Comparative Analysis: Adjustments & Elements

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Chapter: Comparative Analysis: Adjustments & Elements

Introduction

Comparative analysis is the cornerstone of the Sales Comparison Approach (SCA) in real estate appraisal. The SCA rests on the economic principle of substitution: a prudent purchaser will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market. This chapter delves into the scientific underpinnings of comparative analysis, focusing on the systematic process of identifying, quantifying, and applying adjustments to comparable sales to arrive at a credible indication of value for the subject property. We will explore the elements of comparison, different adjustment techniques, and the theoretical basis for each.

1. Understanding the Elements of Comparison

The elements of comparison are those characteristics that cause prices paid for real estate to vary. These are the fundamental characteristics of properties that influence value in the market. The standard elements of comparison, in order of application, are:

• Real Property Rights Conveyed: The legal interests transferred in the sale (fee simple, leasehold, easement, etc.).
• Financing Terms and Cash Equivalency: The impact of non-market financing or unusual payment terms on the sale price.
• Conditions of Sale: The motivations of the buyer and seller. Was it an arm’s-length transaction?
• Market Conditions: Changes in market conditions between the date of the comparable sale and the effective date of the appraisal.
• Location: The desirability of the property’s location, considering factors like access, amenities, and neighborhood characteristics.
• Physical Characteristics: The tangible aspects of the property, such as size, condition, quality of construction, and amenities.
• Economic Characteristics: Factors that affect the income-generating potential of a property (e.g., lease terms, operating expenses, tenant quality).
• Legal Characteristics: Zoning, building codes, easements, and other legal restrictions that impact value.
• Non-Realty Components of Value: Personal property or intangible assets included in the sale.

Scientific Rationale: The identification of these elements stems from microeconomic theory, specifically the principles of supply and demand, utility theory, and the concept of ceteris paribus (all other things being equal). We isolate each element and attempt to quantify its contribution to the overall property value.

2. The Adjustment Process: A Scientific Approach

The adjustment process aims to isolate the differences between the comparable sales and the subject property for each element of comparison and quantify the impact of those differences on value. Adjustments are always made to the comparable sales, not to the subject property. The goal is to make the comparables as similar to the subject as possible. The result is an indicated value for the subject by adjusting for the differences from the comparable.

2.1 The Principle of Consistent Units

A fundamental principle is that all adjustments must be applied using consistent units. This means choosing a unit of measurement that accurately reflects how market participants perceive value differences. This could be:

• Dollar Amount: A fixed dollar adjustment (e.g., \$10,000 for a superior location).
• Percentage: A percentage adjustment based on the comparable’s sale price (e.g., 5% for a more modern kitchen).
• Dollar per Unit: Adjustments based on square footage, front footage, or other measurable units (e.g., \$50 per square foot for a larger building).

Example: A $10,000 location adjustment is more significant for a \$75,000 property than a \$200,000 property. Therefore, using a percentage adjustment might be more appropriate in some cases to reflect the relative impact of location on value.

2.2 Quantitative Adjustment Techniques

Quantitative techniques involve the use of numerical data and statistical analysis to derive adjustments. Common methods include:

• Paired Data Analysis (PDA): This involves finding two comparable sales that are identical except for one characteristic. The difference in their sale prices is attributed to that single difference.

  • Formula: Adjustment = Sale Price of Property A - Sale Price of Property B, where Property A and Property B are identical except for one characteristic.

  • Example: Two identical houses, one with a garage and one without. The house with the garage sold for $10,000 more. The indicated adjustment for a garage is $10,000.

  • Experiment: Collect data on numerous paired sales in a specific market. Calculate the adjustment for the specific characteristic in each pair. Perform a statistical analysis (e.g., calculate the mean, median, and standard deviation) of the adjustments to refine the adjustment amount and understand the range of possible adjustments.

• Statistical Analysis: Using regression analysis or other statistical techniques to identify the relationship between property characteristics and sale prices.

  • Regression Equation (Simplified): Sale Price = β₀ + β₁X₁ + β₂X₂ + … + ε, where β₀ is the intercept, β_i are the coefficients representing the impact of each characteristic (X_i) on the sale price, and ε is the error term.

  • Practical Application: A multiple regression analysis could be used to determine the simultaneous impact of size, location, and age on home values in a given neighborhood.

• Cost Analysis: Using depreciated cost to estimate the value of a physical feature. This is especially useful for condition adjustments.

  • Formula: Depreciated Cost = Replacement Cost New - Accrued Depreciation. Accrued depreciation can be calculated using the age-life method: Accrued Depreciation = (Effective Age / Total Economic Life) * Replacement Cost New.

• Income Capitalization: For income-producing properties, analyzing the income stream to determine the impact of economic characteristics.

2.3 Qualitative Analysis Techniques

Qualitative techniques involve subjective judgment and market knowledge to assess the relative desirability of different property characteristics. These methods are often used when quantitative data is scarce or unreliable.

• Relative Comparison Analysis: Ranking the comparables relative to the subject property for each characteristic (e.g., superior, similar, inferior).
• Trend Analysis: Identifying trends in the market that may influence property values.
• Scenario Analysis: Developing different scenarios based on potential market changes and assessing their impact on value.

3. Addressing Specific Elements of Comparison

3.1 Location Adjustments

Location adjustments reflect the desirability of a property’s location. Support can be derived from:

• Traffic Counts: Comparing traffic volumes for commercial properties.
• Neighborhood Demographics: Analyzing income levels, education levels, and other demographic data.
• Distance to Amenities: Measuring the distance to schools, shopping centers, and other amenities.
• Comparison of Average Prices: Comparing average home prices in different subdivisions.

Example (From Text): If properties in the subject’s subdivision range from \$150,000 to \$250,000 with an average sale price of \$200,000, and comparable sales are in a subdivision ranging from \$200,000 to \$300,000 with an average of \$250,000, this suggests the comparable’s neighborhood is superior. This information could be used to support a location adjustment. Care must be taken to analyze land values as well. A 25% location adjustment against the sale price may not be warranted. A 25% adjustment to land value is possibly more appropriate.

3.2 Physical Characteristics Adjustments

These adjustments are based on tangible aspects of the property. It is important to provide support for all adjustments. Logic should prevail. An easy way to derive support is to base the adjustment on depreciated cost. Market participants tend to think of cost as a basis for an adjustment for a physical characteristic.

• Size
• Condition, quality and age of improvements
• Property amenities
• Functional utility

Example (From Text): A \$25,000 condition adjustment to a \$500,000 property would be easy to understand, but a \$25,000 condition adjustment to a \$50,000 property would require a more detailed explanation.

3.3 Economic Characteristics Adjustments

In valuations of income-producing property, economic considerations such as the potential income generated by the property must be addressed in all phases of the analysis.

Example (From Text): A sales comparison grid for an office building should include an adjustment for economic characteristics if a comparable property’s long-term rental rate is higher than the subject’s.

3.4 Legal Characteristics Adjustments

While the zoning classifications and property uses of the subject and comparable properties do not have to be identical, they should be very similar. If a comparable property has a completely different highest and best use than the subject, it is probably not comparable.

Example (From Text): In many jurisdictions, I-3 zoning may not allow for exterior storage of products or parts, but I-5 zoning does permit this use. Many appraisers will use a comparable sale that is zoned I-5 and a sale that is zoned I-3 for a property that is zoned I-3 or I-5.

3.5 Non-Realty Adjustments

These adjustments compensate for the presence or absence of personal property or intangible assets.

• Depreciated Cost: Estimating the contributory value based on the depreciated cost of personal property.
• Income/Expense Analysis: Assessing the income or expense generated by the item.

4. The Interplay of Multiple Adjustments

In most appraisals, multiple adjustments are necessary. This creates complexity and increases the potential for error. Here are some best practices:

• Minimize Adjustments: Prioritize finding the best comparables possible. This means finding sales that are as similar to the subject property as possible, therefore requiring fewer and smaller adjustments.
• Bracketing: Seek out comparables that are both superior and inferior to the subject property with respect to key characteristics. This helps establish a reasonable range of value.
• Adjustment Sequence: Apply adjustments in a logical order (Real Property Rights, Financial Terms, Condition of Sale, Market Conditions, Location, Physical Characteristics, Economic Characteristics, Legal Characteristics, Non-Realty).
• Consider Interaction Effects: Be aware that the combined effect of multiple adjustments may not be simply additive. The impact of one characteristic may be influenced by the presence or absence of another.

Caution: Large and numerous adjustments can weaken the reliability of the SCA. If numerous adjustments of large magnitude are necessary, use as much data as available and apply as many approaches to value as can be reasonably prepared.

5. Common Pitfalls and How to Avoid Them

• Circular Reasoning: Using the appraisal to justify the adjustments, rather than using the adjustments to derive the value opinion.
• Over-reliance on Rules of Thumb: Applying fixed percentage adjustments without adequate support.
• Ignoring Market Signals: Failing to recognize when the market is deviating from expected patterns.
• Insufficient Data: Making adjustments based on limited or unreliable data.
• Lack of Transparency: Failing to clearly explain and support the adjustments made in the appraisal report.

6. Conclusion

Comparative analysis is a systematic and rigorous process that requires a strong understanding of real estate principles, economic theory, and statistical analysis. By applying the techniques and principles outlined in this chapter, appraisers can develop credible and defensible value opinions.