Sales Comparison Approach: Principles

Sales Comparison Approach: Principles

introduction❓

The Sales Comparison Approach (SCA), also known as the market data❓ Approach, is a cornerstone of real estate appraisal. It operates on the fundamental principle that a rational buyer will pay no more for a property than they would for a comparable substitute. This chapter delves into the underlying principles governing the SCA, exploring the scientific rationale, practical application, and mathematical underpinnings of this crucial appraisal method.

I. The Principle of Substitution: Economic Foundation

A. Core Concept
The Principle of Substitution is the economic foundation of the SCA. It posits that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price attracts the greatest demand and wider distribution. In real estate appraisal, this means that the value of a property tends to be set by the cost of acquiring an equally desirable substitute property, assuming no undue delays.
B. Scientific Justification
The principle aligns with microeconomic theory concerning consumer behavior and market efficiency. Assuming perfect information and rational actors, buyers will invariably choose the option that offers the best utility (satisfaction) per unit of cost. Any property priced significantly above comparable substitutes will experience decreased demand, forcing the price downward until it aligns with the market.
C. Example: Two identical houses located next to each other. One is listed at $500,000, and the other at $450,000. The principle of substitution suggests that the $450,000 house will likely sell first, impacting the pricing expectations for the more expensive house.
D. Limitations:
* Market inefficiencies: Imperfect information, emotional buying, and unique property characteristics can weaken the substitution principle.
* Time constraints: If a buyer needs a property urgently, they may be less price-sensitive.

II. Principles of Supply and Demand: Market Dynamics

A. Interaction of Forces
The values estimated using the SCA are directly influenced by the interplay of supply and demand within the relevant real estate market. Increased demand, coupled with limited supply, drives prices upward. Conversely, an oversupply of properties relative to demand exerts downward pressure on prices.
B. Quantifying Supply and Demand
* Vacancy Rates: Low vacancy rates indicate strong demand and limited supply, supporting higher prices. High vacancy rates signal oversupply and lower prices.
* Absorption Rate: Measures how quickly properties are being sold or leased in a given market. A high absorption rate signifies robust demand.
* Days on Market (DOM): Reflects the time it takes to sell a property. Shorter DOM suggests high demand.
C. Mathematical Representation
A simplified representation of the relationship between supply, demand, and price can be shown using a linear model (although real estate markets are rarely this simple):
P = a + bD - cS
Where:
P = Price
D = Demand (e.g., number of potential buyers)
S = Supply (e.g., number of available properties)
a, b, c = Constants reflecting market sensitivity to changes in demand and supply
D. Practical Application
Appraisers analyze supply and demand trends by researching market statistics, consulting with real estate agents, and examining economic indicators. This data informs the selection of comparable properties and the adjustments made for market conditions.
E. Experiment
Simulate market fluctuations by creating a model real estate market with varying levels of supply and demand. Observe how price is affected. This can be done with students trading assets based on simulated news affecting supply and demand.

III. The Principle of Contribution: Marginal Productivity

A. Defining Contribution
This principle asserts that the value of any component of a property is measured by its contribution to the overall value of the property. A component’s worth is not necessarily equal to its cost; instead, it is determined by how much it adds (or detracts) from the market value. This links to the concept of marginal productivity in economics.
B. Relevance to Adjustments
In the SCA, appraisers apply adjustments to comparable sales to account for differences in property characteristics. These adjustments reflect the contribution of specific features, such as the number of bedrooms, the size of the lot, or the presence of a swimming pool.
C. Diminishing Returns
It is important to note that the principle of contribution can be affected by the law of diminishing returns. Adding more of a particular feature❓ may eventually yield less and less value. For example, while a swimming pool may initially add significant value, adding a second pool will likely contribute very little.
D. Mathematical Perspective
Consider a property with a base value (B) and an added feature (F). The value of the feature is not just its cost (C), but rather its contribution to the overall property value (V):
V = B + ΔV(F)
Where:
V = Total property value
B = Base value without the feature
ΔV(F) = Change in value attributable to the feature F. This may not equal the cost of feature F
E. Practical application and Example
An appraiser compares two similar houses. One has a renovated kitchen (cost $50,000). The comparable house sold for $30,000 more. The adjusted value reflects the $30,000 contribution of the renovated kitchen, not the actual cost of renovation.

IV. The Principle of Conformity: Homogeneity and Value

A. Maximizing Value
This principle states that properties achieve their maximum value when they are similar to other properties in the area. Conformity refers to the degree to which a property aligns with prevailing neighborhood standards in terms of style, size, quality, and use.
B. Psychological Impact
Conformity affects perceived value through the expectations and preferences of buyers. A property that deviates significantly from the norm (e.g., an unusually large or modern house in a traditional neighborhood) may be less desirable to potential buyers.
C. Regression and Progression
* Regression: A higher-valued property may be negatively affected by the presence of lower-valued properties in the neighborhood.
* Progression: A lower-valued property may be positively affected by the presence of higher-valued properties in the neighborhood.
D. Measurement Challenges
Quantifying conformity can be subjective, but appraisers use objective measures such as lot size, house size, architectural style, and quality of construction to assess how well a property conforms to the neighborhood.
E. Practical Implementation
The SCA relies heavily on the principle of conformity when selecting comparable sales. Appraisers prioritize sales of properties that are located in similar neighborhoods and that share similar characteristics with the subject property.

V. The Principle of Anticipation: Future Benefits

A. Value and Future Expectations
The Principle of Anticipation holds that value is based on the expectation of future benefits. These benefits can include income, appreciation, use, or satisfaction. This means that buyers are not just paying for the present condition of the property, but for their anticipated future returns from owning the property.
B. Speculative Bubbles
Anticipation can lead to speculative bubbles, where prices are driven up by unrealistic expectations of future appreciation. When expectations are not met, the bubble bursts, and prices plummet.
C. Discounted Cash Flow
The concept of discounted cash flow (DCF) is a mathematical representation of the principle of anticipation. DCF analysis estimates the present value of future income streams by discounting them back to the present using an appropriate discount rate.
D. Formula and Calculation
Present Value = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n
Where:
CF = Cash flow in each period
r = Discount rate (reflecting risk and opportunity cost)
n = Number of periods
E. Example
An investor purchases a rental property anticipating a stream of rental income over the next ten years, and expecting the property to appreciate in value. The investor will discount the stream of anticipated income, plus the value upon sale, to determine what they are willing to pay.
F. Practical application
Appraisers often consider zoning regulations, planned developments, and other factors that could affect the future value of a property.

VI. Application of these principles in Sales Comparison Approach

A. Comparables selection:
Principles of substitution, conformity, and supply/demand are all utilized to select comparables which serve as the best substitutes for the subject property in the current market conditions.
B. Adjustments:
Principle of contribution dictates how the adjustments of the comparables should be performed so the final adjusted value reflects the true contribution of different characteristics.
C. Reconciliation:
After adjustments, the appraiser reconcile the values given by all comparables based on how well each comparable satisfy the principles introduced above. The final estimate is the most probable price reflecting the principles introduced above.

Conclusion

The Sales Comparison Approach is grounded in sound economic principles. By understanding and applying these principles, appraisers can develop credible and defensible value opinions. The proper application of the principles of substitution, supply and demand, contribution, conformity, and anticipation are essential for accurate and reliable real estate appraisals. This understanding enables the appraiser to account for market dynamics, property characteristics, and buyer behavior, leading to more precise value estimates.