Sales Comparison Approach & Income Capitalization

Chapter: Sales Comparison Approach & Income Capitalization

I. Sales Comparison Approach

A. Core Principle:
The sales comparison approach (SCA) operates on the principle of substitution. This economic principle asserts that a rational buyer will pay no more for a property than they would for an equally desirable substitute. The approach infers value❓ by comparing the subject property to similar properties (comparable❓s) that have recently sold in the same market.

B. Scientific Basis:
The SCA relies on empirical data and statistical analysis. Ideally, a large sample size of comparable sales would be analyzed using regression analysis or other statistical techniques to isolate the impact of specific property characteristics on sales price. In practice, appraisers often rely on a smaller set of comparables and apply adjustments based on market data and professional judgment.

C. Steps in the Sales Comparison Approach:

1. Data Collection:
   a. Identify comparable properties: Look for properties with similar characteristics to the subject property, located in the same or similar market area, and recently sold. Recent sales are crucial to reflect current market conditions.
   b. Gather data on comparable sales: Collect detailed information on the comparable properties, including:

   • Sales price: The actual price paid for the property.
   • Date of sale: When the transaction occurred. Market conditions can change over time.
   • Location: The physical location of the property.
   • Physical characteristics: Size, age, condition, features (e.g., number of bedrooms/bathrooms, garage, landscaping).
   • Financing terms: Details of any mortgages or other financing involved.
   • Conditions of sale: Circumstances surrounding the transaction (e.g., arm’s length transaction, forced sale).
   • Real property rights conveyed.

2. Selection of Comparables:
   a. Analyze collected data to determine the most suitable comparables.
   b. Factors influencing selection:

   • Similarity to the subject property.
   • Proximity (geographic and time).
   • Data reliability.

3. Adjustments:
   a. The goal is to make the comparables equivalent to the subject property. Adjustments are made to the comparable sales prices, not the subject property.
   b. Types of Adjustments:

   • Quantitative Adjustments: Dollar amount or percentage adjustments derived from market data.
     • Paired Data Analysis: A technique used to isolate the value contribution of a single feature. For instance, if two identical houses sold, but one has a swimming pool and the other does not, the difference in sales price can be attributed to the value of the pool. Example: If house A has a pool and sold for $400,000, and house B (identical except no pool) sold for $380,000, then the pool’s adjustment value is $20,000.
     • Statistical Analysis: Regression analysis or other statistical methods can be used to estimate adjustment amounts for various characteristics. This requires a larger dataset.
   • Qualitative Adjustments: Descriptive adjustments (e.g., “superior,” “inferior,” “equal”) used when quantitative data is unavailable or unreliable. Often used with relative comparison analysis.
   • Relative Comparison Analysis: Determines relative position of comparables compared to the subject property for various elements of comparison.

c. Order of Adjustments: Transactional adjustments (e.g., financing terms, conditions of sale) are typically made before property adjustments (e.g., physical characteristics).

d. Formula for percentage adjustments:
* If the percentage adjustment is based on the comparable’s characteristics: Adjusted Price = Sales Price * (1 + Percentage Adjustment) [if superior] or Sales Price * (1 - Percentage Adjustment) [if inferior].
* If the percentage adjustment represents the impact on the sales price due to the difference: Adjusted Price = Sales Price + (Sales Price * Percentage Adjustment) [if the comparable lacks a feature].
e. Example:
* Comparable Property Sales Price: $300,000
* Financing Adjustment: The comparable had favorable financing, requiring a 5% downward adjustment.
* Adjustment Calculation: $300,000 * (1 - 0.05) = $285,000.
* Bedroom Adjustment: The subject has 3 bedrooms. The comparable has 2. Market data shows an adjustment of $10,000 per bedroom.
* Adjusted Price: $285,000 + $10,000 = $295,000

4. Reconciliation:
   a. Analyze the adjusted sales prices of the comparables to arrive at a single indicated value or a range of values for the subject property.
   b. Reconciliation is not simply averaging the adjusted prices. The appraiser should weigh the comparables based on their:
   • Similarity to the subject property.
   • Number and size of adjustments required.
   • Reliability of the data.

D. Mathematical Representation:

• Indicated Value (Subject) = ∑ [Adjusted Sales Price (Comparable i) * Weight (Comparable i)], where the sum is over all comparables, and ∑ Weight (Comparable i) = 1.

E. Limitations:

• Availability of Comparables: The SCA is most reliable when there are numerous recent, similar sales. In thin markets, finding suitable comparables can be challenging.
• Subjectivity: Adjustment amounts can be subjective, especially when relying on qualitative analysis.
• Market Fluctuations: Rapidly changing market conditions can make it difficult to obtain reliable data.
• Complexity: Complex properties with unique features may be difficult to compare.

F. Experiments and Data Analysis:

1. Paired Sales Experiment:
   * Objective: To determine the value of a specific feature (e.g., a finished basement).
   * Procedure: Collect data on pairs of properties that are identical except for the presence of the feature. Analyze the difference in sales prices to estimate the feature’s value. Example: Analyze sales of 20 pairs of houses, identical except that one house in each pair has a finished basement. Calculate the average difference in sales price.
   * Data Analysis: Use statistical tests (e.g., t-test) to determine if the difference in sales prices is statistically significant.

2. Sensitivity Analysis:
   * Objective: To assess the impact of changes in adjustment amounts on the indicated value.
   * Procedure: Vary the adjustment amounts for different characteristics and observe the effect on the final reconciled value. Example: Increase or decrease the adjustment for square footage by 10% and see how the indicated value of the subject changes.

II. Income Capitalization Approach

A. Core Principle:
The income capitalization approach (ICA) values a property based on its ability to generate income. It is based on the principle of anticipation – the value of a property is the present worth of its expected future income stream. This approach is primarily used for income-producing properties such as apartments, office buildings, and retail spaces.

B. Scientific Basis:
The ICA is rooted in financial principles of discounted cash flow (DCF) analysis. It uses mathematical models to estimate the present value of future income, considering factors such as required rate of return (discount rate), income growth, and property lifespan.

C. Key Concepts:

1. potential gross income❓❓ (PGI): The total income a property could generate if fully occupied. PGI = Number of Units * Rent per Unit * Occupancy Rate

2. Effective Gross Income (EGI): The potential gross income less vacancy and collection losses. EGI = PGI - Vacancy Losses - Collection Losses

3. Operating Expenses (OE): The expenses associated with operating the property, including fixed expenses (e.g., property taxes, insurance), variable expenses (e.g., utilities, maintenance), and reserves for replacement.

4. Net Operating Income (NOI): The income remaining after deducting operating expenses from the effective gross income. NOI = EGI - OE. NOI is the most critical component of the ICA.

5. Capitalization Rate (Cap Rate): The rate of return an investor expects to receive on their investment. It reflects the risk and opportunity cost associated with the investment. The Cap Rate is derived from market data.

6. Discount Rate: Rate used in discounted cash flow analysis to determine the present value of future cash flows.

D. Direct Capitalization:

1. Formula: Value = NOI / Cap Rate

2. Process:
   a. Estimate the stabilized NOI (NOI for a typical year).
   b. Determine the appropriate cap rate from comparable sales.
   c. Divide the NOI by the cap rate to estimate the value.

3. Cap Rate Derivation:
   a. Market Extraction (Comparable Sales): Analyze recent sales of comparable properties and calculate their cap rates: Cap Rate = NOI / Sales Price.
   b. Band of Investment: Considers the cost of debt and equity financing. Weighted average of mortgage and equity components. Cap Rate = (Loan Ratio * Mortgage Constant) + (Equity Ratio * Equity Dividend Rate)
   c. Summation Method: Cap Rate = Risk-Free Rate + Risk Premium + Liquidity Premium + Management Premium.

E. Yield Capitalization (Discounted Cash Flow Analysis):

1. Process:
   a. Project the property’s income stream over a specified holding period (e.g., 10 years).
   b. Estimate the property’s resale value (reversion) at the end of the holding period.
   c. Determine the appropriate discount rate to reflect the risk of the investment.
   d. Discount each year’s income and the resale value back to their present values.
   e. Sum the present values to arrive at the property’s value.

2. Formulas:
   a. Present Value of a Single Sum: PV = FV / (1 + r)^n, where PV = Present Value, FV = Future Value, r = Discount Rate, and n = Number of Years.
   b. Present Value of an Annuity: PV = PMT * [1 - (1 + r)^-n] / r, where PMT = Payment per period.
   c. Overall Value: Value = PV (Year 1 NOI) + PV (Year 2 NOI)… + PV (Year n NOI) + PV (Reversion Value).

3. Reversion Value Estimation:
   a. Terminal Cap Rate: Apply a terminal cap rate to the projected NOI in the year following the holding period. Reversion Value = NOI (Year n+1) / Terminal Cap Rate. The terminal cap rate is often higher than the initial cap rate, reflecting increased uncertainty in the future.

F. Gross Income Multiplier (GIM):

1. Formula: Value = Gross Income * GIM

2. Process:
   a. Determine the appropriate GIM from comparable sales: GIM = Sales Price / Gross Income.
   b. Multiply the subject property’s gross income by the GIM to estimate the value.

3. Limitations: Less precise than direct capitalization because it doesn’t directly account for differences in operating expenses.

G. Limitations:

• Data Requirements: Accurate income and expense data are essential. Projected income can be uncertain.
• Cap Rate Estimation: Determining the appropriate cap rate is critical and can be subjective.
• Holding Period: Selecting an appropriate holding period for DCF analysis requires judgement.
• Discount Rate: Selecting the correct discount rate is crucial. Inaccurate rates can significantly impact the results.
• Stability of Income: The ICA assumes a relatively stable and predictable income stream, which may not be realistic for all properties.
• Terminal Value: The terminal value can have a significant impact on the overall indicated value.

H. Experiments and Data Analysis:

1. Rent Survey Analysis:

   • Objective: To determine market rental rates for comparable properties.
   • Procedure: Collect data on rental rates for similar properties in the market. Analyze the data to determine the average or median rental rate per square foot or per unit.
   • Data Analysis: Calculate descriptive statistics (e.g., mean, median, standard deviation) to understand the distribution of rental rates.

2. Expense Ratio Analysis:

   • Objective: To determine the appropriate expense ratio for the subject property.
   • Procedure: Collect data on operating expenses for comparable properties. Calculate the expense ratio (Operating Expenses / Effective Gross Income) for each property.
   • Data Analysis: Calculate the average or median expense ratio and use it to estimate the operating expenses for the subject property.

3. Cap Rate Sensitivity Analysis:

   • Objective: Assess the impact of changes in the cap rate on the indicated value.
   • Procedure: Vary the cap rate used in the direct capitalization formula and observe the effect on the final indicated value. Example: Increase or decrease the cap rate by 0.25% and see how the indicated value changes.

4. Discount Rate Sensitivity Analysis:

   • Objective: Assess the impact of changes in the discount rate on the indicated value in yield capitalization.
   • Procedure: Vary the discount rate used in the DCF model and observe the effect on the final indicated value. Example: Increase or decrease the discount rate by 0.5% and see how the indicated value changes. This shows the effect of risk on the investment.