Valuation Approaches: Sales Comparison and Cost

Okay, here is the scientific content for the chapter “Valuation Approaches: Sales Comparison and Cost” in your training course, “Real Estate Income Analysis: Mastering Direct Capitalization,” based on the book content you provided.

Real Estate Income Analysis: Mastering Direct Capitalization

Chapter [Number]: Valuation Approaches: Sales Comparison and Cost

Introduction

This chapter delves into two fundamental valuation approaches: the Sales Comparison Approach (SCA) and the Cost Approach (CA). While this course focuses on income capitalization, a comprehensive understanding of real estate valuation necessitates proficiency in SCA and CA, as they provide critical context, support land valuations essential for income property analysis (especially when using the building residual technique), and are often legally mandated. This chapter will demonstrate their practical application and relevance to income property evaluation.

1. Sales Comparison Approach (SCA): Unveiling Value Through Market Analogues

• 1.1. Core Principle and Scientific Basis:

  • The SCA, also known as the market data approach, rests on the economic principle of substitution. This principle asserts that a rational investor will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market.
  • The approach leverages empirical data gathered from recent sales of comparable properties (comparables) to infer the value of the subject property.
  • The validity of the SCA hinges on the assumption of a reasonably efficient market where information regarding transactions is readily available and prices accurately reflect supply and demand dynamics.

  • 1.2. Key Steps and Processes:

  • 1.2.1. Identifying Comparables:
    * This is the most crucial step. Comparables should possess similar characteristics to the subject property in terms of location, physical attributes (size, age, condition), legal rights conveyed (fee simple, leasehold), and economic characteristics (income potential).
    * The selection criteria must align with the highest and best use of both the subject and comparable properties. For income properties, this implies similar income-generating capabilities.
    * Utilize detailed property records, MLS data (if applicable), commercial data providers (CoreLogic®, FNC, Inc.), and direct verification with market participants (brokers, owners) to gather information.

  • 1.2.2. Data Collection and Verification:
    * Gather comprehensive data on each comparable, including sale price, date of sale, financing terms, conditions of sale (arm’s length transaction, motivations of buyer/seller), and physical characteristics.
    * Verify the accuracy of the data through multiple sources. Primary data verification (e.g., inspecting the comparable) is preferred.

  • 1.2.3. Adjustments for Dissimilarities:
    * This is a critical process. Adjustments are always made to the comparable’s sale price to reflect differences between the comparable and the subject.
    * Quantitative Adjustments: Dollar or percentage adjustments are applied to the sale price.
    * Example: A comparable has an extra bathroom, valued at $5,000 in the market. The comparable’s sale price is reduced by $5,000 to arrive at an indicated value for the subject.
    * Qualitative Analysis: If quantitative data is insufficient, use relative comparisons: superior, inferior, or equal. Adjustments are more subjective.
    * Common Adjustment Categories:
    * Property Rights Conveyed: Adjust for differences in ownership interests (e.g., leased fee vs. fee simple).
    * Financing Terms: Adjust for below-market financing or seller concessions. This is crucial for accurately reflecting market value.
    * Conditions of Sale: Adjust for atypical motivations or relationships that may have influenced the price.
    * Market Conditions: Adjust for changes in market demand or supply since the comparable’s sale date. This reflects the time value of money concept.
    * Location: Account for differences in neighborhood characteristics, accessibility, amenities, and environmental factors.
    * Physical Characteristics: Adjust for differences in size, age, condition, quality of construction, and features.

  • 1.2.4. Reconciliation:
    * After applying adjustments, multiple value indications will result from the various comparables.
    * Reconciliation is not simple averaging. Instead, the appraiser weighs the reliability of each comparable based on the quality and quantity of adjustments. The comparable requiring the least adjustment typically carries the most weight.
    * Consider the consistency and supportability of the adjustments. A well-supported adjustment is more reliable.

  • 1.3. Mathematical Formulation (Simplified):

  • Subject Value = Comparable Sales Price ± Adjustments

  • Where Adjustments = Σ (Dollar or Percentage Adjustments for each Element of Comparison)

  • 1.4. SCA and Income Property Valuation:

  • While the Income Approach (Direct Capitalization) is the primary valuation method for income properties (as per the course description), SCA is still relevant.

  • sca provides❓ a benchmark to ensure the income approach results align with market trends.
  • SCA is used for land valuation as in “extraction method”.
  • SCA may be used for GRM (Gross Rent Multiplier) for small income-producing properties.
  • 1.5. Practical Application and Related “Experiment”:
    Experiment 1: Impact of the number of bath adjustment to the comparable value.
    * Consider two properties. Property A is valued at $350,000, and property B is located across the same street. However, property A features two full bathrooms compared to property B’s one full bathroom.
    * Based on market data, appraisers determine that extra bathrooms add $7,500 to the values of homes similar to these.
    * The appraiser has to deduct the extra value from property A to get the property B’s approximate value:
    * Value of Property B = Value of Property A - the extra value of the bathroom
    * Value of Property B = $350,000 - $7,500
    * Value of Property B = $342,500

2. Cost Approach (CA): Building Value from the Ground Up

• 2.1. Core Principle and Scientific Basis:

  • The CA is based on the economic principle of substitution - a prudent buyer will pay no more for a property than the cost of constructing a new one with equivalent utility.
  • The approach involves estimating the cost of replacing the existing improvements, deducting accrued depreciation, and adding the value of the land.
  • The CA is most reliable when the improvements are relatively new and depreciation is minimal. It is less reliable for older properties due to the difficulty in accurately estimating accrued depreciation.

• 2.2. Key Steps and Processes:

  • 2.2.1. Estimating Land Value:
    * This is a critical step. For the CA to be valid, the land value must be accurately estimated independently, using the Sales Comparison Approach.
    * As your book content notes, “As noted earlier in this chapter, the cost approach requires a separate valuation of the site.”
  • 2.2.2. Estimating replacement cost new❓❓ (RCN):
    * Determine the cost to construct a new building with equivalent utility as of the appraisal date. This can be achieved through various methods:
    * Cost Service Data: Marshall & Swift, and similar services provide detailed cost data for different building types and components.
    * Quantity Survey Method: A detailed inventory of all materials, labor, and equipment required for construction is compiled. This method is time-consuming and rarely used for routine appraisals.
    * Unit-in-Place Method: The cost of installed building components (e.g., walls, roofs) is estimated on a unit basis (e.g., cost per square foot).
  • 2.2.3. Estimating Accrued Depreciation:
    * Depreciation represents the loss in value due to all causes, relative to a new property. It is estimated separately for physical deterioration, functional obsolescence, and external obsolescence.
    * Physical Deterioration: Loss in value due to wear and tear, deferred maintenance, and physical damage. It can be curable (e.g., painting) or incurable (e.g., structural damage).
    * Functional Obsolescence: Loss in value due to design deficiencies, outdated features, or inadequacies in the utility of the improvements. Can be curable (e.g., remodeling) or incurable (e.g., inefficient floor plan).
    * External (Economic) Obsolescence: Loss in value due to factors external to the property itself, such as neighborhood decline, zoning changes, or economic downturns. Generally incurable.
    * Accurately estimating depreciation, particularly for older properties, is a significant challenge and can be subjective.
  • 2.2.4. Calculating Value Indication:

    *   `Property Value = Land Value + RCN - Accrued Depreciation`
    

• 2.3. Mathematical Formulation:

  • V = VL + RCN - (PD + FO + EO)
  • Where:
    * V = Property Value
    * VL = Land Value
    * RCN = Replacement Cost New
    * PD = Physical Deterioration
    * FO = Functional Obsolescence
    * EO = External Obsolescence

• 2.4. CA and Income Property Valuation:

  • The CA is least applicable for valuing stabilized income-producing properties. The market value of income-producing properties is typically driven by income generation.
  • It helps determine land value (essential for income property analysis and property tax assessment purposes)
  • It helps determine depreciation in order to calculate an appropriate replacement reserve, and calculate an expected income.
  • CA can be more relevant for special purpose income properties where income data is less available (e.g., churches, schools, government buildings).
  • If the property has some environmental problems, appraisers can use this method to calculate the total cost to remediate the conditions, and get an approximate value.

  • 2.5. Practical Application and Related “Experiment”:
    Experiment 2: Calculating depreciation of a commercial real estate property using the Cost Approach.

  • A commercial real estate property has the following characteristics:

    *   **Land Value:** $400,000
    *   **Replacement Cost New (RCN):** $1,000,000
    *   **Physical Deterioration:** Estimated $100,000
    *   **Functional Obsolescence:** Estimated $50,000
    *   **External Obsolescence:** Estimated $25,000
       *   Depreciated Cost = Replacement Cost - (Physical Deterioration + Functional Obsolescence + Economic Obsolescence)
       *   Depreciated Cost = $1,000,000 - ($100,000 + $50,000 + $25,000)
       *   Depreciated Cost = $1,000,000 - $175,000
       *   Depreciated Cost = $825,000
       *   Estimated Commercial Real Estate Value = Land Value + Depreciated Cost
       *   Estimated Commercial Real Estate Value = $400,000 + $825,000
       *   Estimated Commercial Real Estate Value = $1,225,000
    

3. Reconciliation: Synthesis of Value Indications

• It is rare for the SCA and CA to produce identical value indicators.
• As your book notes, “When the value indicators are not identical, the appraiser must somehow forge the value indicators into one estimate of value. This process is called reconciliation.”
• Reconciliation is not a simple averaging of values. It involves:
  * Analyzing the strengths and weaknesses of each approach.
  * Considering the intended use of the appraisal. For income property investments, greater weight is typically given to the income approach (this is core to the course).
  * Evaluating the reliability of the data used in each approach.
  * Applying the appraiser’s judgment and expertise to arrive at the most credible estimate of value.

4. Conclusion

While direct capitalization is the primary focus for income property analysis, a thorough understanding of the Sales Comparison and Cost Approaches is essential. These approaches are valuable for validating income approach results, estimating land value, and for compliance with legal mandates. Mastery of these valuation techniques will contribute to making you a more informed and successful real estate investor and appraiser.

Key Concepts Emphasized:

• Substitution: The economic principle underlying both SCA and CA.
• Highest and Best Use: The cornerstone of all valuation analyses.
• Market Efficiency: The assumption underpinning the SCA.
• Accrued Depreciation: The critical variable in the CA.
• Reconciliation: The process of synthesizing value indications.
• Related to the course description: Practical skills are highlighted to make sound financial decisions.

This detailed response should provide a strong foundation for your chapter on valuation approaches. Good luck!