs. Why do appraisers use the term, cost to “cure”, instead of a cost to “fix” a repair? Are appraisers just trying to use fancy vernacular to try and impress the reader of the report?
Appraiser think in terms of value. The term “cure” may make you think of someone who suffers from an illness, for which a cure is desired. To cure something means to heal or to restore to health. When a home is in need of repairs, it is suffering from something. Namely, physical or functional obsolescence. What is that? Obsolescence in valuation refers to a condition(s) that cause a property to lose value. In real estate, there are three types of obsolescence. Physical, functional and external obsolescence. Repairs fall under physical and functional obsolescence, depending on the repairs needed.
Appraisers are concerned about what it will take to remedy the obsolescence, restoring the home to a condition that no longer suffers from a loss of value, and the cost(s) to do so. We are also must determine the impact such a repair may have on value. How do appraisers accomplish this, especially since most are not general contractors? Let’s talk about it.
Some repairs are basic. Replacing a window, an electrical outlet or simple plumbing repairs like replacing a sink faucet and so on.
For these types of repairs, it is relatively easy to search the internet for estimated prices for making these simple repairs. The cost to make the repair(s), can be reflected in the appraisal report as a negative adjustment to the sales prices of the comparable sales being used, assuming they are not in need of the same, or comparable repairs.
I am currently appraising a home for a client who is considering buying a home being sold in a private estate sale. The home is such disrepair, that it may need to be torn down, or completely gutted down to the studs, with major structural work needed. How does an appraiser reflect the market value of a home that needs extensive repairs?
These situations are much more difficult when it comes to reflecting market value. When a home is in need of such extensive repairs, I try to find other sales that need major renovations, even if the renovations needed are not exactly the same as those needed to the home I am appraising. In this instance, appraisers try to determine what the market is willing to pay for a home that may be in need of extensive repairs, or worse, that may need to be torn down. When appraising a home that is in need of many major repairs, I’m more concerned with the overall condition of the property, and its market appeal, than the cost to cure every individual repair.
In the case of the home I am appraising, I was able to find two homes that sold recently in the area. The MLS comments state that both needed to be torn down, or totally renovated from the studs. Sometimes in these types of listings, the listing agent will state, “the value is in the land”, or something to that effect in their comments. Perhaps there is more value in tearing down a dilapidated house in order to build a new one. This is the case when the cost of the repairs exceeds the what the home will be worth once the repairs are made. In this case, a home suffers from what is called incurable obsolescence.
ENTREPRENEURIAL INCENTIVE & PROFIT
When someone is looking to buy a home, and it is in need of repairs, simply discounting the price of the home enough to cover the cost of making a repair, is generally not going to reflect market value. Especially if the home needs many repairs and/or major ones.
Most buyers expect some type of incentive. That is, a little reward for the time and energy they are going to expend in dealing with the needed repair(s), above and beyond the cost of the repairs. That extra incentive is often called entrepreneurial incentive. That’s the estimated additional percentage most buyers will expect a seller to discount their home, above and beyond the cost of making needed repairs.
When making an adjustment to reflect the cost to repair an item, typically an additional amount is added to reflect the incentive needed to make it worthwhile for a buyer to purchase the home in its current condition.
Closely related to entrepreneurial incentive is entrepreneurial profit. Entrepreneurial profit reflects the value that is created after the repair or renovation is completed.
BIDS & ESTIMATES
Some minor repairs are easy to find cost data on, as I mentioned. However, some repairs and/or renovations require a degree of expertise beyond what most appraisers can provide. In these cases, the appraiser’s client will need to obtain bids from qualified professionals.
I recommend obtaining three bids if possible, because contractor’s prices vary depending on their own expertise and workload. For this reason, an estimated cost to repair an item is not a set number. Like most other aspects of value, cost estimates also have ranges. Once bids are obtained, they can assist the appraiser in having a better idea of the potential impact on value a repair issue will have on the property. Especially if the appraiser cannot find comparable sales that are in need similar repairs.
COST DOES NOT EQUAL VALUE
One of the first things appraisers are taught is that cost does not equal value. For instance, if a buyer spends ten thousand dollars installing new roof shingles, this does not automatically mean that their home is now worth ten thousand dollars more. It would be great if it worked that way, but generally, it does not. A new roof, or other improvements, usually add value, but not dollar for dollar.
Since appraisers generally develop opinions regarding market value (there are other types of value that we sometimes develop), more has to be considered than just the cost to repair something. Appraisers must consider what buyers are likely to pay for a home in its current condition as well as its condition after the repairs have been made. Some minor repairs may make no difference at all, while others will clearly make a difference.
Financing also plays into this situation. For instance, FHA financing has specific repairs that must be made. Those necessary repairs may not necessarily have an impact on market value. For instance, minor peeling paint in a small area on the inside of a home built on or before 1978, or a missing outlet cover. Nonetheless, if a buyer wants to use FHA financing, these repairs must be made. The same may be said of Conventional financing. While less stringent than FHA financing, there may be repairs the lender requires to be made, that may not really impact the market value of the home.
You might be wondering, if cost does not equal value, then how do investors who renovate and flip homes make money?
Investors usually make their money when they buy a home, not necessarily when they sell it. Investors understand that the cost to renovate a home will not bring a dollar for dollar return. They also understand that there is a maximum amount of renovations that can be made without over-improving a home.
That’s why they look for homes to buy that are being sold in duress. It could be an estate sale, a sheriff or bank sale or someone who is simply looking to sell their home quickly and are willing to sell it below market value. Most homes being sold in duress, need work. Investors usually improve a home with the goal of capitalizing on their investment. They are interested in entrepreneurial profit.
There is a lot to think about when it comes to repairs and estimating a cost to repair something, and how that impacts the value of home. And while the cost to repair something is generally a component of value, it is rarely, if ever, an equivalent of value.
Hopefully, I’ve given you some food for thought with this article. If you have questions about this topic, reach out to an appraiser in your area who can help you with your questions. If you’re in Northeast Ohio, give me a call! I would be happy to visit.
Talking about home renovations makes me think of a classic Weird Al Yankovic song called Handy. I hope you enjoy it!
Have a great weekend everyone! Be safe out there!
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Here are some links to other articles I’ve enjoyed recently! I hope you will also…
The Bankable Color of Housing Money – Housing Notes by Jonathan Miller
Why your home isn’t worth 16% more today – Sacramento Appraisal Blog
5 Questions Your Appraiser Should Be Asking – Birmingham Appraisal Blog
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