Central to an appraisali is the determination of a property's market valuei
(also known as the fair market value).  Market value is the most
probable price a buyer is willing to pay a seller for a product on the
open market.  Market value is not the highest price possible for
a home; rather, market value is the most likely price the
property will receive.

Market value should not be confused
with asking price, offering price or sales price.  Asking price is
what a seller indicates as a fair and reasonable offeri for a home. 
A seller is free to set whatever asking price he/she chooses. An offering
price, on the other hand, is a number that the buyer feels as a fair and
reasonable offer for a home.  This may be an accurate reflection
of the true market value of a home or an attempt by the buyer to purchase
the property at a considerable discounti.  The sales price is what
the buyer and seller actually agree upon through negotiations and generally
lies somewhere between the asking price and the offering price.  

To derive a final estimate of
a property's market value, an FHAi appraiseri relies on three appraisal
methods (or approaches)--the sales comparison approach, the cost approach,
and the income approachi.  These methods provide a clear estimate
of value for the lender

Sales Comparison

In the sales comparison approach,
the FHA appraiser determines value by comparing the property being appraised
(i.e. subject property) against properties that have recently sold in
the area and are similar in size, age, construction, and amenities. 
These properties are also known as comparable properties (or comps).  

The goal of the sales comparison
approach is to determine market value.  As stated before, market
value is the most probable price that a property should bring in a sale
under normal market conditions.  Essentially, the sales comparison
approach establishes market value under the premise that a buyer will
not pay more for a property than a cost to purchase another similar property
in the area (i.e. a comparable property).  

The key to successfully determining
value under the sales comparison approach is for the appraiser to identify
three to five properties that have recently sold (generally no more than
six months since the sale of the property) and are similar to the subject
property.  Though it is rare that an appraiser will find exact carbon
copies of the subject property, he/she notes any dissimilar features and
makes an adjustment for each by using the following formula:

Sales Price of Comp 
+ or - Adjustments = Adjusted Value

These adjustments may increase
or decrease the indicated value as determined by the comparable. 
For example, if a comparable property has a heated swimming pool and the
subject property does not, the adjusted value would be decreased since
the comparable has a positive feature that the subject property does not. 
This rule works both ways.  For example, if the subject property
has a two car garage and the comparable property has a one car carport,
the adjusted value would be increased.  Most adjustments include
those made for physical features such as a fireplace, parking,
or a pool, locational influences such as proximity to a freeway,
greenbelt in the backyard, or located in an exclusive and highly desirable
country club, conditions of the sale such as the seller facing
foreclosurei and had to liquidate the property, and time from the date
of the sale (the more recent, the more accurate).  

As a rule of thumb, comparable
properties are always adjusted (up or down) to make it as similar to the
subject property as possible.  A comparable property that has features
or characteristics more valuable than the subject property must be adjusted
downward.  A comparable property that has features or characteristics
less valuable than the subject must be adjusted upward.

Example:

House A, the subject property,
has air-conditioning and a two car garage.  House B, a comparable
property, sold recently for $100,000 and has a garage but not air-conditioning
(valued at $3,000).  House C, another comparable property, recently
sold for $95,000 and has air-conditioning but not a two car garage (valued
at $7,000).  House D, another comparable property, recently sold
for $114,000 and has the identical amenities and features to House A except
that it is located in a better neighborhood.   A summary of
the adjustments are as follows:

It is important to notei that
the accuracy of this approach is dependent upon the appraiser's use of
reliable adjustment values.  These values will vary from region to
region, amenityi to amenity.  Also, large differences in value might
suggest that the properties used are not similar enough to be considered
comparable. 

Cost Approach

In the cost approach, the FHA
appraiser estimates the current market value of the home by estimating
the cost of reconstructing the home (to include any improvementsi) plus
the value of the land minus the estimated depreciationi of the home since
the home was first built.  

Depreciation is the loss in
value from any cause such as physical deterioration, functional obsolescence
and external obsolescence.  Deterioration is the loss in value resulting
from average wear and tear over time (such as exposure to the sun, peeling
paint, .  Functional obsolescence is the loss in value caused by
deficiencies within the property such as poor room layout or design and
inadequate mechanical equipment (such as a home with only an evaporative
cooler instead of an air-conditioner).  External obsolescence is
a loss in value caused by negative conditions outside of the property
such as a change in zoningi or excessive noise and traffic.

The concept behind this approach
is that a knowledgeable buyer will not pay more for a house than the cost
of reconstructing a substitute house on a similar lot in a similar condition. 
It is calculated as follows:

Cost of reconstruction
- Depreciation + Value for land = Property Value

 Example:

The subject house is similar
in size, design and quality of construction to a new house that cost $150,000
to build.  The subject house has depreciated by ten percent due to
normal wear and tear and is on a lot valued at $40,000.  Using the
cost approach, the estimated value of the home is:

$150,000 - (10% x $150,000)
+ $40,000 = Property Value

$150,000 - $15,000 + $40,000
= $175,000

Income Approach

The income approach is rarely
used to determine the value of a home that will be financed by an FHA
insured loan unless it is an income producing property (such as a triplexi
or four-plex).  The income approach is an analysis based on the relationship
of value as related to the market rent that a property can be expected
to earn.

Market rent is the rental income
that a property would most likely receive on the open market as indicated
by current rentals paid for comparable space.  In addition, the appraiser
will analyze the sales prices of comparable properties in order to determine
the gross rent multiplier (GRM) that represents the relationship
between market rent and market value.  This ratio is calculated by:  

Sales Price divided by
Gross Rent = GRM

The following illustrates how
to calculate a monthly gross rent multiplier:

Based upon this analysis, the
appraiser can used this estimated GRM and apply it to the projected gross
rents of the subject property.  For example, if the appraiser had
determined that the market rent for the subject property is $700 per month,
the estimated value of the subject property would be:

Gross Rent x GRM = Market
Value 

$700 x 121.11 = $84,777

Approach Comparison

All three methods used to determine
market value, the sales comparison approach, the cost approach, and the
income approach, are market oriented and must reflect market data and
the market behavior of buyers.  

Using the sales comparison approach,
the market value is determined by adjusted the sales prices of recently
sold similar properties (comparablesi).  The sales prices of the market
comparables reflect the behavior of typical buyers in the marketplace.  

With the cost approach, market
value is determined by calculating the replacement cost of an identical
home plus the cost of the land underneath the home minus any depreciation
over the years since the home was first constructed.  

The income approach analyzes
the market rents of comparable properties and applies the gross rent multiplier
in relation to expected rents from the subject property to determine the
market value.  

As a general rule of thumb,
the sales comparison approach has the most weight when determining the
market value of a home that is to be insured by an FHA loan.  The
cost approach is calculated and often supports the conclusions that the
FHA appraiser calculated using the sales comparison approach.  The
income method is only used when the borroweri is financing a triplex or
a four-plex under FHA guidelines.

FHA VC Sheet

Effective September 10, 1999
all FHA insured loans will require the appraiser to include the Valuation
Conditions (VC) sheet (HUDi Form 92564-VC) with the standard FHA appraisal. 
The purpose of the VC sheet is to insure that the appraised property meets
HUD's minimum property standards.

The form outlines several areas
in and around the property that may require repairs to be completed before
a borrower can close on his/her loan.  Areas covered include site
hazards and nuisances such as excessive noise from traffic, property considerations
such as soil contamination, drainage and termites, structural conditions
such as significant cracks in the foundation, the roof, mechanical systems
such as the furnace, AC, the electrical system and the plumbing, as well
as health and safety issues such as the potential for lead based paint.

It is important to note that
the VC sheet is not an inspection.  A home inspectioni gives the home
buyer/seller more detailed information about the entire house.  The
VC sheet details the minimum property standards required by FHA and does
not include everything.  Furthermore, the conditions are evaluated
by a licensed appraiser, not a home inspector.  The level of detail
only involves readily observable conditions of necessary repairs.  

If any deficiencies are noted on the VC sheet, the
home buyer must receive within five days prior to closingi a copy
of the Home buyer Summary (HUD Form 92564-HS).  Any repair
items indicated must be completed before the close of escrowi. 
If a home buyer receives the Home buyer Summary in relation to an
FHA loan, it is within his/her rights to request a copy of the VC
Sheet and the appraisal.  It is the lender's responsibility
to coordinate the repairs on the home (though not necessarily responsible
for the cost of repairs).

Refer to HUD handbook 4150.2
for more information about the site and property considerations for an
FHA insured property.

Home Inspections

When applying for an FHA insured
home loan, the borrower(s) must sign a disclosure that details the importance
of a home inspection.  

In previous sections, we learned
that FHA offers a detailed home appraisal that covers many items often
included in a home inspection.  However, an FHA appraisal is not
a home inspection.  An appraisal is only an estimate of the market
value of a property.  Furthermore, FHA does not guarantee the value
or the condition of the home.  If a home buyer finds problems or
defects after the closing, FHA will not give the home owner money for
repairs or buy back the property.

A home inspection gives the
buyer more detailed information than an appraisal--information you need
to make a wise decision. In a home inspection, a qualified inspector takes
an in-depth, unbiased look at your potential new home to:

• evaluate the physical condition:
  structure, construction, and mechanical systems

• identify items that need
  to be repaired or replaced

• estimate the remaining useful
  life of the major systems, equipment, structure, and finishes 

A home inspection gives the
buyer an impartial, physical evaluation of the overall condition of the
home and items that need to be repaired or replaced. The inspection gives
a detailed report on the condition of the structural components, exterior,
roofing, plumbing, electrical, heating, insulation and ventilation, air
conditioning, and interiors. 

The cost for a home inspection
is only a few hundred dollars (which the seller may be willing to pay
for).  Most importantly, hire only home inspectors that have the
American Society of Home Inspectors (ASHI) designation.  These are
inspectors that have met the rigorous standards of education, professionalism
and expertise set by ASHI in order to attain that designation.