Valuation Approaches: Cost, Sales Comparison, and Income

Chapter 6: Valuation Approaches: Cost, Sales Comparison, and Income

Course: Understanding Property Rights: Easements, Co-ownership, and Partial Interests

Description: Unlock the complexities of property ownership! This course delves into easements, co-ownership types like joint tenancy and tenancy in common, and partial interests such as leaseholds. Learn how these factors impact property value and gain practical insights for real estate appraisal and investment decisions. Discover the nuances of legal entities owning property and the intricacies of partition actions. Master the knowledge to navigate the world of property rights with confidence and expertise.

I. Introduction: The Three Valuation Approaches

In real estate appraisal, determining❓ the fair market value of a property is a critical task. This involves applying established appraisal principles, particularly when considering partial interests like easements, co-ownership arrangements (joint tenancy, tenancy in common), and leaseholds, which can significantly impact a property’s worth. This chapter focuses on the three primary valuation approaches used by appraisers:

1. cost approach❓: Estimates value based on the cost to reproduce or replace the property.
2. Sales Comparison Approach (Market Approach): Compares the subject property to similar properties that have recently sold in the market.
3. Income Approach: Determines value based on the income the property is expected to generate.

Each approach provides a different perspective on value, and the most reliable estimate is often achieved by reconciling the results of all three. It’s rare that all 3 value indicators will be identical, therefore, the appraiser must reconcile the value indicators in step 7, reconciliation of the appraisal process. The following discussion delves into each approach, emphasizing its scientific basis, practical applications, and relevance to understanding property rights and partial interests.

II. Cost Approach: Reproduction, Replacement, and Depreciation

The Cost Approach rests on the economic principle of substitution: a rational buyer will pay no more for a property than the cost to acquire an equivalent substitute. It’s particularly useful for valuing unique properties, new construction, or properties where market data is scarce. This is particularly helpful with valuing unique properties, new construction, or properties where market data is scarce. Furthermore, the cost approach requires a separate estimate of site value.

A. Scientific Basis and Formula

The cost approach fundamentally assumes that the value of an improved property is indicated by the value of the site, plus the cost to construct a new improvement, less any depreciation. The formula for the cost approach is:

Property Value = Site Value + <a data-bs-toggle="modal" data-bs-target="#questionModal-103963" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container"><a data-bs-toggle="modal" data-bs-target="#questionModal-369472" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">replacement cost new</span><span class="flag-trigger">❓</span></a></span><span class="flag-trigger">❓</span></a> (RCN) - Accrued Depreciation

Where:

• Site Value: The estimated market value of the land as if vacant and available for its highest and best use.
• Replacement Cost New (RCN): The estimated cost to construct a new building with equivalent utility to the subject property, using current materials, design, and standards. It is crucial to use replacement cost new rather than reproduction cost new. Reproduction cost new estimates the cost to exactly duplicate the subject property which is often impossible in a practical sense.
• Accrued Depreciation: The loss in value from all causes, including physical deterioration, functional obsolescence, and external obsolescence. Depreciation is the difference in value between the RCN of the improvements and their current value, regardless of the reasons for the difference.

B. Estimating Replacement Cost New (RCN)

Several methods exist for estimating RCN:

1. Quantity Survey Method: The most detailed and accurate, it involves quantifying all materials, labor, and overhead costs for construction. This is used more in construction estimating than appraisal.
2. Unit-in-Place Method: Estimates the cost of installing individual building components (e.g., cost per square foot of wall, cost per installed door).
3. Comparative-Unit Method: The most commonly used method in appraisal, it applies a cost per square foot or cubic foot based on similar buildings. The difficulty with the Comparative-Unit Method is that not all buildings are the same so accuracy is questionable.

C. Depreciation Analysis

Estimating accrued depreciation is often the most challenging aspect of the cost approach. Depreciation can be categorized into three types:

1. Physical Deterioration: Loss in value due to wear and tear, age, or damage. It can be curable (e.g., painting, roof repair) or incurable (e.g., structural damage).

   • Mathematical Models: The Age-Life Method is a simple approach:
     Depreciation (%) = Effective Age / Total Economic Life Depreciation Amount = Depreciation (%) * RCN
     Where:
     * Effective Age: The age of the property considering its condition.
     * Total Economic Life: The estimated period the property can be profitably used.
     This is not a particularly accurate measure of depreciation.
     2. Functional Obsolescence: Loss in value due to outdated design, poor layout, or inadequate features compared to current market standards. Can be curable (e.g., adding a bathroom) or incurable (e.g., low ceiling heights).

2. External Obsolescence (Economic Obsolescence): Loss in value due to factors external to the property itself, such as neighborhood decline, zoning❓ changes, or environmental problems. This cannot be cured.

D. Practical Applications and Experiment

1. Experiment - Cost Estimation: Obtain cost data from local contractors for various building components (e.g., framing, roofing, plumbing fixtures). Estimate the RCN of a small structure (e.g., a shed) using both the Unit-in-Place and Comparative-Unit methods. Compare the results.
2. Case Study: Analyze a property with a legal nonconforming use. If the building were destroyed, could it be rebuilt? If not, how would this affect the depreciation calculation and the overall value estimate using the cost approach?
3. Impact of Easements: Consider a property burdened by a utility easement. How would the presence of the easement impact the estimated replacement cost due to restrictions on building location or size? How does this affect the highest and best use?

E. Relevance to Course Description

The cost approach is particularly relevant to understanding the impact of property rights and partial interests on value. For example:

• Easements: An easement granted to a neighbor for access across a property might restrict the development potential, impacting the Site Value component and potentially increasing Accrued Depreciation if the easement hinders optimal use.
• Co-ownership: In co-ownership scenarios, the cost approach might be used to determine the proportionate share of value, especially when partitioning the property or settling disputes regarding improvements made by one co-owner. A joint tenant who installs a pool without the permission of the other tenant will not be able to include the cost of the pool in any determination of value in a partition action.
• Leaseholds: When appraising a leasehold interest, the cost approach can be relevant for valuing improvements made by the lessee. Depreciation must consider the remaining lease term.

III. Sales Comparison Approach: The Market’s Perspective

The Sales Comparison Approach (also known as the Market Approach) is a systematic process of analyzing sales of similar properties (comparables) to arrive at an opinion of value for the subject property. Under the Sales Comparison Approach, the value of the subject property is indicated by the values (sale prices) of similar properties in the market. These similar properties are referred to as comparables. It is the most widely used approach, especially for residential properties, as it directly reflects market behavior.

A. Scientific Basis and Formula

The Sales Comparison Approach is grounded in the principle of substitution: a buyer will pay no more for a property than what they would pay for a similar property in the market. The approach relies on identifying key value drivers and adjusting the sale prices of comparables to account for differences from the subject property.

The basic formula can be expressed as:

Subject Value = Comparable Sales Price +/- Adjustments

B. Selecting Comparable Sales

The key to an effective Sales Comparison Approach is finding properties that are genuinely “comparable” to the subject property. Ideal comparables should:

• Be similar in physical characteristics (size, age, condition, features).
• Have similar utility and appeal to buyers.
• Be located in the same or similar market area (neighborhood).
• Have sold recently (typically within the last 6-12 months, but shorter periods are preferable).
• Have sales prices that are easy to verify, such as sales prices.

C. Elements of Comparison and Adjustments

The adjustment process is central to the Sales Comparison Approach. Adjustments are made to the comparable sales prices to account for differences from the subject property. Common elements of comparison include:

1. Property Rights Conveyed: Adjustments may be needed if the comparables have different property rights (fee simple vs. leasehold, easement rights).
2. Financing Terms: Non-market financing (e.g., below-market interest rates) can inflate sales prices and require downward adjustments.
3. Conditions of Sale: “Arm’s length” transactions are preferred. Sales involving duress or special relationships may need adjustment.
4. Market Conditions (Time): Adjustments are necessary to account for market appreciation or depreciation between the comparable sale date and the appraisal date. This would require use of Paired Data Sets.
5. Location: Adjustments account for differences in neighborhood desirability, access to amenities, school districts, traffic, etc.
6. Physical Characteristics: These are the most commonly encountered differences. They include: lot size, square footage, number of bedrooms and bathrooms, landscaping, improvements, and age.
7. Economic Characteristics: These are most important for income producing properties. They include: rent levels, expense ratios, lease terms.

D. Adjustment Techniques

1. Dollar Adjustments: Most commonly used, involve adding or subtracting a fixed dollar amount to the comparable sale price.
2. Percentage Adjustments: Can be used, particularly for market condition adjustments, but should be applied cautiously and in a logical sequence. The percentage adjustments must be based on market data that the appraiser can support.
3. Paired Data Analysis: The most scientific approach, involves analyzing sales of properties that are identical except for one key characteristic (e.g., one property has a pool, the other doesn’t). The difference in sale price isolates the value of that characteristic.

E. Practical Applications and Experiment

1. Paired Data Analysis Experiment: Find two sales of nearly identical homes in the same neighborhood, where the only significant difference is the presence of a finished basement. Calculate the value contribution of a finished basement.
2. Adjustment Grid Exercise: Construct a sales comparison adjustment grid. Select three comparable sales and systematically adjust their prices based on the following differences from the subject property: Date of Sale, lot size, square footage, quality of construction, and view.
3. Easement Case Study: Determine how an easement for pedestrian access across a residential property would affect its comparability to other sales. What adjustments would be necessary? How would this easement affect its desirability.

F. Relevance to Course Description

The Sales Comparison Approach is particularly useful in analyzing the impact of various property rights on value:

• Easements: Properties burdened by easements will typically sell for less than unencumbered properties. The Sales Comparison Approach can help quantify this value diminution by comparing sales of similar properties with and without easements. The comparable data would have to indicate a loss due to the negative features associated with the negative easement.
• Co-ownership: The Sales Comparison Approach can be applied to analyze the value of a partial interest in a co-owned property. However, it’s important to recognize that a fractional interest may sell at a discount compared to its proportionate share of the whole property value due to the complexities and potential for disputes associated with co-ownership.
• Leaseholds: The Sales Comparison Approach can be used to value leasehold interests. This would require finding comparable leasehold sales, but these can be difficult to locate.

IV. Income Approach: Valuing Cash Flow

The Income Approach estimates value based on the income a property is expected to generate. It is primarily used for income-producing properties (e.g., apartments, office buildings, retail centers), but can also be applied to residential properties with rental income potential.

A. Scientific Basis and Formula

The Income Approach rests on the principle of anticipation: the value of a property is the present value of its expected future income stream. The basic formula for direct capitalization is:

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

Where:

• Net Operating Income (NOI): The property’s annual income after deducting operating expenses but before deducting debt service (mortgage payments) and income taxes.

  NOI = <a data-bs-toggle="modal" data-bs-target="#questionModal-369465" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container"><a data-bs-toggle="modal" data-bs-target="#questionModal-103960" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">Potential Gross Income</span><span class="flag-trigger">❓</span></a></span><span class="flag-trigger">❓</span></a> (PGI) - Vacancy & Collection Losses + Other Income = Effective Gross Income (EGI) - Operating Expenses
  * Capitalization Rate (Cap Rate): The rate of return an investor expects to receive on their investment. It reflects the risk associated with the property and the market’s overall yield requirements.

B. Estimating Net Operating Income (NOI)

1. Potential Gross Income (PGI): The total rental income the property could generate if fully occupied.
2. Vacancy & Collection Losses: Deductions for vacant units and uncollectible rents.
3. Other Income: Any additional income sources (e.g., laundry facilities, parking fees).
4. Operating Expenses: Costs necessary to maintain the property and generate income (e.g., property taxes, insurance, repairs, management fees). Capital expenditures (CapEx) such as roof replacements, while not annual expenses, should be accounted for, usually by creating a Replacement Reserve.

C. Determining the Capitalization Rate (Cap Rate)

The capitalization rate can be derived using several methods:

1. Market Extraction: The most common method, involves analyzing sales of comparable income-producing properties and extracting the cap rate from their sales prices and NOIs:

   Cap Rate = NOI / Sales Price
   Multiple comparable sales can provide a range of cap rates, which the appraiser then reconciles to arrive at a rate for the subject property. The selection of a rate within the range is dependent on factors, such as property and tenant quality.
   2. Band of Investment Technique: A more complex method that considers the required rates of return for both debt and equity investors.

D. Gross Rent Multiplier (GRM)

The income approach may use net income or gross income. Typically, residential appraisers utilize the gross rent multiplier to determine value by the income approach. In this approach, the monthly income from each comparable rental sale is divided into its sale price to determine a GROSS RENT MULTIPLIER. The appraiser then selects a multiplier from the range thus determined and multiplies it by the subject’s gross monthly income to determine a value by the income approach.

Multiplier = Value ÷ Gross Rent

E. Practical Applications and Experiment

1. NOI Calculation Exercise: Given a property’s PGI, vacancy rate, operating expenses, and replacement reserve estimate the NOI.
2. Cap Rate Extraction: Analyze several sales of comparable apartment buildings and extract the capitalization rates from each.
3. GRM analysis: With information of gross rental of the subject and comparable sales, estimate the range and multiplier.

F. Relevance to Course Description

The Income Approach is directly applicable to analyzing the value of partial interests that generate income:

• Leaseholds: The value of a leasehold interest is directly tied to the net income it generates for the lessee. The Income Approach is the primary method for appraising leaseholds.
• Easements: If an easement generates income (e.g., a cell tower easement), the Income Approach can be used to estimate its value.
• Co-ownership: In co-ownership situations, the Income Approach can be used to value a proportionate share of the property’s income stream. Tenancy in Common in commercial properties is well suited for using the income approach.

V. Reconciliation and Final Value Estimation

After applying all three valuation approaches, the appraiser must reconcile the results to arrive at a single, supportable value conclusion. 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. Reconciliation is not a simple averaging of the three value indicators. There is no set formula at all for reconciling the values. The process relies entirely on the judgment and ability of the appraiser to arrive at the most reliable estimate of value.
The reconciliation process requires a thorough review of the reliability of the data, the logic and analysis applied to the data, and the resulting value indicators. Each of the three approaches to value results in a separate indication of value for the subject property. The greater the similarity among the three value indicators, the more reliable they are.
The final step in the appraisal process is the preparation of the appraisal report.

VI. Conclusion

Understanding the Cost, Sales Comparison, and Income Approaches is fundamental to real estate appraisal. The selection of the most appropriate approach or combination of approaches depends on the specific property, the availability of data, and the intended use of the appraisal. The ability to apply these approaches effectively is critical for providing accurate and reliable value estimates, particularly when dealing with complex property rights and partial interests.