Applying the Three Approaches to Value: Site, Cost, Sales Comparison, and Income

Chapter 6: Applying the Three Approaches to Value: Site, Cost, Sales Comparison, and Income

Introduction

This chapter delves into the practical application of the three fundamental approaches to value – the cost approach, the sales comparison approach, and the income approach – with a particular focus on their relevance to site valuation. This is particularly relevant in the appraisal profession as outlined in the course description, since a firm grasp of these approaches is vital for accurate valuation, regulatory compliance, and future adaptability in a dynamic market. The emphasis will be on how these approaches, when appropriately applied, contribute to a credible estimate of value, aligning with the certification requirements and regulatory standards of the appraisal profession.

Relating to the Course Description: This chapter directly addresses the core skill set required for success in the appraisal profession. Understanding and applying the three approaches is fundamental to the certification process and essential for navigating the regulatory landscape. By mastering these techniques, aspiring appraisers will be better equipped to excel in this dynamic field.

I. The Interconnectedness of Site Valuation and the Three Approaches

A. Why Site Valuation Matters

As the book content highlights, separate site valuation is critical for:

1. Cost Approach: The cost approach relies on the premise that a buyer will pay no more for a property than the cost to acquire the land and construct a new building. This necessitates a reliable estimate of the site’s value.
2. Income Approach (Building Residual Technique): Certain income capitalization techniques, such as the building residual technique, require isolating the value contribution of the land separately from the improvements.
3. Legal and Regulatory Compliance: Property tax assessments, condemnation appraisals, and other legal proceedings often mandate separate site valuations.

B. Highest and Best Use as the Guiding Principle

The concept of highest and best use (HBU) is paramount in site valuation. HBU is defined as the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.

*   **Scientific Principle:** HBU is rooted in the economic principles of scarcity, utility, demand, and transferability.  The market seeks to allocate resources (land) to their most productive uses, maximizing economic efficiency.

C. The Three Approaches: A Synergistic Relationship

While each approach provides an indication of value, the most robust appraisal process involves considering all three and reconciling their findings. This reconciliation process, detailed in the book content, reflects a weighting based on the appraiser’s judgment, data reliability, and the specific appraisal problem.

II. Applying the Cost Approach

A. Scientific Basis

The cost approach is underpinned by the principle of substitution, which asserts that a prudent buyer will pay no more for a property than the cost to acquire an equivalent substitute. It is expressed mathematically as:

*   `Property Value = Site Value + (Cost New - <a data-bs-toggle="modal" data-bs-target="#questionModal-88451" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container"><a data-bs-toggle="modal" data-bs-target="#questionModal-330381" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">accrued depreciation</span><span class="flag-trigger">❓</span></a></span><span class="flag-trigger">❓</span></a>)`

B. Application to Site Valuation

1. Determining Replacement Cost: The “cost (new)” component involves estimating the current cost of replacing the improvements with a new, functionally equivalent structure.

2. Calculating Accrued Depreciation: This is the most challenging aspect, encompassing physical deterioration (wear and tear), functional obsolescence (design inadequacies), and external obsolescence (economic or locational factors). Different depreciation methods exist, each with varying scientific validity:

   • Straight-Line Depreciation: Simplest method, assuming constant depreciation over time. Annual Depreciation = (Cost New - Salvage Value) / Useful Life. Salvage value can be estimated using market comparables or assumed by standard industry practice (typically 5%).
   • Observed Condition (Breakdown) Method: Analyzes each physical component (roof, foundation, etc.) to estimate its remaining useful life and depreciation. This method is rooted in engineering and material science.

C. Example and Experiment

1. Scenario: A residential property on a 10,000 sq ft lot in a suburban area.
2. Site Valuation: Assume the appraiser, using the sales comparison approach (discussed below), estimates the site value to be \$200,000.
3. Cost New of Improvements: The replacement cost of the existing house is estimated to be \$300,000 based on current construction costs per square foot.

4. Accrued Depreciation: Using the observed condition method, the appraiser estimates accrued depreciation to be \$50,000.

   • Property Value = \$200,000 + (\$300,000 - \$50,000) = \$450,000

D. Limitations and Considerations

The cost approach is most reliable for new or nearly new properties. Its accuracy diminishes with age and the difficulty of estimating depreciation, particularly for older improvements. The appraisal profession and the USPAP standards are continually moving towards more support and evidence based opinion which may make the more subjective method less reliable.

E. Connection to the Course Description: The cost approach is vital for new appraisers to understand, and for those with prior years of experience, it is vital to stay current with evolving standards and data sources.

III. Applying the Sales Comparison Approach

A. Scientific Basis

The sales comparison approach hinges on the principle of substitution, similar to the cost approach. It operates under the premise that a rational buyer will pay no more for a property than the price of a comparable property with similar characteristics.

B. Key Components

1. Identifying Comparable Properties: As noted in the book content, the selection of truly comparable properties is crucial. Factors to consider include location, property rights, financing terms, conditions of sale, market conditions, physical characteristics (size, age, condition), and economic characteristics (income potential, expense ratios). As the profession and data availability evolves, more complex methods may need to be considered and implemented.

2. Making Adjustments: Adjustments are applied to the sales prices of the comparable properties, not the subject property, to account for differences. These adjustments reflect the contributory value of specific features.

   • Adjustment Formula: Subject Value = Comparable Sales Price +/- Adjustments

C. Elements of Comparison and Adjustment Techniques

1. Market Conditions Adjustment: Real Estate markets can be dynamic. Appraisers use statistical techniques, paired sales analysis, and market surveys to quantify changes in values over time. For example: Market Condition Adjustment = (Sale Price) * (Market Appreciation Rate) * (Time Since Sale)

2. Location Adjustment: Quantifying locational differences can be based on paired sales analysis (identifying similar properties in different locations) or by analyzing land value differentials. For instance: Location Adjustment = Land Value in Subject Area - Land Value in Comparable Area. If data for pure land value is difficult to determine, you can look for percentage shifts in pricing between similar properties or neighborhoods.

3. Physical Characteristics Adjustment: Quantifying the value of extra bedrooms, bathrooms, square footage differences, or views often relies on regression analysis (using statistical modeling to isolate the effect of individual features on sales prices) or cost estimates (for items like adding a bedroom).

D. Example and Experiment

1. Scenario: Appraising a vacant lot in a residential neighborhood.

2. Comparables:

   • Comparable 1: Sold for \$180,000, similar location, but 10% smaller lot size.
   • Comparable 2: Sold for \$200,000, same lot size, but better view (estimated at \$15,000 value).
   • Comparable 3: Sold for \$190,000, similar lot size and view, but sold 6 months ago in a rising market (+5%).

3. Adjustments:

   • Comparable 1: Add 10% for smaller lot size (estimated to add \$18,000) = \$198,000
   • Comparable 2: Subtract \$15,000 for better view = \$185,000
   • Comparable 3: Subtract 5% for market conditions = \$180,500

4. Indicated Value Range: \$180,500 - \$198,000. The appraiser would then reconcile these indicators to arrive at a final value estimate, weighting comparables based on their reliability and the extent of required adjustments.

E. Limitations and Considerations

The sales comparison approach is most reliable when there is an active market with ample comparable sales data. It becomes less reliable in illiquid markets or when substantial adjustments are necessary.

F. Connection to the Course Description: The sales comparison approach is critical to the development of an appraisers understanding of data analysis, which makes it the most likely approach to be utilized in the appraiser reconciliation and final value estimate.

IV. Applying the Income Approach

A. Scientific Basis

The income approach is grounded in the principle of anticipation, which dictates that the value of a property is a function of the future income it is expected to generate. This approach uses net operating income❓❓ to find the value of a property. It can also be described as a calculation as to what a property is worth based on its Net Operating Income. In this formula you need to know two variables, Net Operating Income and CAP Rate. This number then determines the Value.

B. Key Income Approach Methods

1. Direct Capitalization: This involves dividing a single year’s net operating income (NOI) by a capitalization rate (cap rate) to arrive at an estimate of value: Value = NOI / Cap Rate

   • Estimating NOI: This is calculated by subtracting operating expenses (excluding debt service) from gross income. Accurate expense data is crucial.

   • Determining the Cap Rate: This is extracted from comparable sales of income-producing properties. The cap rate reflects the market’s perception of risk and return. Appraisers often utilize band of investment and weighted average methods to determine a cap rate for specific properties.

2. Gross Rent Multiplier (GRM): This method is simpler and typically used for residential rental properties. It involves multiplying the gross monthly rent by a GRM: Value = Gross Monthly Rent x GRM.

   • GRM Calculation: Calculated from comparable properties ( GRM = Sales Price / Gross Monthly Rent).

C. Example and Experiment (Direct Capitalization for a Commercial Site)

1. Scenario: Appraising a commercial site leased to a retail tenant.
2. Net Operating Income: Projected NOI for the first year is \$50,000.

3. Capitalization Rate: Analysis of comparable sales indicates a cap rate of 8%.

   • Value = \$50,000 / 0.08 = \$625,000

D. Example and Experiment (Gross Rent Multiplier for a Residential Site)

1. Scenario: Appraising a residential property rented out for $2,000 per month.

2. Comparable GRM Values: Analysis of comparable rentals indicates a GRM of 135.

   • Value = \$2,000 x 135 = \$270,000

E. Limitations and Considerations

The income approach is most applicable to properties with a clear and predictable income stream. The accuracy depends heavily on the reliability of the income and expense projections and the validity of the capitalization rate or GRM used. For new construction or developments, pro forma financials require diligent analysis and sensitivity testing.

F. Connection to the Course Description: This approach is commonly applied to commercial and investment properties, which may require general certification, emphasizing the importance of income analysis in expanding the appraiser’s scope of practice.

V. Reconciliation and Final Value Estimation

A. Reconciliation Defined

The book content states that reconciliation is not a simple averaging of the value indicators. It is a critical step requiring the appraiser’s expertise and judgment to analyze the appraisal problem, select the most appropriate method of the three, and give it the most weight in determining the final estimate of value.

B. The Reconciliation Process

1. Data Reliability: Evaluate the quality and quantity of data supporting each approach. Are the comparables truly comparable? Are the cost estimates accurate and up-to-date? Are the income and expense projections realistic?
2. Approach Applicability: Consider the suitability of each approach for the specific property type and market conditions. For example, the cost approach may be more reliable for new construction, while the sales comparison approach is generally preferred for residential properties with ample comparable sales data.
3. Weighting: Assign weights to each value indicator based on their reliability and applicability. Justify the weights in the appraisal report.
4. Final Value Opinion: Arrive at a single, supportable value estimate that reflects the market’s perception of value.

C. Example

Let’s assume for a residential property:

• Cost Approach Indication: \$450,000
• Sales Comparison Approach Indication: \$460,000
• Income Approach Indication (GRM): \$440,000

Reconciliation: The appraiser might assign the greatest weight (60%) to the sales comparison approach due to the active residential market and the availability of strong comparables. The cost approach might receive a 30% weighting as it reflects the cost to create a substitute property, and the income approach receives 10% as it is not the primary driver of residential value.

Final Value Estimate: (\$460,000 * 0.6) + (\$450,000 * 0.3) + (\$440,000 * 0.1) = \$455,000

D. Considerations for Regulatory Compliance and USPAP

The reconciliation process must be transparent and well-documented, adhering to the requirements of USPAP and regulatory agencies. The appraiser must provide a clear explanation of the rationale for the weighting assigned to each approach and justify the final value opinion.

VI. The Future of Appraisal and Technological Integration

A. The Impact of Technology

The appraisal profession is continually evolving due to technological advancements. Appraisers can now leverage sophisticated data analytics tools, automated valuation models (AVMs), and Geographic Information Systems (GIS) to gather and analyze data more efficiently. This can help expand the skillsets of appraisers and allow them to be more marketable in the future.

B. Embracing Mobile Technology (Relating to the book content)

The book content and the course description both emphasize the importance of embracing technology. Mobile appraisal apps, drones for property inspections, and cloud-based platforms are transforming the appraisal workflow. These tools offer time savings, increased accuracy, and improved communication. It is vital for appraisers to stay current with the technologies.

C. Skills and Considerations for Future Appraisers

• Data Analysis Proficiency: Ability to interpret and utilize data from various sources, including public records, market databases, and online tools.
• Technological Adaptability: Willingness to learn and integrate new technologies into the appraisal process.
• Critical Thinking and Judgment: Technology assists but does not replace the need for human judgment and critical thinking in the valuation process.
• USPAP Compliance and Ethics: Maintaining ethical standards and adhering to USPAP guidelines in the use of technology and automated valuation tools.

Conclusion

Mastering the three approaches to value is a cornerstone of the appraisal profession. By understanding the scientific principles, applying them diligently to site valuation, and integrating technology to enhance efficiency and accuracy, appraisers can provide credible and reliable opinions of value, navigating the regulatory landscape and adapting to the ever-changing demands of the real estate market. The appraisal profession will be continuing to evolve and it is vital that modern appraisers keep up with the changes in the industry. The ability to keep current can also ensure❓ that the value indicators continue to be accurate.