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Income & Sales Comparison: Property Valuation Approaches
Chapter 11: Income & Sales Comparisonโโ: Property Valuation Approaches
I. Introduction: The Complementary Nature of Income & Sales Comparison
The valuation of real property often involves considering multiple perspectives to arrive at a comprehensive and reliable estimate. While the cost approach focuses on the expenses associated with recreating a property, the income capitalization approach and sales comparison approach focus on market behavior. These latter two, while distinct, are deeply intertwined and often used in tandem to provide a robust valuation. The income capitalization method looks at the investment value.
A. Overview of the Two Approaches:
* Sales Comparison Approach (SCA): Relies on the principle of substitution. A buyer will pay no more for a property than they would for a comparable alternative. This approach analyzes recent sales of similar properties, adjusting for differences to arrive at an indicated value.
* Income Capitalization Approach (ICA): Based on the premise that the value of a property is directly related to its ability to generate income. This approach estimates potential income streams and capitalizes them to arrive at a present value estimate.
B. Interdependence:
* Market sales influence income approach. The sales comparison approach informs the income approach by helping to determine market rents, vacancy rates, and appropriate capitalization rates.
* Income drives sale prices. Conversely, the income capitalization approach is validated and refined by the sales comparison approach, as sales prices ultimately reflect investor expectations of future income.
II. Scientific Principles and Theories Underlying the Sales Comparison Approach
The sales comparison approach is rooted in several core economic and statistical principles:
A. Principle of Substitution:
* Definition: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
* Application: This principle justifies the use of comparable sales. If a similar property sells for a certain price, that price serves as an upper limit for the subject property’s value, assuming necessary adjustments are made.
B. Market Efficiency:
* Theory: In an efficientโ market, prices quickly reflect all available information.
* Implication: Sales data, if recent and reliable, offers a valid snapshot of market sentiment. Appraisers must strive to access the most current sales data to accurately reflect market dynamics.
C. Adjustment Theory:
* Concept: Adjustments are made to comparable sales prices to account for differences between the comparable and the subject property. These adjustments are based on market evidence and reflect the amount a buyer would likely pay for or discount due to a specific feature.
* Equation: Adjusted Sale Price = Sale Price +/- Adjustments
* Where adjustments can be positive (if the comparable is inferior to the subject) or negative (if the comparable is superior to the subject).
* Example: Comparable has one less bathroom. Market research shows buyers pay \$5,000 extra for an additional bathroom. Add \$5,000 to the comparable’s price.
D. Regression Analysis (Statistical):
* Application: Can be used to quantify the contribution of various property characteristics to the overall sale price. This method can provide a more statistically sound basis for adjustments.
* Formula: A multiple regression model can be represented as:
* Y = b0 + b1X1 + b2X2 + … + bnXn + ฮต
* Where:
* Y is the dependent variable (sale price).
* X1, X2, …, Xn are independent variables (property characteristics like square footage, lot size, number of bedrooms).
* b0, b1, b2, …, bn are regression coefficients that quantify the impact of each independent variable on the sale price.
* ฮต is the error term.
III. Application of the Sales Comparison Approach
A. Steps:
1. Identify Comparable Sales:
* Criteria: Recent sales (within 6-12 months ideally), similar location, physical characteristics, and zoning.
* Data Sources: Public records, MLS, real estate professionals.
2. Verify Data:
* Confirm sale details with involved parties (buyer, seller, agent).
* Examine property condition via inspection.
3. Select Relevant Elements of Comparison:
* Location, size, age, condition, amenities, terms of sale.
4. Adjust Comparable Sale Prices:
* Quantitative Adjustments: Based on market data (e.g., price per square foot differences).
* Qualitative Analysis: For elements difficult to quantify (e.g., superior view). Relative ranking (superior, similar, inferior) may be required.
5. Reconcile Adjusted Sale Prices:
* Analyze adjusted prices of all comparables.
* Give more weight to the most similar and reliable comparables.
* Arrive at a final value indication.
B. Experiments and Data Analysis:
* Experiment: Conduct a market survey to determine typical adjustment amounts for specific features (e.g., a garage, a swimming pool).
* Procedure: Analyze sales data from a specific neighborhood, focusing on sales pairs where the only significant difference is the presence of the feature. Calculate the average price difference to determine the appropriate adjustment.
* Data Analysis: Use scatter plots to visualize the relationship between sale prices and property characteristics. Regression analysis can then be employed to quantify these relationships.
IV. Scientific Principles and Theories Underlying the Income Capitalization Approach
The income capitalization approach is grounded in financial theory and investment principles.
A. Present Value Theory:
* Concept: A dollar received in the future is worth less than a dollar received today due to the time value of money.
* Application: The income approach estimates the present value of future income streams generated by the property.
B. Capitalization Rate (Cap Rate):
* Definition: The rate of return an investor requires to compensate for the risk of investing in a particular property.
* Formula: Capitalization Rate = Net Operating Income (NOI) / Property Value
* Derivation: Market extraction, band of investment, summation.
C. Discount Rate:
* Definition: Reflects the time value of money and the risk associated with an investment. Used to discount future cash flows to their present value.
V. Application of the Income Capitalization Approach
A. Steps:
1. Estimate Potential Gross Income (PGI):
* Determine market rent for the property.
* Consider historical rental data, market surveys, and economic trends.
2. Estimate Effective Gross Income (EGI):
* Deduct vacancy and collection losses from PGI.
* EGI = PGI - Vacancy & Collection Losses
3. Estimate Net Operating Income (NOI):
* Subtract operating expenses from EGI.
* NOI = EGI - Operating Expenses
4. Select Capitalization Rate (Direct Capitalization):
* Derive cap rate from comparable sales.
* Cap Rate = NOI / Sale Price
5. Apply Capitalization Rate:
* Value = NOI / Cap Rate
6. Discount Future Cash Flows (Discounted Cash Flow Analysis):
* Project future NOIs over a specified holding period.
* Estimate the reversion value (sale price) at the end of the holding period.
* Discount all future cash flows and the reversion value back to their present value using an appropriate discount rate.
* Value = ฮฃ [NOIt / (1+r)^t] + [Reversion Value / (1+r)^n]
* Where:
* NOIt = Net Operating Income in year t.
* r = Discount rate.
* t = Year of the cash flow.
* n = Number of years in the holding period.
B. Experiments and Data Analysis:
* Sensitivity Analysis: Examine how changes in key assumptions (e.g., vacancy rates, cap rates) impact the final value estimate.
* Market Research: Conduct surveys to determine appropriate discount rates and holding periods for specific property types in a given market.
VI. Reconciliation and Final Value Opinion
A. Weighing the Approaches:
* Sales Comparison: Most reliable for properties with active markets and abundant comparable sales data (e.g., single-family homes).
* Income Capitalization: More applicable to income-producing properties (e.g., apartments, commercial buildings) where future income is a primary driver of value.
B. Reconciliation Process:
* Review all data, calculations, and assumptions used in each approach.
* Identify strengths and weaknesses of each approach in relation to the specific appraisalโ problem.
* Assign weights to each value indicator based on its reliability and relevance.
* Arrive at a final, single value opinion (point estimate) or a range of values.
C. Considerations:
* Data Quality: Prioritize approaches that rely on the most accurate and verifiable data.
* Market Conditions: Consider how current market trends might affect the reliability of each approach.
* Appraiser Judgment: The final value opinion should be well-supported by the appraisal evidence and reflect the appraiser’s expertise and understanding of the market.
VII. Practical Application: Case Study
- Subject Property: A 10-unit apartment building.
- Data: Recent sales of comparable apartment buildings and detailed income and expense data for the subject property and comparable properties.
- Procedure:
- Apply the sales comparison approach, adjusting comparable sale prices for differences in size, location, and condition.
- Apply the income capitalization approach, estimating potential gross income, vacancy rates, operating expenses, and appropriate capitalization rates.
- Reconcile the value indicatorsโ from both approaches, giving more weight to the income capitalization approach due to the income-producing nature of the property.
VIII. Conclusion
Both the sales comparison and income capitalization approaches are essential tools for property valuation. Understanding their underlying scientific principles and applying them appropriately, coupled with careful reconciliation, allows appraisers to arrive at well-supported and credible value opinions. Market changes, financial theory and scientific applications can change or alter value in various ways. These can be better understood with application.
Chapter Summary
Summary of “incomeโ & sales comparisonโ: Property Valuation Approaches”
This chapter focuses on the crucial process of reconciliation in property valuation, specifically when using the income capitalization and sales comparison approaches. Reconciliation is defined as the analytical procedure where an appraiser weighs various value indicators to arrive at a single, credible opinion of value. It’s not a simple averaging or mathematical exercise, but rather a reasoned judgment based on the reliability of each indicator.
Key Scientific Points and Principles:
- Judgment and Experience are Paramount: Reconciliation relies heavily on the appraiser’s professional judgment and experience. Mathematical formulas, including simple averages, are specifically discouraged.
- Systematic Review: The process begins with a thorough review of all data, calculations, and reasoning used to derive the different value indicators (e.g., from various comparable properties, different units of comparison, or different appraisal techniques).
- Accuracy and Consistency: Calculations must be checked and corrected, and appraisal techniques must be consistently applied across the subject property and all comparables.
- Reliability Assessment: The reliability of each value indicator must be rigorously assessed based on the amount of supporting data, its accuracy, and its relevance to the appraisal problem. More data, greater verification, and closer alignment with the appraisal assignment increase reliability.
- Relevance is Key: The relevance of a value indicator to the specific appraisal problem significantly influences the appraiser’s judgment. The chosen valuation technique must be appropriate for the property type and consistent with the assignment’s requirements.
Conclusions and Implications:
- Supportable Value Choice: The final reconciled value must be defensible and supported by the evidence presented in the appraisal report. The appraiser’s judgment is the determining factor, but it must be transparent and well-justified.
- Comprehensive Review: Reaching a final opinion of value is essentially the same process as reconciliation, requiring a review of all data, calculations, and reasoning. Additional data collectionโ or analysis may be necessary.
- Reporting Requirements: Appraisers must complete the Reconciliation section of the Uniform Residential Appraisal Report (URAR), indicating the appraisal type, any conditioning factors, approaches used, and reaffirming the appraisal’s purpose.
- Point Estimate or Range Value: The final value opinion is typically stated as a “point estimate” (single dollar amount), but a “range value” (a likely range of values) is also an option. Value opinions should always be appropriately rounded.
- Clarity for Non-Appraisers: Appraisers must ensure their work is easily understandable to readers without appraisal expertise.
In essence, the chapter emphasizes that reconciliation is a critical step requiring skilled analysis, reasoned judgment, and clear communication to arrive at a credible and supportable opinion of value. It highlights the appraiser’s role as an expert who synthesizes various data points and techniques to provide a reliable assessment for clients and other intended users.
