Valuation Methods: An Overview

Sales Comparison Approach

• The Sales Comparison Approach is based on the principle of substitution, stating a buyer will not pay more for a property than for a comparable one available. It relies on comparing the subject property with similar properties recently sold in the same geographic area.
• Key steps:
  1. Identify comparable properties based on location, size, design, and other features.
  2. Collect accurate sales data, sale dates, and conditions of sale for comparable properties.
  3. Adjust the sale prices of comparable properties to reflect differences between them and the subject property. These adjustments include:
     • Time adjustments❓❓ to reflect changes in the real estate market between the sale date and the valuation date.
     • Location adjustments to reflect differences in the attractiveness of the location.
     • Physical characteristic adjustments to reflect differences in size, design, features, and finishes.
     • Financing terms adjustments to reflect the impact of different❓ financing terms on sale prices.
  4. Analyze the adjusted data to determine a value range for the subject property.
• Formula: Subject Value = Comparable Sales Price +/- Adjustments
• Example: A comparable property with two bathrooms sold for $145,000, while the subject property has one bathroom. The market data indicates an additional bathroom increases the value by $5,000. The appraiser❓ would deduct $5,000 from the comparable property’s price, indicating a $140,000 value for the subject property.
• Limitations: Requires sufficient sales data of comparable properties, which can be difficult to find. Accuracy depends on the adjustments made.

Cost Approach

• The Cost Approach is based on the principle that the value of a property should not exceed the cost of building a similar new property. It estimates the cost of replacing the property with a new one, then deducts the value of depreciation (physical deterioration, functional obsolescence, and external obsolescence).
• Key Steps:
  1. Estimate the land value as if vacant and ready for construction.
  2. Estimate the replacement cost using methods like:
     • Unit cost method: estimating cost based on the average cost per unit area.
     • Quantity survey method: estimating cost based on calculating the quantities of materials and labor needed for construction.
  3. Estimate the accumulated depreciation, including:
     • Physical Depreciation: deterioration from use and wear.
     • Functional Obsolescence: deficiency in function or design.
     • External Obsolescence: deterioration from external factors, like changes in the surrounding environment.
  4. Calculate the property value by subtracting depreciation from the replacement cost and adding the land value.
• Formula: Property Value = Land Value + (Replacement Cost – Depreciation)
• Applications: Commonly used for valuing new or specialized properties without sufficient sales data and for property insurance valuation.
• Limitations: Estimating depreciation accurately can be difficult. The Cost Approach does not necessarily reflect the market value of the property.

Income Approach

• The Income Approach is based on the principle that a property’s value is determined by the income it can generate. It estimates the net income the property can achieve, then uses this income to estimate the property’s value.
• Key Steps:
  1. Estimate the Potential Gross Income if the property were fully leased.
  2. Estimate the Vacancy and Collection Losses.
  3. Calculate the Effective Gross Income by subtracting vacancy and collection losses from the potential gross income.
  4. Estimate the Operating Expenses.
  5. Calculate the Net Operating Income (NOI) by subtracting operating expenses from the effective gross income.
  6. Determine the Capitalization Rate (Cap Rate).
  7. Calculate the property value by dividing the NOI by the cap rate.
• Formula: Property Value = NOI / Cap Rate
• Gross Rent Multiplier (GRM): For residential real estate appraisers, the GRM is used to determine value through the income approach. In this method, the monthly income from each comparable rental sale is divided into its sales price to determine a gross rent multiplier. The appraiser then selects a multiplier from the determined range and multiplies it by the subject property’s gross monthly income to determine value.
• Example: A property generates $1,525 monthly income. After analyzing comparable properties, the suitable GRM is 135. The estimated property value is: $1,525 Subject Monthly Rent x 135 = $206,000 Value by Income Approach.
• Applications: Commonly used for valuing commercial and investment properties that generate income, such as apartment buildings, offices, and stores.
• Limitations: Accuracy depends on estimating NOI and the cap rate. Estimating the appropriate cap rate can be difficult.

Reconciliation

• After using the three approaches, the appraiser will have different value indicators. Reconciliation is the process of analyzing the valuation problem and selecting the most appropriate method of the three and giving it the greatest weight in determining the final value estimate.
• Key Considerations:
  • Data reliability.
  • Logic and analysis.
  • Appraisal usage.
• Example: If the appraiser arrived at the following value indicators:
  • Cost Approach: $150,000
  • Market Approach: $145,200
  • Income Approach: $144,500
    Since the value indicators are reasonably similar, it is safe to assume that the value of the property falls somewhere between $144,500 (lowest indicator) and $150,000 (highest indicator).

Reporting Value Estimation

• Types of Basic Appraisal Reports:
  1. Appraisal Report: Summarizes enough information for the client to understand. Usually found in a model report.
  2. Limited Appraisal Report: States information and is limited to the use of one client. These reports may be oral or written.
• Basic Elements of an Appraisal Report:
  1. Identification of the property under evaluation.
  2. Determination of estimated real property rights.
  3. The purpose of the evaluation.
  4. Definition of the value used in the evaluation.
  5. The actual date of the evaluation and the date of the report.
  6. Description of the scope of the evaluation.
  7. Any assumptions and restrictive conditions that affect the evaluation.