Sales Comparison and Income Approaches: Mastering Valuation

Sales Comparison and Income Approaches: Mastering Valuation

Chapter 9

I. Sales Comparison Approach: A Market-Driven Valuation

A. The Essence of Sales Comparison
The sales comparison approach, a cornerstone of real estate valuation, operates on the principle of substitution. This principle asserts that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. The appraiser’s role is to identify these substitutes (comparable properties), analyze their sales prices, and adjust for differences to arrive at an indicated value for the subject property.
*Comparable property sales prices are adjusted, not the subject property.

B. Data Collection and Verification: The Foundation of Accuracy

1. Assembling the Data Set
   The appraiser meticulously gathers data on recent sales of properties sharing key characteristics with the subject. This data typically includes:
   a. Sales prices
   b. Property characteristics (size, features, condition)
   c. Location attributes (neighborhood, amenities)
   d. Conditions of sale (financing, motivations)
   e. Date of sale

2. Data Verification: Ensuring Reliability
   The appraiser subjects the collected data to rigorous verification to ensure its accuracy and reliability. This involves:
   a. Confirming sales details with involved parties (buyers, sellers, brokers)
   b. Inspecting the comparable properties to assess their physical condition and features
   c. Scrutinizing public records to verify sales prices and property characteristics

C. Units of Comparison: Standardizing the Metrics

1. Selecting the Appropriate Units
   To facilitate meaningful comparisons, the appraiser selects appropriate units of comparison. These units should be relevant to the property type and market conditions. Common examples include:
   a. Price per square foot (for residential and commercial properties)
   b. Price per acre (for land)
   c. Price per unit (for apartment buildings)

2. Applying Multiple Units
   The appraiser can enhance the reliability of the final value indicator by employing multiple units of comparison. This provides a broader perspective and helps to identify potential inconsistencies.
   a. Example: For a commercial building, the appraiser might use both price per square foot and price per rental unit.

D. Elements of Comparison and Adjustment: Isolating Value Drivers

1. Identifying Key Elements
   The appraiser identifies the critical elements of comparison that influence property values in the subject’s market. These elements typically fall into categories such as:
   a. Property Rights Conveyed: Fee simple, leasehold, etc.
   b. Financing Terms: Cash equivalent sales are preferred. Non-market financing requires adjustment.
   c. Conditions of Sale: Arm’s length transaction.
   d. Expenditures Immediately After Sale: These can reflect price negotiations.
   e. Market Conditions: Adjust for changing market conditions over time.
   f. Location: Neighborhood quality, proximity to amenities.
   g. Physical Characteristics: Size, age, condition, features.
   h. Economic Characteristics: For income-producing properties – income, expenses, tenant mix.

2. Comparative Analysis: Quantifying Differences
   The appraiser systematically compares the subject property to each comparable property with respect to the identified elements.
   For each element, the difference between the subject and the comparable is measured.
   If the differences are significant or market data for adjustments is unavailable, the comparable sale may be rejected.

3. Adjustment Techniques: Isolating the Impact of Each Element
   The appraiser employs various adjustment techniques to isolate the impact of each element on the comparable’s sales price.
   a. Quantitative Adjustments: Based on market data (e.g., paired data analysis). Expressed as dollar amounts or percentages.
   b. Qualitative Adjustments: Used when quantitative data is lacking. Expressed as relative ratings (e.g., superior, inferior, equal). Relative Comparison Analysis is used.

E. Mathematical Considerations in Adjustment

1. Paired Data Analysis

Paired data analysis is a powerful technique for deriving adjustment amounts from market data. By analyzing sales of similar properties with only one significant difference, the appraiser can attribute the price difference to that characteristic.

a. Example: Two identical houses, one with a garage and one without. The difference in their sales prices indicates the market value of a garage.

2. Percentage Adjustments: Converting to Dollar Amounts

The conversion of percentage adjustments into dollar amounts depends on how the percentage relationship is defined. There are two primary methods:

a. Percentage of Comparable Sale Price: The adjustment amount is calculated as a percentage of the comparable's original sale price.
    *Adjustment Amount = (Percentage Adjustment) * (Comparable Sale Price)*

b. Percentage of Adjusted Sale Price: The adjustment amount is calculated as a percentage of the comparable's sale price after prior adjustments have been made. This is less common due to its compounding effect.

3. Adjustment Sequence

While the specific sequence of adjustments depends on market analysis, a general guideline is:

a. Transactional Elements: Adjust for property rights, financing, and conditions of sale before physical characteristics.
    *Rationale: These elements influence the overall sale transaction and affect the base price before considering property-specific features.*

F. Reconciling Adjusted Prices: The Final Value Indication

1. Totaling Adjustments
   All individual adjustments (both positive and negative) are totaled to arrive at a net adjustment for each comparable.

2. Applying Net Adjustments
   The net adjustment is added to or subtracted from the comparable’s sales price to obtain an adjusted price.
   Adjusted Price = Comparable Sales Price + Net Adjustment

3. gross adjustment❓: Reliability Indicator
   The gross adjustment (the sum of the absolute values of all adjustments) serves as an indicator of the reliability of the adjusted price.

   a. Higher Gross Adjustments: Indicate less reliable comparables.
   b. Lower Gross Adjustments: Indicate more reliable comparables.

4. Value Range and Reconciliation
   The subject’s value should fall within the range indicated by the adjusted prices of the comparables.

The appraiser reconciles the various adjusted comparable sales prices, considering the reliability of each comparable, to estimate a single value or range of values for the subject property.

G. Example Application

Subject Property: 1,700 sq ft Rambler, 3 bedrooms, 1 bath, 2-car garage.

Comparable A: 1,800 sq ft, 2 baths, sold for $97,500.
Comparable B: 1,800 sq ft, 1-car garage, sold for $92,000.
Comparable C: 2 baths, 3-car garage, sold for $95,500.

Market Adjustments:
Garage space: $2,000 per car.
Bath: $3,500.
Living area: $4,000 per 100 sq ft.

Comparable A Adjustments:

Size: - $4,000 (100 sqft @ $4,000 per 100 sqft)
Bath: -$3,500 (superior)

Total Adjustment: -$7,500
Adjusted Price: $97,500 - $7,500 = $90,000

Comparable B Adjustments:

Size: -$4,000
Garage: +$2,000 (inferior)

Total Adjustment: -$2,000
Adjusted Price: $92,000 - $2,000 = $90,000

Comparable C Adjustments:

Garage: -$2,000
Bath: -$3,500

Total Adjustment: -$5,500
Adjusted Price: $95,500 - $5,500 = $90,000

Based on the information, all comparables show an adjusted price of $90,000, offering a reliable indicator of value.

Chapter 10

II. Income Approach: Capitalizing Future Benefits

A. The Investment Perspective: Value as Present Worth of Future Income

The income approach to value views real estate as an investment, akin to stocks or bonds. An investor exchanges present dollars for the right to receive future income.

The approach seeks to establish the mathematical relationship between income and value, enabling the conversion of a property’s income stream into a value indicator.

Value = Amount of Income / Rate of Return

The appraiser estimates the rate of return an average investor requires to invest in the property. This rate, when applied to the property’s income, reveals its value.

An investor seeks: (1) return “of” the invested capital, and (2) return “on” the investment as profit/reward for the risk taken.

B. Investor’s Rate of Return: Influencing Factors

1. Risk Assessment
   The principle of anticipation posits that value is tied to the expectation of future benefits.
   However, future income is not guaranteed, creating risk. This element of risk significantly influences the relationship between income and value.
   Greater risk equates to a higher required return, and consequently, lower value.

2. Competing Investment Opportunities
   Investors consider alternative investments globally. The willingness to invest in a specific property hinges on its potential return and risk profile compared to other investment options.

C. Income Capitalization: The Methodologies

Income capitalization involves estimating value based on income. There are two primary methods:
Direct Capitalization and Yield Capitalization.

1. Direct Capitalization: A Single-Period Snapshot

Direct capitalization converts the income from a single period (typically a year or month) directly to value.
It is market-oriented, emphasizes market evidence, and gathers investor assumptions.

Value = Income / Capitalization Rate

Income is the estimated annual/monthly income at the time of investment. The capitalization rate converts income to value.

Alternatively,

Value = Income * Multiplier

A multiplier is the reciprocal of the capitalization rate. To convert, divide 1 by either the multiplier or rate.
1 / Multiplier = Rate and 1 / Rate = Multiplier

2. Income Estimation: Defining the Income Streams

The amount of income a property can generate is determined by analyzing similar properties’ income and existing leases. An appropriate factor converts the income to value.
Depending on circumstances, appraisers may estimate value based on:
a. Potential Gross Income (PGI)
b. effective gross income❓❓ (EGI)
c. Net Operating Income (NOI)
d. Pre-Tax Cash Flow

3. Potential Gross Income (PGI): Maximum Revenue

PGI is the total revenue a property can generate at full occupancy, without expense deductions.
Rent is the primary component. The amount under an existing lease is “scheduled rent” or “contract rent.” If no existing lease, “market rent” is used.
PGI can also include other revenue streams (e.g., laundry facilities in apartments).

4. Effective Gross Income (EGI): Accounting for Vacancy

EGI is PGI less an allowance for vacancies and bad debt losses (uncollected rents).
Expressed as a percentage of PGI. This deduction may not be necessary with long-term leases to high-quality tenants.

5. Net Operating Income (NOI): Return to the Investor

NOI is the most common income metric for direct capitalization. It is a reliable value indicator, representing income available as a return to the investor.
Properties with similar gross incomes may have different NOIs due to differing operating expenses.

NOI is calculated by subtracting operating expenses from EGI. Payments on principal and interest are not deducted.

6. Operating Expenses: Categories of Costs

Operating expenses are ongoing costs to maintain the income flow, categorized as:
a. Fixed Expenses: Expenses not varying with occupancy (e.g., property taxes, insurance).
b. Variable Expenses: Vary with occupancy (e.g., utilities, management fees, maintenance).
c. Reserves for Replacement: Funds set aside for short-lived components (e.g., carpeting, roofing).
Some accounting/tax-related expenses (mortgage interest, depreciation, income taxes) are not included as operating expenses.

7. Pre-Tax Cash Flow: Income to the Equity Investor

Pre-tax cash flow (equity dividend/before-tax cash flow) is the income available to the equity investor after the debt investor is paid.

Calculated by subtracting mortgage debt service from NOI.
Cash expenses are deducted from gross to determine cash flow.

8. Reconstructed Operating Statements: A Standardized Approach

A reconstructed operating statement is used for income capitalization in appraisal, differing from owner-prepared statements in two key aspects:

a. Inclusion/Exclusion of Items: Only items aligning with appraisal definitions of income.
b. Future vs. Past: Focuses on future income, aligning with the principle of anticipation.

D. Multipliers and Capitalization Rates: Converting Income to Value

Income multipliers and capitalization rates are two expressions of the same concept, converting income to value. The capitalization rate represents the relationship between income and value.

A capitalization rate in a market value appraisal reflects the return expected by investors for similar investments.
Reliable rates are based on market data for comparable properties.

1. comparable sales method❓❓: Market Extraction

The comparable sales method is considered the most reliable when adequate data is available. It derives the capitalization rate by analyzing sales prices and incomes of comparable properties.
Divide the net income of the comparable by its sales price to obtain the capitalization rate.

Capitalization Rate = Net Operating Income/ Sales Price

2. Operating Expense Ratio (OER) Method: An Indirect Route

When operating expense data is limited, the OER method offers an indirect approach.
a. Calculate the capitalization rate of the comparable based on EGI using the comparable sales method.
b. Determine the average ratio of operating expenses to EGI (OER) for similar properties from market data.
c. Calculate the capitalization rate for NOI:

NOI Cap Rate = EGI Cap Rate * (1 - OER)

3. Band of Investment Method: Debt and Equity Combined

This method accounts for financing with borrowed money. Calculate separate capitalization rates for equity investors and lenders.
Weight the average of these rates to find the overall capitalization rate.

The capitalization rate for the debt portion is annual debt service/original loan amount (mortgage constant).
The equity capitalization rate is derived from market data, pre-tax cash flow divided by the equity investment.
Overall Cap Rate = (Mortgage Percentage * Mortgage Constant) + (Equity Percentage * Equity Cap Rate)

4. Debt Coverage Ratio: Lender’s Perspective

Lenders require a minimum debt coverage ratio, confirming sufficient income to support mortgage payments.
The Debt Coverage Ratio is calculated as NOI / Annual Debt Payment
Debt Coverage Ratio = Net Operating Income/ Annual Debt Payment

E. Calculating Value by Direct Capitalization
Value = Income / Capitalization Rate

As noted earlier in this chapter, the conversion of income to value is sometimes accomplished by a multiplier instead of a rate.
When a multiplier is used to convert income, the appraiser uses multiplication, rather than division, to calculate the value.

Multipliers are most often used to convert gross income to value. The use of gross income multipliers is limited almost exclusively to appraisals of single- family residences and small multi-family residences.

Gross income multipliers may be derived for either annual or monthly income, so long as they are derived and applied consistently for all properties. In residential appraisals, a gross income multiplier is often referred to as a gross rent multiplier (GRM), since rent is usually the only form of gross income for smaller residential properties.

As discussed above, gross income is often an unreliable indicator of capitalized value, since it does not take into account operating expenses that affect the return to the investor. When using the gross income multiplier method, the appraiser simply assumes that the subject property and the comparables have similar levels of operating expenses.

F. Residual Techniques

RESIDUAL TECHNIQUES use direct capitalization to determine the value of one compone