How to Determine the Price of a Home

When you are planning to make a real estate purchase, it is absolutely crucial that you know how to properly estimate the price of the home (or other real estate property) in TODAY’s market. You need this information not only to determine what homes you can afford and what you should offer, but also because the lender on your mortgage  will send their own appraiser to estimate the value of the property, and they will not lend you more than that estimated value. (If there is a difference, you will need to come up with the difference in cash.) 

While you can never be 100% certain about the price of a house until it sells, a  good real estate agent should be able to do this estimation quite accurately, and I highly recommend selecting an agent who has this process down cold.

But even when you have a good agent working for you, YOU should also know how to do it so that you can make sure you are getting good value for money. In this article I will explain how you can do your own estimation.

How real estate properties are appraised

Commercial real estate properties are appraised differently than residential properties (homes).

With commercial properties, an appraiser will use the following three methods of valuation:

-       Income: A valuation is made based on the monthly income the property produces

-       Replacement cost: A valuation is made based what it would cost to replace the property (i.e. rebuild it from scratch)

-       Comparables: A valuation is made based on what other similar properties in the area have sold for RECENTLY (in a volatile market, recently means up to 3 to 6 months, and in a stable market, it can mean up to year, depending on how many comparables are available)

Theoretically, all these methods should come to about the same price. And when they do, you know that that price is a solid place to negotiate from.

With a home purchase, the ONLY RELEVANT METHOD OF VALUATION IS: COMPARABLES. 

Note that some properties have a bit of crossover between residential and commercial, i.e. a home that is used as an investment property for AirBNB or long-term rental, or a home that is used as a care facility, such as for elderly care. Or a small apartment building where the owner will live in one of the units and rent out the others. Income may come into play with these types of properties, but for the purpose of this article, we will focus on residential properties that will purely be used as a primary residence.  

So you know that you need to find comparables to the home you’re interested in. But what makes something “comparable”? 

Finding the comparables and making your estimate

Here are the steps for finding the comparables in TODAY’s market in your market area.

1.     First, you determine the market area. One neighborhood is not priced the same as another neighborhood, so it is very important that you define “your neighborhood” very precisely (when it comes to price comparables). The best way to do this is to walk and/or drive the area. Market area boundaries are usually defined by big avenues or specific geographical features, such as parks, lakes, hills, cemeteries, etc. The boundary of a certain school district may also come into play. As you walk and/or drive around, you will notice that the homes and/or neighborhood changes character when you cross a certain street or a certain geographical feature. The homes will look different or the vibe feels different. You may also see that there is a significant different in the price at which similar-size homes are listed when you look at a real estate website like Zillow. Sometimes homes on one side of a street can be more expensive than homes on the other side, or it may be that one street is priced the same, but the next street over is different because it belongs to a different market area. Take a map and delineate these boundaries exactly. It is important to get this right.

2.     Find the comparables. A comparable home is one that is located in the same market area AND has a square footage of up to 20% high or 20% lower than the home you are looking at. Example: you are trying to valuate a 1,000 sq ft home. The comparables are going to be homes in that same market area that have a square footage of 800-1,200 sq ft. The number of bedrooms is also important. Ideally you want to pick homes that have the same number of bedrooms as the home you are looking at, because homes with more bedrooms can be priced a little higher even when the square footage is the same. The number of bathrooms can be relevant too, but it is less important than the number of bedrooms.

3.     Looks at the coomparables listed and the comparables sold. Look at ALL categories of comparables that you can find in the market area: What is currently listed, what is “pending” or “under contract” (i.e. in escrow), what is expired (the home didn’t sell and was removed from the market), and what has recently sold (as per the above definition of “recently”). Note the prices of the comparable homes in each category. Give the most weight to the price in the category of what has sold.

4.     Look at the volume of comparable sales. Count how many comparable homes have sold in that same market area in:

a.     the last 12 months

b.     the last 6 months

c.     the last 3 months

d.     the last month

Note down what you find.

When doing this, you want to determine the trend of the speed at which homes are selling. For example: in the last 12 months, 10 homes have sold, but in the last month, 3 have sold. That means that homes are selling faster in the past month than they were selling in previous months of the year. There is a lot of current demand for homes in that market area.

If, on the other hand, 10 homes were sold in the past year, but only 1 in the last three months and 0 in the last month, the demand for homes in that market area seems to be decreasing.

5.     Look at the current inventory of comparable homes in the market area. You simply count all the comparable homes that are currently for sale in the market area, as well as the homes that are currently in escrow. Homes in escrow are usually designated as “pending” or “under contract” on most platforms.   

6.     Calculate the average number of monthly sales of comparable homes that can be expected in the market area in the next month. Depending on what you find in point 4 in terms of the trend, it may make sense to take the average monthly sales for the last 12 months, for the last 6 months, for the last 3 months, or even just the monthly sales for the last month.

7.     Determine the “months of inventory” of comparable homes in your market area.  “Months of inventory” means how many months it would theoretically take to sell the current number of (comparable) homes in the market area. You calculate this by dividing the current inventory of comparable homes in the market area by the average number of monthly sales of comparable homes in the market area. For example, if the market has been stably selling in the last 12 months, there were an average of 5 sales per month during that time, then you can reasonably expect that in the next few months there will also be 5 sales per month. If there are currently 15 homes for sale, then you can expect that it will take 3 months to sell that inventory (at 5 per month).

8.     Determine if the current market is a buyer’s market or a seller’s market, or if the market is balanced. Traditionally the market is considered balanced when there is 4-6 months’ worth of inventory. When there is more than 6 months’ worth of inventory, it is considered a buyer’s market (there are more options than buyers, so buyers have a lot of homes to choose from and price may have to come down in order to entice a buyer to buy a particular home). When there is less than 4 months’ worth of inventory, it is considered a sellers’ market, which means that there are few homes for sale and many competing buyers. When this happens, homes usually sell quickly and at higher prices than expected.

Taking all this data into account, you can now come to a reasonable price for the home you are looking at IN THE CURRENT MARKET. 

Additional things to consider:

-       The condition of the home is also important, for example if the home you are looking at needs extensive renovations. You cannot compare homes that if one home is in top condition but the other is in disrepair and needs extensive renovation, even if the have the same number of bedrooms and bathrooms and comparable square footage. If the home that you are looking at needs extensive renovations but you can only find comparable homes that are fully renovated, you can take the average price of the comparables and deduct the expected costs of renovation. (Unless you are experienced in this, it is wise to get one or more quotes from contractors for the specific work you plan to have done.) Then go even a little lower than that to account for time passing during renovations (and during which you will have to pay interest on your mortgage, if you are getting one), the “risk” factor, and the time and work that YOU personally will be spending to supervise the renovations, and deduct that also. This will give you a rough estimate of where the home should be priced. Most people want a home that is ready to move into, where they have to do no or very little renovation. Thus, great deals can often be had if you ARE willing to do the work, spend the time and take on that risk.

-       Additionally, keep an eye on the price per square foot (the home price divided by the square footage of the habitable spaces inside the home, excluding the garage and unfinished basements, crawl spaces, etc.), and make sure that it is comparable to the homes that have sold in your neighborhood (providing they were in the same condition). This is not as important as the number of bedrooms, but still something to take stock of. Also keep in mind that smaller homes do tend to have a higher price per square foot than larger homes, and this is considered normal. 

-       Also keep in mind that real estate sales can be somewhat seasonal, with the summer months usually experiencing more sales than the winter months. Homes tend to fetch higher prices in the summer months, when demand is higher.

-       You will probably find that home prices tend to incline toward the average of the neighborhood. That means that a big house in a neighborhood full of medium sized homes will not fetch as high a price as it would if it was surrounded by other large homes. Similarly a small home in a neighborhood full of large (and thus expensive homes) will tend to fetch a higher price than if it had been surrounded by other small homes. Financially speaking, it is best to “buy the cheapest house in the most expensive neighborhood.”

-       Some homes have few (or even no) comparable. This can happen for example in a high-end area where all the homes are custom built, don’t have a high turnover and are all quite different in character from one to the next. When the lender sends an appraiser to such a home, the appraiser may choose to use the “cost-approach” method for valuation of the home instead. This means he will estimate what it would cost to build that same home from scratch in today’s market. The income approach is usually not used (what the house could rent for monthly), because the home price far tends to far exceed any logical relationship to monthly rent in these high-end areas.  

Getting professional estimates

In addition to making your own estimations, it is wise to ask your (prospective) real estate agent for an estimate and have him/her explain his reasoning. This is one of the ways in which you can know if he or she is a good agent.

Additionally, if you are selling a home, you can actually pay for an appraisal by an official appraiser even before you put the home on the market. This will cost you a few thousand dollars. After you accept an offer from a buyer, their lender (if they are using one) will still send their own appraiser to come and appraise your home for mortgage purposes (which the buyer will pay for). But having an official appraisal done upfront will increase your negotiating power with buyers and ensure that you are putting your home on the market at a reasonable price, which can be very important, especially when home sales are slowing. 

If you are the buyer and you are purchasing the property with a mortgage, then the lender will send an appraiser of their choice as part of the loan application process (which you will pay for). If you are paying cash, then you still have the option of hiring your own appraiser and getting an official appraisal. But you don’t have to. If you have done a good estimate of the value of the home as per the above procedure and/or you are working with a competent real estate agent, then you may not even need an official appraisal at all.