Sales Comparison and Income Approaches to Value

Introduction: Sales Comparison and Income Approaches to Value

This chapter, “Sales Comparison and Income Approaches to Value,” within the “Foundations of Appraisal: Value, Practice, and Technology” training course, delves into two primary methodologies employed in real estate appraisal to estimate property value. These approaches, the Sales Comparison Approach and the Income Approach, represent distinct yet complementary frameworks for deriving credible value opinions.

The Sales Comparison Approach operates on the fundamental economic principle of substitution. It posits that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This approach entails a systematic analysis of recent sales of comparable properties, with adjustments made to account for differences in characteristics such as location, size, condition, amenities, and date of sale. The scientific validity of this approach rests on the assumption of market efficiency and the availability of sufficient, reliable data on comparable transactions. Careful statistical analysis of paired sales data or regression analysis may be employed to quantify the value attributable to specific property characteristics.

The Income Approach, conversely, treats real estate as an investment asset, focusing on its capacity to generate future income streams. This approach utilizes capitalization techniques to convert anticipated income into a present value estimate. The scientific basis of this method lies in financial theory, specifically the concept of discounted cash flow analysis. Key considerations include accurate forecasting of future income, appropriate selection of capitalization rates or discount rates reflecting market risk and opportunity costs, and accounting for factors such as vacancy rates, operating expenses, and property tax implications. Different income capitalization methods, such as direct capitalization and yield capitalization, offer varying degrees of analytical sophistication in modeling the relationship between income and value.

The scientific importance of mastering these approaches lies in their application to a wide range of real estate decisions, including property valuation, investment analysis, lending decisions, property tax assessment, and litigation support. A sound understanding of these methodologies is crucial for ensuring transparency, objectivity, and accuracy in real estate transactions and financial reporting.

The educational goals of this chapter are to equip trainees with the following competencies:

1. Comprehend the theoretical underpinnings and practical applications of both the Sales Comparison and Income Approaches to Value.

2. Develop proficiency in collecting, verifying, and analyzing market data relevant to each approach.

3. Master the techniques for making appropriate adjustments to comparable sales prices and income streams.

4. Learn to select and apply appropriate capitalization rates or discount rates based on market evidence and risk assessment.

5. Understand the strengths and limitations of each approach and the circumstances under which each is most applicable.

6. Effectively reconcile value indications derived from multiple approaches to arrive at a well-supported final value opinion.

By achieving these educational goals, trainees will be well-prepared to apply sound appraisal principles and methodologies in their professional practice, contributing to the integrity and reliability of the real estate valuation process.

Sales Comparison and Income Approaches to Value

I. The sales comparison approach❓❓

A. Core Principles:
The sales comparison approach, also known as the market approach, estimates the value of a subject property by comparing it to similar properties that have recently sold in the same market area. The underlying principle is that a prudent buyer will pay no more for a property than what other similar properties have recently sold for.

B. Steps Involved:
1. Data Collection: Gather information on recent sales of comparable properties (comparables). This includes sales prices, property characteristics (size, location, condition, amenities), and terms of sale.
2. Selection of Comparables: Choose properties that are most similar to the subject property in terms of location, physical characteristics, date of sale, and conditions of sale. The more similar the comparables, the more reliable the value indication.
3. Adjustment Process: Adjust the sales prices of the comparables to account for differences between them and the subject property. Adjustments can be made for various elements of comparison.
4. Reconciliation: Analyze the adjusted sales prices of the comparables and reconcile them into a single value indication for the subject property. This involves weighting the comparables based on their similarity to the subject and the reliability of the data.

C. Elements of Comparison:
These are the characteristics that are used to compare the subject property to the comparables. Adjustments are made to the comparable sales prices to account for differences in these elements. Common elements include:

1. Real Property Rights Conveyed: Adjustments are made to account for any differences in the rights being conveyed in the transaction (e.g., fee simple vs. leasehold).
2. Financing Terms: If the financing terms of the comparable sale are not typical of the market (i.e., not cash equivalent), an adjustment may be necessary.
   • Formula: Adjusted Sales Price = Sales Price - (Present Value of Financing Advantage)
3. Conditions of Sale: Adjustments are made to ensure that the sale was an arm’s-length transaction, meaning that the buyer and seller were not related and were acting in their own best interests. Unusual motivations (e.g., forced sale, distress sale) should be considered.
4. Expenditures Made Immediately After Sale: Account for expenditures that would have to be made upon purchase of the property and that a knowledgeable buyer may negotiate into the purchase price.
5. Market Conditions (Date of Sale): Market conditions can change over time, affecting property values. Adjustments are made to account for changes in market conditions between the date of sale of the comparable and the date of the appraisal.
   • Percentage Adjustment: Adjustment = Sales Price * (Percentage Change in Market)
6. Location: Properties in different locations may have different values due to factors such as school district, proximity to amenities, and neighborhood desirability.
7. Physical Characteristics: These include factors such as size, condition, age, quality of construction, number of bedrooms and bathrooms, and presence of amenities (e.g., garage, pool).
8. Economic Characteristics: For income-producing properties, economic characteristics such as income, operating expenses, lease provisions, management, and tenant mix are used.

D. Adjustment Techniques:
1. Quantitative Adjustments: These involve making adjustments based on a specific dollar amount or percentage.
* Paired Data Analysis: This technique involves analyzing the sales prices of comparable properties that are identical except for one characteristic. The difference in sales prices is attributed to the value of that characteristic.
* Example: Two identical houses sold for $300,000 and $310,000, the only difference being a swimming pool. The value of the pool is estimated to be $10,000.
2. Qualitative Adjustments: These involve making adjustments based on a subjective assessment of the relative differences between the subject and the comparables (e.g., superior, inferior, equal).
* Relative Comparison Analysis: Similar to paired data analysis, but the resulting adjustment values are qualitative instead of quantitative.

E. Example:
Subject Property: 3-bedroom, 2-bath house with a 2-car garage.
Comparable 1: 3-bedroom, 1-bath house with a 1-car garage, sold for $350,000.
Market data indicates:
* Additional bath: $10,000
* Additional garage space: $5,000

Adjustment to Comparable 1:
* Add $10,000 for the additional bath.
* Add $5,000 for the additional garage space.
Adjusted sales price of Comparable 1: $350,000 + $10,000 + $5,000 = $365,000.

F. Mathematical Formula for Percentage Adjustments:
Converting percentage adjustments into dollar amounts depends on how the percentage relationship is defined.
If adjustment is a percentage of the comparable’s price:
Dollar Adjustment = Sales Price of Comparable * Percentage Adjustment
If adjustment is a percentage of the subject’s characteristic:
Dollar Adjustment = Value of Subject’s Characteristic * Percentage Adjustment

G. Sequence of Adjustments:
Adjustments for transactional elements of comparison (e.g., financing terms, conditions of sale) are usually made before adjustments for physical elements of comparison (e.g., size, condition).

H. Calculating Adjusted Price and Reliability:
1. Net Adjustment: The sum of all individual adjustments (positive or negative) made to a comparable’s sales price.
2. Adjusted Price: The comparable’s sales price plus the net adjustment.
3. Gross Adjustment: The sum of the absolute values of all individual adjustments, regardless of sign. The gross adjustment is an indicator of the reliability of the adjusted price as an indicator of the subject property’s value. Lower gross adjustment generally indicates a more reliable comparable.

I. Reconciliation and Value Indication:
The appraiser reconciles the adjusted sales prices of the comparables to arrive at a final value indication for the subject property. This involves considering the strengths and weaknesses of each comparable and weighting them accordingly. The subject property’s value should fall within the range indicated by the adjusted prices of the comparables.

II. The Income Approach

A. Core Principles:
The income approach estimates the value of a property based on the income it is expected to generate. It is most commonly used for income-producing properties such as apartments, office buildings, and shopping centers. The underlying principle is that the value of a property is directly related to its ability to generate income.

B. Investor’s Perspective:
An investor purchases real estate to generate income and profit from its eventual sale. The income approach seeks to quantify what an investor would pay for the right to receive that future income stream.

C. Rate of Return:
The rate of return is the ratio between the amount of income and the amount of the investment. It reflects the investor’s required return on capital, considering risk and alternative investment opportunities.

Formula:
Rate of Return = Amount of Income / Amount of Investment

Value = Amount of Income / Rate of Return

D. Components of Rate of Return:
1. Risk: The higher the perceived risk, the higher the required rate of return.
2. Return “of” Investment (Recapture): Investors need to recover their initial investment over the economic life of the property.
3. Competing Investment Opportunities: The rates of return available on other investments influence the required rate for real estate.

E. Income Capitalization:
The process of converting income into an estimate of value. There are two main techniques:

1. Direct Capitalization:
   In direct capitalization, the income from a single period (usually a year) is converted directly into value using a capitalization rate (cap rate).

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

Value = Income x Multiplier

Multiplier = 1 / Rate

a. Income Estimation:  Accurately estimating income is crucial. Key terms include:
* Potential Gross Income (PGI): The total income the property could generate at 100% occupancy. Includes scheduled rent (contract rent) and market rent.
* Effective Gross Income (EGI): PGI less vacancy and collection losses.
* Net Operating Income (NOI): EGI less operating expenses.

b.  Reconstructed Operating Statement:
* Potential Gross Income (PGI)
* Less: Vacancy and Collection Losses
* Equals: Effective Gross Income (EGI)
* Less: Operating Expenses
    * Fixed Expenses (property taxes, insurance)
    * Variable Expenses (utilities, maintenance, management fees)
    * Reserves for Replacement (funds for replacing short-lived items)
* Equals: Net Operating Income (NOI)

c. Multipliers and Capitalization Rates:
    * Capitalization Rate: The rate used to convert income to value.  Derived from market data of comparable sales.
    * Gross Income Multiplier (GIM):  Ratio of sales price to gross income.  Used for smaller properties.
        * GIM = Sales Price / Gross Income

d. Methods for Deriving Capitalization Rates:

    * Comparable Sales Method:  Analyze sales of comparable properties to extract their implied cap rates (NOI / Sales Price).
    * Operating Expense Ratio Method: Uses the operating expense ratio to calculate a cap rate.
    * Band of Investment Method:  Considers the mortgage and equity components of financing.
    * Debt Coverage Ratio: The annual net operating income divided by the annual debt payment.

e. Residual Techniques:

Use direct capitalization to determine the value of one component.
* Building Residual
* Land Residual

2. Yield Capitalization:
   Analyzes all anticipated future cash flows over the investment’s life and discounts them to their present value. More complex than direct capitalization.

F. Discounting:
The process of determining the present value of future income. This considers the time value of money.
G. Formula: PV = FV / (1 + r)^n
Where:
PV = Present Value
FV = Future Value
r = Discount Rate (Yield Rate)
n = Number of Periods

1. Compounding:
   The process of calculating the future value of a present sum of money. The opposite of discounting.
2. Annuities:
   A series of equal payments made over a period of time. The present value of an annuity can be calculated using a specific formula.
3. Yield Rates:
   The rate of return required by an investor, considering risk and the time value of money.

III. Examples and Experiments

A. Sales Comparison Approach:
1. Experiment: Conduct a market search for comparable sales of a single-family home. Vary the selection criteria (e.g., location radius, age of sale) and observe how the adjusted value indication changes. This demonstrates the sensitivity of the approach to comparable selection.
2. Practical Application: Appraise a vacant lot. Find sales of similar lots, and make adjustments for size, location, zoning, and availability of utilities.

B. Income Approach:
1. Experiment: Given a commercial property, calculate the NOI using different assumptions for vacancy rates and operating expenses. Analyze how changes in these assumptions affect the final value indication.
2. Practical Application: Appraise an apartment building. Develop a reconstructed operating statement, determine a capitalization rate using the comparable sales method, and calculate the property’s value using direct capitalization.

C. Combined Approach:
A real world example would be to review the approaches used by different professionals for valuing the same property, and understand what the differences are.

IV. Scientific Theory and Principles

A. Sales Comparison Approach:
* Law of Supply and Demand: This economic principle underlies the sales comparison approach. Property values are influenced by the availability of properties and the demand for them.
* Principle of Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
* Statistical Analysis: Paired data analysis and regression analysis can be used to quantify adjustments and improve the accuracy of the sales comparison approach.

B. Income Approach:
* Time Value of Money: A dollar received today is worth more than a dollar received in the future. This is due to the opportunity to invest the dollar today and earn a return.
* Risk and Return: Investors require a higher rate of return for investments with higher risk.
* Financial Modeling: Discounted cash flow analysis and sensitivity analysis are important tools for income property valuation.

C. Mathematics:
* Algebraic manipulation of formulas
* Statistical analysis for extracting information from market data.
* Financial mathematics for compounding and discounting.