Sales Comparison & Income: Approaches to Value

Chapter: Sales Comparison & Income: Approaches to Value

I. Sales Comparison Approach: Principles and Application

The Sales Comparison Approach, also known as the Market Data Approach, is a valuation technique that relies on the principle of substitution. This principle posits that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market. The approach is based on the premise that value can be estimated by comparing a subject property to similar properties that have recently sold in the same market.

A. Theoretical Foundation

The Sales Comparison Approach is rooted in economic theory, particularly the concepts of:

1. Supply and Demand: The price of a property is influenced by the interaction of supply and demand forces in the market.
2. Competition: Similar properties compete with each other, influencing market prices.
3. Substitution: Buyers will choose the property that offers the most value for their money.

B. Steps in the Sales Comparison Approach

The application of the Sales Comparison Approach involves a systematic process:

1. Data Collection and Verification:

   • Gather information on recent sales of comparable properties. This includes sales prices, dates of sale, locations, physical characteristics, financing terms, and conditions of sale.
   • Verify the accuracy of the data by contacting involved parties such as buyers, sellers, real estate agents, and lenders.
   • Analyze all prior sales transactions of the subject and comparables for the reporting period, addressing concerns regarding property flipping.

2. Selection of Comparable Properties:

   • Identify properties that are similar to the subject in terms of location, size, style, age, condition, and use.
   • Prioritize comparables that are located in the same neighborhood and have similar market influences.
   • Consider the number of comparables needed (typically three or more, but an additional sheet may be added if needed), balancing quantity with quality of data.

3. Identification of Elements of Comparison:

   • Determine the key characteristics that influence property values in the subject’s market.
   • These elements typically include:
     • Real Property Rights Conveyed: Differences in legal rights (e.g., fee simple, leasehold) can affect value.
     • Financing Terms: Non-market financing terms (e.g., below-market interest rates) require adjustment.
     • Conditions of Sale: Unusual motivations of buyers or sellers (e.g., forced sale) can skew prices. Arm’s length transactions are preferred.
     • Expenditures Immediately After Sale: Costs incurred by the buyer immediately after purchase should be accounted for.
     • Market Conditions: Changing market conditions (e.g., increasing or decreasing prices) require adjustments for the date of sale. Recent sales are preferred.
     • Location: Proximity to amenities, schools, and transportation, as well as neighborhood characteristics, influence value. Comparables in the same neighborhood are most reliable.
     • Physical Characteristics: Size, age, condition, construction quality, and amenities affect value.
     • Economic Characteristics: For income-producing properties, income, operating expenses, lease provisions, and tenant mix are critical.
     • Other Influencing Characteristics: Any factor that could influence value must be considered and adjusted for.

4. Comparative Analysis:

   • Analyze the differences between the subject property and each comparable for each element of comparison.
   • Measure the extent of these differences quantitatively (dollar amount or percentage) or qualitatively (superior, inferior, equal).
   • If differences are too large, or market data to determine the effect of the difference on value is unavailable, the comparable may need to be rejected.

5. Adjustment of Comparable Sales Prices:

   • Adjust the sales prices of the comparables to account for the identified differences. Adjustments are always made to the comparables, not the subject.
   • Determine the appropriate adjustment amounts using techniques such as:
     • Paired Data Analysis: Analyze sales of very similar properties that differ only in one key characteristic. The difference in sales price is attributed to the value of that characteristic. Analysis of large numbers of transactions is often required to extract reliable adjustment values.
       Example: Two identical houses sold recently. House A has a garage, and House B does not. House A sold for $10,000 more than House B. The indicated adjustment for a garage is $10,000.
     • Relative Comparison Analysis: Use qualitative assessments (superior, inferior, equal) to make relative adjustments. The resulting adjustment values are qualitative instead of quantitative.
   • The sequence of adjustments depends on market analysis, but transactional elements are usually adjusted before physical elements.

6. Reconciliation of Adjusted Sales Prices:

   • Reconcile the adjusted sales prices of the comparables to arrive at a single indicated value or a range of values for the subject property. The subject property’s value should fall within the range indicated by the adjusted prices of the comparables.
   • Consider the number and magnitude of adjustments required for each comparable.
   • Give more weight to comparables that require fewer and smaller adjustments. The gross adjustment is an indicator of the reliability of the adjusted price as an indicator of the subject property’s value.

C. Mathematical Considerations

1. Percentage Adjustments:

   • The formula for converting percentage adjustments into dollar amounts depends on how the percentage relationship is defined.
   • It is important to apply percentage adjustments consistently.

2. Net and Gross Adjustments:

   • The net adjustment is the sum of all individual adjustments, added to or subtracted from the comparable sales price.
   • The gross adjustment is the sum of the absolute values of all individual adjustments.

D. Practical Applications and Experiments

1. Experimental Design for Paired Data Analysis:

   • To determine the value of a swimming pool, researchers could collect data on sales of houses that are identical in every respect except for the presence of a pool.
   • Statistical analysis (e.g., t-tests) could be used to determine if the difference in sales prices is statistically significant.
   • Caveat: Controlling for all variables in real estate is difficult, so findings may be subject to error.

2. Market Surveys:

   • Conduct surveys of real estate agents and buyers to gather information on typical adjustment amounts for various property features.
   • This can be used to supplement data from paired sales analysis.

II. Income Approach: Theory and Techniques

The Income Approach is a valuation method that estimates the value of a property based on its capacity to generate income. It is based on the principle of anticipation, which holds that the value of an asset is the present worth of the future benefits of ownership. This approach is most applicable to income-producing properties such as apartments, office buildings, retail centers, and industrial properties.

A. Investor Perspective

The Income Approach views real estate as an investment, similar to stocks or bonds. The value is determined by the return an investor expects to receive on their investment. An investor expects two things:

1. Return “of” Investment (Recapture): Repayment of the invested capital.
2. Return “on” Investment (Yield or Interest): A reward or profit as payment for the risk of making an investment.

B. Key Concepts

1. Rate of Return: The ratio between the amount of income and the amount of the investment.

   • Formula: Rate of Return = Amount of Income / Amount of Investment
   • Rearranged: Value = Amount of Income / Rate of Return

2. Capitalization Rate (Cap Rate): A rate used to convert income into value. It reflects the expected rate of return for a property, considering risk and return “of” investment.

3. Economic Life Expectancy: An investment also has an economic life expectancy, with the investor wanting their investment returned.

C. Income Capitalization Methods

There are two primary methods of income capitalization:

1. Direct Capitalization: Involves converting a single year’s income estimate into value using a capitalization rate or income multiplier.
2. Yield Capitalization (Discounted Cash Flow Analysis): Projects future income streams and discounts them back to present value using a discount rate.

D. Direct Capitalization

Direct Capitalization is the simpler of the two methods and is often used for properties with relatively stable income streams.

1. Steps in Direct Capitalization:

   a. Estimate Potential Gross Income (PGI): The total income a property could generate at full occupancy.
   * Scheduled Rent/Contract Rent: The amount of rent specified in existing leases.
   * Market Rent: The amount of rent a property could command in the current market. Used for vacant or owner-occupied units.

   b. Estimate Effective Gross Income (EGI): PGI less an allowance for vacancies and collection losses.
   * Formula: EGI = PGI - (Vacancy Rate x PGI)

   c. Estimate Net Operating Income (NOI): EGI less operating expenses.
   * Formula: NOI = EGI - Operating Expenses
   * Operating Expenses include:
   * Fixed Expenses: Expenses that do not vary with occupancy (e.g., property taxes, insurance).
   * Variable Expenses: Expenses that fluctuate with occupancy (e.g., utilities, maintenance, management fees).
   * Reserves for Replacement: Funds set aside for replacing short-lived components (e.g., roofing, HVAC systems, appliances). The funds are calculated by dividing the replacement cost of the item by its remaining useful life.
   Note that mortgage principal and interest payments, depreciation, and income taxes are not included in operating expenses.

   d. Determine the Capitalization Rate (Cap Rate):
   * Comparable Sales Method: Derive the cap rate from sales prices and incomes of comparable properties. Cap Rate = NOI / Sales Price. Considered the most reliable method.
   * Operating Expense Ratio Method: Calculate cap rate using the Operating Expense Ratio (OER). This involves first calculating a cap rate based on Effective Gross Income.
   Formula: OER = Operating Expenses / Effective Gross Income
   * Band of Investment Method: Calculates separate cap rates for debt and equity and weights them according to the proportion of financing. Weighted Average of debt and equity rates.
   Mortgage Constant: Annual debt service divided by the loan amount.
   Equity Dividend Rate: Pre-tax cash flow divided by the amount of the equity investment.

   e. Capitalize the Income: Divide the NOI by the cap rate to arrive at an estimate of value.
   * Formula: Value = NOI / Cap Rate

   f. *Pre-Tax Cash Flow: Sometimes also know as Equity Dividend or Before-Tax Cash Flow. Represents the amount of income that is available to the equity investor after the debt investor has been paid. It is calculated by subtracting mortgage debt service from net operating income.

2. Gross Income Multiplier (GIM):

   • Another form of direct capitalization that uses a multiplier instead of a rate.
   • Formula: Value = Gross Income x GIM
   • GIM = Sales Price / Gross Income
   • Most often used for single-family residences and small multi-family properties.
   • Less reliable than NOI capitalization because it does not account for operating expenses.

3. *Debt Coverage Ratio: Useful check, but is NOT reliable on its own, since it is not based on market data.

E. Residual Techniques

Residual techniques are variations of direct capitalization used to value individual components of a property when the value of the whole is known or can be estimated. There are two main residual techniques:

1. Building Residual: Determine Value of Improvements
2. *Land Residual: Determine Value of Land

F. Yield Capitalization (Discounted Cash Flow Analysis)

Yield Capitalization is a more sophisticated method that projects a property’s future income streams over a specified holding period and discounts them back to present value. This method is particularly useful for properties with fluctuating or complex income patterns.

1. Steps in Yield Capitalization:

   a. Project Future Cash Flows: Estimate the annual cash flows the property is expected to generate over the holding period. This includes rental income, operating expenses, and potential resale value.

   b. Determine the Discount Rate: Select a discount rate that reflects the risk associated with the investment.

   c. Discount the Cash Flows: Discount each year’s cash flow back to its present value using the discount rate. This calculation applies the concept of “present value,” which recognizes that money received in the future is worth less than money received today due to the time value of money.
   Discounting Formula: PV = FV / (1 + r)^n
   Where:
   *PV = Present Value
   FV = Future Value
   r = Discount Rate
   n = Number of Years

• Discounting: The process of determining the present value of a future sum.

• Compounding: The process of determining the future value of a present sum.

  d. Sum the Present Values: Add up the present values of all future cash flows to arrive at an estimate of the property’s value.
  Value = PV1 + PV2 + PV3 + … + PVn

• Reversion Factors:

• Annuities:

• Yield Rates:

G. Practical Applications and Experiments

1. Sensitivity Analysis:

   • Conduct sensitivity analysis to assess how the value estimate changes in response to variations in key assumptions such as rental growth rates, vacancy rates, and discount rates.

2. Case Studies:

   • Analyze real-world case studies of income-producing properties to understand how the Income Approach is applied in practice.

III. Reconciliation and Final Value Opinion

After applying both the Sales Comparison and Income Approaches, the appraiser must reconcile the value indications to arrive at a final value opinion.

A. Reconciliation Process

1. Evaluate the Reliability of Each Approach: Assess the quality and quantity of data used in each approach, as well as the reasonableness of the assumptions.
2. Consider the Applicability of Each Approach: Determine which approach is most appropriate for the subject property and the purpose of the appraisal.
3. Weigh the Value Indications: Assign weights to the value indications from each approach based on their reliability and applicability.
4. Arrive at a Final Value Opinion: Select a single value or a narrow range of values that represents the appraiser’s best estimate of the property’s market value.

B. Factors Influencing Reconciliation

1. Data Availability: The approach with the most reliable and complete data should be given greater weight.
2. Market Conditions: The Sales Comparison Approach is generally more reliable in active markets with ample comparable sales data.
3. Property Type: The Income Approach is generally more reliable for income-producing properties.
4. Appraisal Purpose: The purpose of the appraisal may influence the weighting of the approaches.

C. Final Value Opinion

The final value opinion should be clearly stated and supported by the data and analysis presented in the appraisal report. It should reflect the appraiser’s professional judgment and expertise.