Chapter: What appraisal approach is most often used for residential properties? (EN)

Chapter: What Appraisal Approach is Most Often Used for Residential Properties? (EN)

The Sales Comparison Approach: Dominance in Residential Appraisals

The sales comparison approach, also known as the market data approach, is overwhelmingly the most frequently used appraisal method for residential properties. Its prominence stems from its direct reliance on market evidence – actual transactions of similar properties – making it readily understandable and defensible in most residential appraisal contexts. The underlying principle is that a willing buyer will pay no more for a property than what a similar property has recently sold for in the same market area. This approach mirrors basic economic principles of supply and demand and the substitution principle.

Principles Underlying the Sales Comparison Approach:

• Principle of Substitution: A rational buyer will pay no more for a property than the cost to acquire an equally desirable substitute.
• Principle of Supply and Demand: The interaction of supply and demand forces influences market prices.
• Principle of Contribution: The value of a particular component of a property is measured by its contribution to the overall value of the property. This helps in making adjustments for differences between the subject property and comparable sales.

The Process of the Sales Comparison Approach:

1. Identifying Comparable Sales: This involves locating properties that have recently sold, are similar to the subject property, and are located in the same market area. “Recently” is context-dependent, typically within the last 6-12 months, but can extend longer in slow markets. Similarity criteria include:

   • Location: Proximity to the subject property, neighborhood characteristics.
   • Physical Characteristics: Size (square footage of living area, lot size), age, style, condition, number of bedrooms and bathrooms, presence of garage, pool, etc.
   • Legal Characteristics: Ownership interests, easements, zoning regulations.
   • Date of Sale: More recent sales are generally preferred.
   • Financing Terms: Unusual financing can distort the sale price and requires adjustment.

2. Verifying the Data: This step involves confirming the accuracy of the information obtained on the comparable sales. Public records, real estate agents involved in the transactions, and the buyers/sellers themselves can be sources of verification.

3. Selecting Relevant Elements of Comparison: These are the characteristics where the comparable sales differ from the subject property and have a demonstrable impact on value. Common elements include:

   • Property Rights Conveyed: Fee simple versus leasehold interests.
   • Financing Terms: Assumed mortgages, seller concessions.
   • Conditions of Sale: Arm’s length transactions versus related-party sales.
   • Market Conditions: Changes in market conditions between the date of sale of the comparable and the date of valuation of the subject property.
   • Location: Differences in desirability of specific locations.
   • Physical Characteristics: As listed previously (size, condition, etc.).

4. Adjusting the Sale Prices: This is a critical step that involves making quantitative or qualitative adjustments to the sale prices of the comparable properties to account for differences between them and the subject property.

   • Quantitative Adjustments: These are adjustments expressed in dollar amounts. They are based on market data and analysis. For example, if a comparable sale has a larger lot than the subject property and market data indicates that each additional acre of land contributes $X to value, the comparable sale price is adjusted downward by $X.

     • Adjustment Calculation Formula: Adjusted Sale Price = Sale Price ± Adjustment Amount

   • Qualitative Adjustments: These are subjective adjustments based on the appraiser’s judgment and experience. They are often expressed as “superior,” “inferior,” or “similar” relative to the subject property. If quantitative data is lacking, bracketing can be used. Bracketing involves selecting comparables that are both superior and inferior to the subject property with respect to a given characteristic.

     • Relative Comparison: Comparable 1 (Superior), Subject Property, Comparable 2 (Inferior)
     • Ranking System: Assigning relative ranks (e.g., “S,” “E,” “I” for Superior, Equal, Inferior) for each comparison element.

5. Reconciling the Adjusted Sale Prices: This involves analyzing the adjusted sale prices of the comparable properties and arriving at a single indicated value for the subject property. This is not simply averaging the adjusted sale prices. The appraiser must weigh the reliability and relevance of each comparable sale, giving more weight to those that are most similar to the subject property and required the fewest adjustments.

Mathematical Considerations in Adjustments:

While the approach relies heavily on market analysis and judgment, some mathematical principles underpin the adjustment process.

• Percentage Adjustments: Used to adjust for market conditions. This requires understanding the rate of appreciation or depreciation in the market.

  • Formula: Adjusted Sale Price = Sale Price * (1 + Appreciation Rate) or Sale Price * (1 - Depreciation Rate)

• Paired Data Analysis: This is a technique used to isolate the value of a single characteristic by analyzing paired sales that are identical except for that one characteristic.

  • Example: Two identical houses sold, one with a garage and one without. The difference in sale price represents the market value of the garage.

Practical Applications and Experiments:

• Experiment: Paired Sales Analysis for a Swimming Pool: Gather data on recent sales of comparable homes in a neighborhood. Identify pairs of homes that are nearly identical except that one has a swimming pool and the other does not. Calculate the difference in sales price for each pair. Average these differences to estimate the contribution of a swimming pool to market value in that neighborhood.
• Scenario: Adjusting for Date of Sale: The appraiser identifies a comparable sale that sold six months prior to the effective date of appraisal. Market analysis reveals that property values in the area have increased at a rate of 0.5% per month. The appraiser would adjust the sale price of the comparable upward by 3% (0.5% x 6 months) to reflect the change in market conditions.

Important Discoveries and Breakthroughs:

• Development of Statistical Methods: The application of statistical methods, such as regression analysis, has enhanced the objectivity and reliability of the sales comparison approach by providing a more rigorous framework for quantifying adjustments.
• Advancements in Data Availability: The proliferation of online databases and multiple listing services (MLS) has significantly improved access to comparable sales data, making the sales comparison approach more efficient and accurate.

Limitations of the Sales Comparison Approach:

• Availability of Comparable Sales: In some markets, particularly those with limited sales activity or unique properties, finding sufficient comparable sales can be challenging.
• Subjectivity of Adjustments: The adjustment process inherently involves some degree of subjectivity, which can lead to variations in appraised value.
• Changing Market Conditions: Rapidly changing market conditions can make it difficult to rely on historical sales data.

Alternatives to the Sales Comparison Approach: When are they used?

While the sales comparison approach dominates, other appraisal approaches exist and are used in specific situations, though much less frequently for typical residential properties:

• Cost Approach: This approach estimates the value of a property by determining the cost to reproduce or replace it, less depreciation. It is most applicable for new or unique properties where comparable sales are scarce, or for special-purpose properties. For typical residential appraisals, it serves as a check on the other approaches. The cost approach estimates value as:

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

• Income Capitalization Approach: This approach estimates the value of a property based on its potential to generate income. It is primarily used for income-producing properties, such as apartment buildings or rental properties. While it can be applied to single-family homes rented out, it is less common because the rental income often doesn’t strongly correlate with market value as it does for larger income-producing properties. The most basic formula is:

  • Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)

Conclusion:

The sales comparison approach remains the cornerstone of residential property appraisals due to its reliance on direct market evidence and its alignment with fundamental economic principles. While the cost and income approaches have their place, the sales comparison approach provides the most reliable and defensible estimate of value for the vast majority of residential properties. Its effective application requires a thorough understanding of market dynamics, sound judgment in selecting and adjusting comparable sales, and adherence to established appraisal principles and guidelines.