Chapter: Which appraisal approach is MOST likely to be used when determining the value of a single-family residence? (EN)

Chapter: Which Appraisal Approach is MOST Likely to be Used When Determining the Value of a Single-Family Residence? (EN)

The Sales Comparison Approach: A Primary Valuation Method

The sales comparison approach (SCA) is the valuation method most commonly employed when appraising single-family residences. Its foundation lies in the economic principle of substitution, which posits that a rational buyer will pay no more for a property than for a comparable substitute. The SCA analyzes recent sales of similar properties (comparables) in the subject property’s market area, adjusting the sales prices of these comparables to account for differences between them and the subject property.

• Foundation in Economic Theory: The approach directly reflects market behavior and buyer preferences, adhering to fundamental supply and demand principles. The price of a single-family home is ultimately determined by what buyers are willing to pay, a factor directly observed in recent sales of comparable properties.

• Market-Driven Analysis: The reliability of the SCA depends on the availability of sufficient and relevant comparable sales data. Active, liquid markets with numerous transactions provide the best foundation for this approach.

Key Steps in the Sales Comparison Approach

The SCA involves a systematic process:

1. Identify Comparable Sales: Select properties that are similar to the subject property in terms of location, physical characteristics (size, age, condition, features), terms of sale, and market conditions. The goal is to find properties that a typical buyer would consider substitutes for the subject property.

2. Verify the Data: Confirm the details of each comparable sale by contacting parties involved in the transaction, reviewing public records, and/or consulting multiple listing services (MLS). Accuracy is paramount.

3. Adjust Comparable Sales Prices: Adjust the sales prices of the comparables to account for differences between them and the subject property. Adjustments are made for elements of comparison such as:

   • Location: Addresses variations in neighborhood desirability, school districts, proximity to amenities, and other location-specific factors.
   • Physical Characteristics: Accounts for differences in square footage, lot size, number of bedrooms and bathrooms, architectural style, age, condition, and quality of construction.
   • Terms of Sale: Addresses differences in financing, seller concessions, or unusual sale conditions (e.g., forced sale, sale between related parties).
   • Market Conditions: Adjusts for changes in market activity between the date of the comparable sale and the date of the appraisal. This addresses shifts in supply, demand, interest rates, and other macroeconomic factors.

4. Reconcile Adjusted Sales Prices: Analyze the adjusted sales prices of the comparables and arrive at a final estimate of value for the subject property. This is not simply an average of the adjusted prices; rather, it is a weighted analysis that considers the reliability and relevance of each comparable.

Mathematical Representation of Adjustments

Adjustments are typically expressed as dollar amounts or percentages.

• Dollar Adjustment: Directly subtracts or adds a specific dollar value to the comparable’s sale price to reflect a difference in a specific feature.

  • Adjusted Sale Price = Comparable Sale Price ± Dollar Adjustment

• Percentage Adjustment: Applies a percentage adjustment to the comparable’s sale price.

  • Adjusted Sale Price = Comparable Sale Price * (1 ± Percentage Adjustment)

  • Example: If a comparable sold for $300,000 and has a superior view that is worth 5%, the adjustment would be:

    • Adjusted Sale Price = $300,000 * (1 - 0.05) = $285,000 (since the subject property lacks the superior view)

Practical Applications and Considerations

• Matched Pairs Analysis: A technique used to isolate the value of a specific feature by comparing two nearly identical properties that differ only in that one feature. The difference in sales prices can then be attributed to the feature in question. This is a form of controlled experiment.

• Regression Analysis: A statistical technique that can be used to analyze a larger set of comparable sales and identify the relative contributions of different factors to the overall property value. A multiple regression model might take the form:

  • Sale Price = β₀ + β₁*SqFt + β₂*Bedrooms + β₃*Bathrooms + β₄*LotSize + ε

  where:
  * β₀ is the intercept
  * β₁, β₂, β₃, β₄ are coefficients representing the marginal impact of each variable on sale price.
  * SqFt, Bedrooms, Bathrooms, and LotSize are the independent variables.
  * ε is the error term.

  While powerful, regression analysis requires substantial data and expertise in statistical modeling.

• Bracketing: The process of selecting comparables that are both superior and inferior to the subject property with respect to key characteristics. This provides a range of values and helps to support the final value conclusion.

Why the Sales Comparison Approach is Preferred for Single-Family Residences

• Direct Market Evidence: Single-family residences are typically bought and sold in active markets, generating ample sales data. The SCA directly leverages this data.

• Reflects Buyer Behavior: The approach replicates the decision-making process of a typical buyer, who would consider comparable properties before making an offer.

• Ease of Understanding: The SCA is relatively easy to understand and explain, making it more transparent to clients and other stakeholders.

Limitations of the Sales Comparison Approach

• Data Availability: The approach is less reliable in markets with limited sales data or where properties are highly unique.

• Subjectivity: The selection of comparables and the determination of adjustment amounts involve some degree of subjectivity.

• Changing Market Conditions: In rapidly changing markets, historical sales data may not accurately reflect current values.

Other Appraisal Approaches and Their Limited Applicability to Single-Family Residences

While the SCA is the most prevalent approach, other appraisal methods exist:

1. Cost Approach: Estimates value by summing the estimated land value and the depreciated cost of constructing improvements. This approach is more commonly used for new or unique properties, or when comparable sales data are scarce.

   • Value = Land Value + Cost of New - Accrued Depreciation

   Accrued depreciation can be further divided into physical deterioration, functional obsolescence, and external obsolescence. The accuracy of this approach depends on accurate cost estimates and depreciation calculations, which can be challenging for older single-family homes.

2. Income Capitalization Approach: Estimates value based on the income-producing potential of a property. This approach is primarily used for income-generating properties, such as apartment buildings or commercial properties. It is rarely applicable to single-family residences unless they are being rented out, and even then, the SCA is typically given more weight due to the prevalence of owner-occupancy in single-family housing markets.

   • Value = Net Operating Income / Capitalization Rate

   Where:
   * Net Operating Income (NOI) = Gross Potential Income - Operating Expenses
   * Capitalization Rate = NOI / Property Value (derived from comparable income-producing properties)

Conclusion

The sales comparison approach is the most frequently used and generally the most reliable method for appraising single-family residences due to its direct reliance on market data and reflection of buyer behavior. While other approaches may be used in specific circumstances, the SCA typically forms the cornerstone of the appraisal process for this property type. A thorough understanding of the SCA, its underlying principles, and its limitations is crucial for anyone involved in the real estate valuation process.