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Smart Money Moves for Your Home

Find out how real estate is valued and which remodeling projects payback the most at resale.

By
Laura Adams, MBA
December 9, 2008
Episode #101

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Today's topic is about real estate valuation and which home-improvement projects will bring you the most “bang for your buck” at resale.

Don't Over-Improve

One of the most important real estate tips I can give you is to never over-improve a property. Over-improvement is putting more money into your home relative to the value of similar properties in your immediate neighborhood.

In terms of getting the most value for the size and features of your home, it's actually better not to be the biggest, most expensive house on the block. If you have a smaller or less expensive home in a neighborhood of more valuable homes, their market value will tend to pull yours up.

Let's say you want to remodel your bathroom and it's going to cost $15,000. Does that mean that after the remodel you can sell your home or condo for $15,000 more than before the remodel? Usually, the answer is no. You rarely get a dollar-for-dollar increase in market value from remodeling projects.

To understand why this is the case, I’ll give you a brief overview of how real estate is valued. There are three approaches or methods used by licensed real estate appraisers:

  1. Cost approach
  2. Sales comparison approach
  3. Income capitalization approach

The analysis and calculation of each approach results in a different valuation. The appraiser then applies a weighted average to the three numbers to determine the property’s final value estimate.

The Cost Approach

The cost approach is an objective analysis of what it would cost to rebuild the exact same structure on the exact same piece of land today. Appraisers add this replacement value to the estimated value of the land. If this were the only method used to value real estate, then spending $20,000 to upgrade your kitchen would mean your home is now worth an additional $20,000.

Sales Comparison Approach

However, the second method to appraising real estate is much more subjective than simple replacement cost. With the sales comparison approach, the appraiser considers what's going on with recent sales in the neighborhood as well as overall conditions and amenities in the surrounding communities. A property's market value is largely based on the price comparable properties have sold for within the recent past. If the “comps” don’t exist to support a higher home value that you hoped a remodel would bring, you’ll have difficulty selling at the higher price. This is especially true if the buyer needs a mortgage for any portion of the home purchase. Lenders rarely loan money for real estate purchases that exceed the appraised value. This underwriting guideline has become even more stringent in the current cautious lending environment that we’re experiencing now.

Income Capitalization Approach

And the last method real estate appraisers use is the income capitalization approach. This analysis determines what a property is worth based on the income it does or could generate for the owner. This approach is typically only used if the property is in a rental neighborhood or is multi-family.

These three appraisal methods are used in conjunction to arrive at a final estimated value for the owner or lender. But it’s important to understand that a property is ultimately worth no more than what a willing buyer will pay a willing seller.

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