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Applying Valuation Approaches: Sales Comparison, Cost, and Income
Chapter 6: Applying Valuation Approaches: Sales Comparison, Cost, and Income
Introduction
This chapter, crucial for aspiring real estate appraisers, provides a detailed exploration of the three primary valuation approaches: Sales Comparison, Cost, and Income. These methods are foundational for generating accurate and reliable appraisal reports, as emphasized in the course description of “Mastering Appraisal Reports: A Comprehensive Guide.” Understanding and applying these approaches effectively are essential skills for any professional seeking credibility in the real estate appraisal field.
I. The Appraisal Process and Value Indicators
- The Core Concept: Real estate appraisal is the meticulous process of estimating the value of a property, blending scientific techniques with market insights.
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Three Approaches: This process uses three distinct methodologies:
- Sales Comparison Approach: Examines recent sales of similar properties.
- Cost Approach: Calculates the cost of building a new replacement, factoring in depreciation.
- Income Approach: Focuses on the property’s potential income generation.
* Value Indicator: Each approach independently provides a value indication, also called a value indicator.
II. Cost Approach
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Definition and Formula: Assumes a property’s value equates to the sum of the site’s value and the cost to construct new improvements, minus any accrued depreciation. This is represented by:
Property Value = Site Value + (Cost New - Depreciation)Where:
- Property Value = Estimated total value of the property.
- Site Value = Value of the land as if vacant.
- Cost New = Current cost to construct a new building of equivalent utility.
- Depreciation = Loss in value due to physical deterioration, functional obsolescence, or external obsolescence.
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Scientific Theories and Principles:
- Substitution Principle: A buyer won’t pay more for a property than the cost of acquiring a substitute property with similar utility.
- Accrued Depreciation Theory: This is the most difficult part of applying the cost approach to value, especially for older improvements or improvements that do not conform to the highest and best use of the land as if vacant.
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Practical Applications and Experiments:
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Example: Determine the depreciation value based on out-dated design, physical deterioration, and environmental factors.
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Mathematical Formulas and Equations:
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Depreciation (Straight-Line Method):
Annual Depreciation = (Cost New - Salvage Value) / Useful Life - Accrued Depreciation:
Depreciation = Effective Age / Total Economic Life * Cost New
III. Sales Comparison Approach
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Definition and Formula: Values a property based on recent sales prices of comparable properties, adjusted for differences. The basic formula is:
Subject Value = Comparable Sales Price +/- Adjustments -
Scientific Theories and Principles:
- Principle of Substitution: This is the core of the sales comparison approach, suggesting a buyer will pay no more for a property than for a comparable alternative.
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Practical Applications and Related Experiments:
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Example: Adjusting a comparable sale because it has an additional bath, using paired data analysis.
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Mathematical Formulas and Equations:
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Percentage Adjustment:
Adjusted Value = Sales Price * (1 +/- Percentage Adjustment)
IV. Income Approach
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Definition and Formula: Estimates value based on the potential income a property can generate. This approach is vital for investment properties, and the formula for Gross Rent Multiplier (GRM) is often used in residential appraisals.
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Gross Rent Multiplier (GRM) = Sales Price / Gross Monthly RentProperty Value = GRM * Subject Property’s Gross Monthly Rent
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Scientific Theories and Principles:
- Principle of Anticipation: Value is influenced by the anticipation of future benefits.
- Economic Rent: Economic rent determines the income capitalization.
- Practical Applications and Related Experiments:
- Example: Using a range of GRMs from comparable properties to estimate the value of the subject property.
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Mathematical Formulas and Equations:
- Direct Capitalization Rate:
Capitalization Rate = Net Operating Income (NOI) / Property Value
- Direct Capitalization Rate:
V. Reconciliation of Value Indicators
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Definition: Combines the value indicators from each of the three approaches into a single, final estimate of value. Reconciliation is the process of analyzing the appraisal problem, selecting the most appropriate method of the three, and giving it the most weight in determining the final estimate of value.
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The Process: It involves analyzing the data’s reliability, applied logic, and the relevance of each approach to the property being valued.
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Scientific Theories and Principles:
- Weighting: Assigning different weights to each approach depending on its reliability and relevance to the property.
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Practical Applications and Related Experiments:
- Example: In an investor-focused appraisal, the income approach may be given greater weight.
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Mathematical Considerations: No strict formula exists, but understanding statistical tendencies can inform judgment.
VI. Importance in Appraisal Reporting
- Compliance: Adhering to the Uniform Standards of Professional Appraisal Practice (USPAP).
- Reporting: Clearly documenting each approach, the data used, and the reasoning behind the final value conclusion.
Conclusion
Mastery of the Sales Comparison, Cost, and Income approaches is pivotal for real estate appraisers. This chapter has outlined the scientific basis, practical applications, and reconciliation techniques associated with these approaches. By integrating Theoretical knowledgeโโ with practical skills, appraisers can develop reliable and credible value estimates, aligning with the core objectives of the “Mastering Appraisal Reports: A Comprehensive Guide” course.
Chapter Summary
Scientific Summary: Applying Valuation Approaches: Sales Comparison, Cost, and Income
This chapter, titled “Applying Valuation Approaches: Sales Comparison, Cost, and Income,” within the training course “Mastering Appraisal Reports: A Comprehensive Guide,” provides a comprehensive overview of the three fundamental approaches used in real estate appraisal: the sales comparison approach, the cost approach, and the income approach. The content aligns directly with the course description, equipping students with the necessary skills to accurately analyze property data, apply these valuation methodologies, and create compliant appraisal reports.
Main Scientific Points and Conclusions:
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The Appraisal processโ: The chapter highlights step 6 of the appraisal processโapplying the three approaches to valueโemphasizing its dependence on earlier steps (data collection, highest and best use analysis, and site valuation). Each approach results in a ‘value indicator.’
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Cost Approach: This approach asserts that property value is the sum of the site value, the cost to construct improvements (new), minus depreciationโ (difference between new cost and current value). The method requires a separate site valuation and accurate estimation of accrued depreciationโ (physical deterioration, functional obsolescence, and external obsolescence). Accrued depreciation is the most difficult part to estimate.
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Sales Comparison Approach: Also known as the ‘market approach,’ it determines value by comparing the subject property to similar properties (comparables) that have recently sold. The key is to identify comparables and make appropriate adjustments to their sale prices to account for differences between them and the subject property. Adjustments (up or down) account for features more or less valuable than the subject, considering aspects like the number of bathrooms or other amenities.
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Income Approach: This approach values property based on its income-generating potential. For residential properties, the gross rent multiplier (GRM) method is typically used. The GRM is calculated by dividing the sale price of comparable rental properties by their gross monthly rent. Then an appropriate GRM is selected from the range and multiplied by the subject’s gross monthly income to estimate the property’s value.
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Reconciliation of Value Indicators: The chapter introduces Step 7, reconciliation. The appraiser weighs each approach’s reliabilityโ and applicability to the specific appraisal problem. This process is not a simple averaging of values; judgment and expertise are essential. The reconciliation is the process of analyzing the appraisal problem, selecting the most appropriate method of the three, and giving it the most weight in determining the final estimate of value.
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Reporting the Value Estimate: The chapter touches upon the importance of reporting the final value estimate, which is then provided within either an Appraisal Report, which summarizes sufficient information to be understood by the client, or a Restricted Appraisal Report, which is restricted to the use of one client.
Implications:
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Accuracy and Compliance: Understanding and correctly applying these valuation approaches is crucial for generating accurate and compliant appraisal reports, a key objective of the course.
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Professional Credibility: Mastery of these approaches enhances an appraiser’s professional credibility and decision-making ability.
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Market Analysis: These approaches provide insights into market dynamics, allowing appraisers to identify trends and factors influencing property values.
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Uniform Standards of Professional Appraisal Practice (USPAP): The chapter prepares students to adhere to USPAP guidelines by emphasizing the importance of thorough data analysis, reasoned judgment, and clear reporting.
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Uniform Residential Appraisal Report (URAR): Familiarity with these approaches is essential for completing the URAR effectively, a central focus of the course.
In summary, this chapter is foundational for any aspiring real estate appraiser. A deep understanding of these three valuation approaches is crucial for providing reliable and credible property valuations that meet professional standards and client needs.
