Sales Comparison and Income Approaches to Value

Sales Comparison and Income Approaches to Value

This chapter delves into two fundamental appraisal approaches: the Sales Comparison Approach and the Income Approach. We will explore the theoretical underpinnings, practical applications, and relevant mathematical formulations for each method.

I. Sales Comparison Approach to Value

The Sales Comparison Approach (SCA), also known as the Market Data Approach, estimates value by comparing the subject property to similar properties that have recently sold in the same market area. The underlying principle is that a buyer will pay no more for a property than the cost of acquiring a comparable substitute.

A. Theoretical Foundations

1. Principle of Substitution: As stated above, this principle dictates that a rational buyer will not pay more for a property than the cost of an equally desirable substitute.

2. Principle of Supply and Demand: The SCA is heavily reliant on current market conditions. Changes in supply (the number of properties available) and demand (the number of potential buyers) directly influence prices.

3. Principle of Conformity: Properties tend to achieve their maximum value when they are in harmony with surrounding properties. This principle highlights the importance of neighborhood analysis.

4. Market Efficiency: The SCA assumes a reasonably efficient market where information about sales is readily available, and prices reflect true market value.

B. The Sales Comparison Process

1. Data Collection and Verification:

   • Subject Property: Gather detailed information on the subject property’s characteristics, location, legal rights, and any other factors that may influence value.
   • Comparable Properties: Identify recently sold properties (comparables) that are similar to the subject property. Data sources include public records, MLS databases, real estate professionals, and appraisers’ own files.
   • Verification: Confirm the accuracy of the sales data with parties involved in the transactions (e.g., buyers, sellers, brokers). This step is critical to mitigate the risk of relying on inaccurate or misleading information; reporting and analysis of all prior sales transactions of the subject and comparables for the reporting period is necessary due to lender concerns regarding criminal property flipping.

2. Selection of Comparables:

   • Choose comparables that are as similar as possible to the subject property in terms of:
     • Location: Ideally, comparables should be located in the same neighborhood or a similar, competing area.
     • Physical Characteristics: Size, age, condition, quality of construction, number of bedrooms/bathrooms, lot size, etc.
     • Legal Rights: Fee simple ownership, leasehold interests, easements, etc.
     • Date of Sale: Recent sales are preferred to minimize the impact of changing market conditions.
     • Competitive properties: the sale must be competitive with the subject property.
   • A sale must be considered “comparable” for the sale comparison approach to value.

3. Elements of Comparison:

   • Identify key differences between the subject property and each comparable property that may affect value. These elements are what adjustments are based on.
     • Real Property Rights Conveyed: Account for differences or restrictions as to the real property rights conveyed in a transaction.
     • Financing Terms (Cash Equivalency): If financing terms are not typical of those available in the market, the financing is not cash equivalent, and may require an adjustment based on market data. Financing on terms that are typical of the market is called cash equivalent financing.
     • Conditions of Sale: Ensure that the sale represents an arm’s-length transaction (i.e., both buyer and seller are acting independently and rationally). Motivation of buyer and seller should indicate an arm’s length transaction.
     • Expenditures Immediately After Sale: Account for expenditures that would have to be made upon purchase of the property and that a knowledgeable buyer may negotiate into the purchase price.
     • Market Conditions (Date of Sale): Recent sales are preferred, because changing market conditions affect values.
     • Location: Comparables located in the same neighborhood as the subject are the most reliable.
     • Physical Characteristics: The majority of adjustments in residential appraisals are for differences in physical characteristics.
     • Economic Characteristics: such as income, operating expenses, lease provisions, management, and tenant mix are used to analyse income-producing properties.
     • Other Factors: Be alert to any other characteristics of the subject or a comparable that could influence value, and make whatever adjustments are necessary.

4. Adjustments to Comparable Sales Prices:

   • Adjust the comparable sales prices to account for differences between the comparables and the subject property, rather than adjusting the subject’s price. The comparables’ prices are adjusted to the subject’s features.
   • If the comparable is superior to the subject in a certain aspect, a downward adjustment is made to the comparable’s price. This reflects the fact that the comparable would have sold for less if it had been similar to the subject in that aspect.
   • Conversely, if the comparable is inferior to the subject, an upward adjustment is made to the comparable’s price.
   • Adjustments can be quantitative (dollar amount or percentage) or qualitative (superior, inferior, equal).
   • The sequence of adjustments depends on the appraiser’s analysis of the market, but adjustments for transactional elements of comparison are usually made before adjustments for physical elements of comparison.
   • All the individual adjustments are totaled, then added to or subtracted from the comparable sales price to give an indicator of subject property value.
   • The net adjustment is used to calculate the adjusted price of the comparable.

   • The gross adjustment is an indicator of the reliability of the adjusted price as an indicator of subject property’s value.

     • Quantitative Adjustments:

       • Paired Data Analysis (Extraction): Analyze pairs of comparable sales that are identical except for one characteristic. The price difference between the paired sales is attributed to the value of that characteristic.
         Example: Two identical houses sold for \$300,000 and \$310,000, respectively. The only difference is that the second house has a finished basement. The \$10,000 price difference suggests the value of the finished basement. Analysis of large numbers of transactions is often required in order to extract reliable adjustment values.

       • Regression Analysis: Use statistical techniques to identify the relationship between various property characteristics and sales prices.
         Equation: A simplified linear regression model:
         Sales Price = b0 + b1*Size + b2*Bedrooms + ... + error
         Where:
         * b0 is the intercept (base price).
         * b1, b2, etc., are the coefficients representing the value of each characteristic.
         * error is the error term (unexplained variation).
         * Qualitative Analysis:

       • Relative Comparison Analysis: Rate comparables as superior, inferior, or equal to the subject property for each element of comparison.
       • Adjust the comparable prices accordingly based on market knowledge and judgment. The resulting adjustment values are qualitative instead of quantitative.

5. Reconciliation and Value Indication:

   • After adjustments, the appraiser has a range of adjusted sales prices for the comparables.
   • Reconciliation is the process of analyzing the adjusted prices and arriving at a single, best estimate of value for the subject property.
   • Give more weight to the comparables that are most similar to the subject property, require the fewest adjustments, and have the most reliable data.
   • The subject property’s value should fall within the range indicated by the adjusted prices of the comparables.
   • The appraiser must reconcile the various adjusted comparable sales prices, and estimate a value or range of values for the subject that is indicated by the sales comparison approach.
   • The appraiser summarizes and analyzes the sales comparison approach, as well as records the indicated value by the sales comparison approach.
   • The final indicated value is an opinion of value, not an exact calculation.

C. Mathematical Considerations

1. Percentage Adjustments:

   • Converting percentage adjustments to dollar amounts requires careful attention to the base. The formula for converting percentage adjustments into dollar amounts depends on how the percentage relationship is defined.

   • Example: A comparable sold for \$250,000. Market data indicates a 5% adjustment is needed for a superior location.

     • The adjustment can be applied to the comparable’s price:
       Adjustment = $250,000 * 0.05 = $12,500 (downward adjustment)
Adjusted Price = $250,000 - $12,500 = $237,500

2. Statistical Measures:

   • Appraisers may use statistical measures (e.g., mean, median, standard deviation) to analyze the adjusted sales prices of the comparables.

D. Limitations of the Sales Comparison Approach

1. Data Availability: The SCA relies on the availability of sufficient, reliable sales data for comparable properties. In some markets, this data may be scarce or unreliable.
2. Subjectivity: Adjustments involve subjective judgment, which can introduce bias into the valuation process.
3. Market Instability: In rapidly changing markets, past sales may not be a reliable indicator of current value.

II. Income Approach to Value

The Income Approach estimates value based on the present worth of the future income stream that a property is expected to generate. This approach is primarily used for income-producing properties, such as office buildings, apartment complexes, and retail centers.

A. Theoretical Foundations

1. Principle of Anticipation: Value is based on the expectation of future benefits (income) to be derived from ownership of the property.

2. Time Value of Money: A dollar received today is worth more than a dollar received in the future, due to the potential for earning interest or investment returns.

3. Investor’s Perspective: The income approach views real estate as an investment, just like stocks or bonds or savings accounts. It measures value through the eyes of an investor.

B. Key Concepts

1. Income Capitalization: The process of converting an income stream into an estimate of value. Income Capitalization can be accomplished through Direct Capitalization and Yield Capitalization.

2. Rate of Return: The ratio between the amount of income and the amount of the investment. The rate of return on an investment is equal to the amount of income it produces divided by the amount the investor paid for the investment. Stated in mathematical terms:
   Rate of Return = Amount of Income / Amount of Investment

   When this formula is rearranged, it becomes the basis for the income approach to value:
   Value = Amount of Income / Rate of Return
   * The rate of return depends on two factors: the risk associated with the investment and the rates of return for a risk-free investment opportunity
   * The greater the risk that the future income may not be realized, the higher the return an investor will require, and therefore the lower the value of the investment.
   * Investors want more than just a rate of return on their investment. They want their investment returned as well over the economic life of the investment. If they did not get the investment back their effective yield would be for less than indicated.
   * repayment of the invested capital return “of” the investment is called RECAPTURE, while the profit return “on” the investment is referred to as INTEREST or YIELD.

3. Capitalization Rate (Cap Rate): A rate (expressed as a percentage) that reflects the relationship between income and value.

4. Discount Rate: A rate used to convert future income streams into their present value.

C. The Income Approach Process

1. Income Estimation:

   • Potential Gross Income (PGI): The total income a property could generate if fully occupied and rented at market rates.
   • Effective Gross Income (EGI): PGI less vacancy and collection losses.

   • Net Operating Income (NOI): EGI less operating expenses.

     • Operating Expenses: Expenses necessary to maintain the flow of income, including fixed expenses, variable expenses, and reserves for replacement.
       • FIXED EXPENSES are operating expenses that do not vary depending on the occupancy of the property. The most common examples of fixed expenses are property taxes and hazard insurance premiums.
       • VARIABLE EXPENSES are operating expenses that do vary depending on occupancy. They may include a wide variety of expenses, such as utility costs, property management fees, cleaning and maintenance expenses, and leasing commissions.
       • RESERVES FOR REPLACEMENT are funds that are set aside for replacing short-lived components of the property.

   • Pre-Tax Cash Flow: Net Operating Income less mortgage debt service.

     • Amount of debt service deducted from net operating income includes both principal and interest payments on the mortgage loan(s).

   *Monthly income is sometimes used to capitalize income for single-family or small multi- family residential properties.

2. Reconstructed Operating Statements

   • A statement of income and expenses that is used for income capitalization in appraisal is known as a RECONSTRUCTED OPERATING STATEMENT.
   • The reconstructed statement is an attempt to determine future income for the property, while the owner’s statement reflects past revenues and expenses.
   • There are two primary differences between a reconstructed operating statement and an owner’s operating statement.
     • First, the reconstructed statement includes all items, but only those items, that are included in the definitions of income for appraisal purposes.
     • Second, the reconstructed statement is an attempt to determine future income for the property, while the owner’s statement reflects past revenues and expenses.

3. Direct Capitalization:

   • Use a single year’s NOI and a capitalization rate to estimate value.
   • Equation:
     Value = NOI / Cap Rate
   • The challenge lies in selecting an appropriate cap rate.
   • Determining Cap Rates:
     • Comparable Sales Method: Extract cap rates from sales of comparable properties.
       Cap Rate = NOI / Sales Price

     • Operating Expense Ratio Method: Use the operating expense ratio (OER) and capitalization rate for effective gross income to derive a capitalization rate for net operating income.
       OER = Operating Expenses / Effective Gross Income

       Calculate the capitalization rate for net operating income: To do this, the OER is subtracted from 1, and the result is multiplied by the capitalization rate for effective gross income.
       NOI rate = 0.175 x (1 - 0.60)
NOI rate = 0.175 x 0.40
NOI rate = 0.070, or 7.0%
       * Band of Investment Method: Use capitalization rates for the equity investor and for the lender(s) to calculate an overall capitalization rate for the property.
       The weighted average of these rates is then used as the overall capitalization rate for the property.
       Overall Cap Rate = (Mortgage % * Mortgage Rate) + (Equity % * Equity Rate)
       * Debt Coverage Ratio (DCR): Divide the annual net operating income by the annual debt payment.

4. Yield Capitalization:

   • Project all future cash flows (NOIs) over the investment holding period, including the resale value of the property at the end of the holding period.
   • Discount these cash flows back to their present value using a discount rate that reflects the risk of the investment.
   • The sum of the present values of all future cash flows represents the estimated value of the property.
   • Discounting is the process of computing the present worth of a payment that is to be received in the future. Discounting acknowledges that the value of the dollar received in the future is less than one received now.

D. Mathematical Considerations

1. Present Value (PV) of a Single Future Sum:

   • Equation:
     PV = FV / (1 + r)^n
     Where:
     * PV is the present value.
     * FV is the future value.
     * r is the discount rate.
     * n is the number of periods.

2. Present Value of an Annuity (Regular Stream of Payments):

   • Equation:
     PV = PMT * [1 - (1 + r)^-n] / r
     Where:
     * PMT is the payment amount.
     * r is the discount rate.
     * n is the number of periods.

3. Terminal Value:

   • The estimated value of the property at the end of the holding period. Can be calculated using direct capitalization:
     Terminal Value = NOI (Year n+1) / Terminal Cap Rate

E. Limitations of the Income Approach

1. Reliability of Projections: The income approach relies on accurate projections of future income and expenses, which can be difficult to predict.
2. Selection of Discount Rate: The discount rate is a critical input, and its selection can significantly impact the estimated value.
3. Market Volatility: In volatile markets, it can be challenging to estimate future income streams and resale values with confidence.

III. Conclusion

The Sales Comparison and Income Approaches are valuable tools for estimating property value. The SCA is most appropriate for properties where sufficient comparable sales data are available. The Income Approach is best suited for income-producing properties where future income streams can be reasonably projected. Appraisers must carefully consider the strengths and limitations of each approach and apply them appropriately based on the specific characteristics of the property and the available market data. In practice, appraisers often use multiple approaches and reconcile the results to arrive at a final opinion of value.