Valuation Methodologies: Cost, Sales Comparison, and Income

Chapter 7: Valuation Methodologies: Cost, Sales Comparison, and Income

This chapter delves into the three primary approaches to value used in residential construction appraisal: the cost approach, the sales comparison approach, and the income approach. Understanding these methodologies is crucial for property assessment, renovation decisions, and navigating the real estate market. This chapter builds upon previous discussions of the appraisal process, site valuation, and residential construction principles to provide a comprehensive understanding of these valuation techniques.

I. Introduction to Valuation Methodologies

Appraising residential properties involves estimating their fair market value. This process relies on three fundamental approaches:

1. Cost Approach: Value is derived from the cost to replace the property, accounting for depreciation.
2. Sales Comparison Approach: Value is based on the prices of similar properties (comparables) recently sold in the market.
3. Income Approach: Value is determined by the potential income the property can generate (primarily for rental properties).

Each approach offers a unique perspective and is more suitable for certain types of properties or market conditions. The appraiser must understand the strengths and weaknesses of each method and reconcile the results to arrive at a final, well-supported value estimate. This reconciliation process is covered in later chapters. This section relates directly to the course description, as an essential terminology to understanding the building process, enhance your property assessment skills.

II. The Cost Approach

The cost approach operates on the principle of substitution: a rational buyer will pay no more for a property than the cost to acquire a similar site and construct a new improvement. This approach is most reliable when the improvements are relatively new and depreciation is minimal. It is particularly useful for specialized properties or when comparable sales data is scarce. It also directly relates to the book content, such as site valuation, which is necessary to apply the approach.

A. Theoretical Basis:

The cost approach relies on economic theories of production and diminishing returns. The value of a property is intrinsically linked to the cost required to create a similar asset. The formula summarizes this concept:

Property Value (VCost) = Site Value (VSite) + Reproduction/Replacement Cost (C) - Depreciation (D)

Where:

• VSite: The market value of the land as if vacant, determined using site valuation techniques (discussed in Chapter 6).
• C: The estimated cost (new) to either reproduce or replace the existing improvements.
• D: The accrued depreciation❓ of the existing improvements.

Reproduction Cost is the cost to create an exact replica of the existing structure, using the same materials and construction techniques. This is often difficult to estimate, especially for older buildings.

Replacement Cost is the cost to construct a structure of equivalent utility, using modern materials and design. This is a more practical approach and is commonly used in residential appraisals.

B. Practical Application:

The cost approach involves the following steps:

1. Estimate Site Value (VSite): Employ techniques from Chapter 6 (sales comparison, allocation, etc.) to determine the value of the land as if vacant.

2. Estimate Reproduction/Replacement Cost (C):

   • Quantity Survey Method: Detailed inventory of all materials and labor required, providing the most accurate estimate but is time-consuming. (Not typically used in residential appraisals.)
   • Unit-in-Place Method: Estimates cost per unit of measure for each component (e.g., cost per square foot of wall).
   • Comparative-Unit Method: Applies a cost per square foot or cubic foot derived from recent construction projects of similar properties. This is the most common method for residential appraisals. It often uses cost estimating manuals and services.

3. Estimate Accrued Depreciation (D): This is the most challenging aspect of the cost approach, requiring careful analysis and judgment. Depreciation represents the loss in value due to any cause.

   • Physical Deterioration: Wear and tear, deferred maintenance, damage. (Curable and Incurable)
   • Functional Obsolescence: Defects in design, layout, or utility (e.g., outdated kitchen, poor floor plan, inadequate insulation which directly relate to the previous chapter, Residential Construction. Can be curable or Incurable).
   • External Obsolescence: Loss of value due to factors outside the property itself (e.g., neighborhood decline, increased traffic noise). Generally incurable.

   Depreciation can be estimated using:

   • Age-Life Method: Depreciation is estimated based on the ratio of the property’s effective age to its total economic life.
     • Depreciation = (Effective Age / Economic Life) * Reproduction Cost
   • Breakdown Method: Depreciation is estimated separately for each type of depreciation (physical, functional, external). Requires more detailed analysis and data.

4. Calculate Property Value: Apply the formula VCost = VSite + C - D.

C. Example:

Consider a 2,000 sq ft home on a lot valued at $100,000. Replacement cost new is estimated at $150 per sq ft. Effective age is 20 years, economic life is 60 years.

1. Site Value (VSite) = $100,000
2. Replacement Cost (C) = 2,000 sq ft * $150/sq ft = $300,000
3. Depreciation (D) = ($300,000) * (20/60) = $100,000
4. Property Value (VCost) = $100,000 + $300,000 - $100,000 = $300,000

D. Related Experiments:

• Cost Estimation: Compare cost estimates from different sources (e.g., Marshall & Swift, local contractors) and analyze the differences.
• Depreciation Analysis: Conduct a detailed inspection of a property to identify and quantify different types of depreciation.
• Sensitivity Analysis: Evaluate how changes in site value, cost estimates, or depreciation assumptions affect the final value indication.

III. The Sales Comparison Approach

The sales comparison approach, also known as the market approach, is based on the principle that a willing buyer will pay no more for a property than what similar properties have recently sold for in the same market. This approach is the most reliable when there are sufficient comparable sales data available and when the market is relatively stable. This approach directly relates to the book content in applying sales prices of comparables.

A. Theoretical Basis:

The sales comparison approach relies on the economic principle of supply and demand. The price of a property is determined by the interaction of buyers and sellers in the market. By analyzing recent sales of similar properties, appraisers can infer the market’s perception of value for the subject property.
The following formula underlies this concept:

Subject Value (VSubject) = Comparable Sales Price (CAdj) +/- Adjustments

Where:

• CAdj: Comparable Sales Price
• Adjustments: Positive or negative adjustments reflecting differences between the subject property and the comparable.

B. Practical Application:

The sales comparison approach involves these steps:

1. Identify Comparable Sales: Select properties that are similar to the subject in terms of location, physical characteristics, legal rights, financing, conditions of sale, and market conditions.

   • Data can be sourced from MLS databases, public records, and direct verification with involved parties.
   • Chapter 5 covered data collection techniques and identifying comparable properties.

2. Adjust Comparable Sales Prices: Adjust the sales prices of the comparables to account for differences between them and the subject property. Adjustments are made for:

   • Property Rights Conveyed: Fee simple vs. leasehold, etc.
   • Financing Terms: Favorable financing, seller concessions.
   • Conditions of Sale: Arm’s-length transaction, motivations of buyer and seller.
   • Market Conditions: Changes in market demand, interest rates, or economic conditions between the sale date of the comparable and the appraisal date.
   • Location: Neighborhood characteristics, proximity to amenities, traffic noise.
   • Physical Characteristics: Site size, building size, number of bedrooms/bathrooms, age, condition, quality of construction, energy efficiency, and other features.

   Adjustments can be made as:

   • Dollar Amounts: Reflecting the estimated market value of a specific difference.
   • Percentages: Applying a percentage increase or decrease to the comparable’s sales price.

3. Reconcile Adjusted Sales Prices: Analyze the adjusted sales prices of the comparables and arrive at a final value indication for the subject property. The appraiser considers the reliability of each comparable and the size and justification of the adjustments.

C. Example:

Subject property is a 3-bed, 2-bath home in good condition.

• Comparable 1: Sold for $300,000 three months ago. Similar in most respects, but has a smaller lot (adjust +$5,000) and outdated kitchen (adjust -$10,000).
• Comparable 2: Sold for $310,000 one month ago. Located in a slightly more desirable neighborhood (adjust -$8,000), but has the same physical characteristics.
• Comparable 3: Sold for $290,000 six months ago. Identical location and features, but market conditions have increased prices by 5% since then (adjust +$14,500).

Adjustments:

• Comparable 1: $300,000 + $5,000 - $10,000 = $295,000
• Comparable 2: $310,000 - $8,000 = $302,000
• Comparable 3: $290,000 + ($290,000 * 0.05) = $304,500

Reconciliation:

Given the proximity in time, location and condition of the comparable sales, with all the relevant attributes of the house. The adjusted sales prices range from $295,000 to $304,500. Based on the appraiser’s judgement, the value of the subject property is indicated as $300,000.

D. Related Experiments:

• Comparable Selection: Analyze a dataset of sales transactions and determine which properties are the most comparable to a given subject property.
• Adjustment Analysis: Research market data to support the adjustments made to comparable sales prices.
• Sensitivity Analysis: Assess how changes in the adjustments affect the final value indication.

IV. The Income Approach

The income approach determines value based on the potential income a property can generate. This approach is primarily applicable to income-producing properties, such as rental houses or apartment buildings. This approach directly relates to the book content.

A. Theoretical Basis:

The income approach is rooted in the economic principle of anticipation: the value of an asset is based on the present value of its expected future benefits. In the case of real estate, the primary benefit is the income stream the property is expected to generate.

Two primary techniques are used:

1. Direct Capitalization: A single-year’s income is capitalized to arrive at a value indication.

2. Discounted Cash Flow (DCF) Analysis: Projects future income streams over a holding period and discounts them back to present value. (Beyond the scope of this introductory chapter, and usually involves advance appraisal methods).

The formula for direct capitalization is:

Property Value (VIncome) = Net Operating Income (NOI) / Capitalization Rate (R)

Where:

• NOI: Net Operating Income, representing the property’s income after deducting operating expenses but before debt service or income taxes.
• R: Capitalization Rate, reflecting the rate of return an investor expects to receive on their investment.

B. Practical Application:

The income approach involves these steps:

1. Estimate Potential Gross Income (PGI): The total income the property could generate if it were fully occupied.

2. Estimate Vacancy and Collection Losses: Account for periods of vacancy or uncollectible rent.

3. Calculate Effective Gross Income (EGI): EGI = PGI - Vacancy & Collection Losses

4. Estimate Operating Expenses: Include expenses such as property taxes, insurance, maintenance, repairs, utilities (if paid by the landlord), and management fees. Do not include debt service or income taxes.

5. Calculate Net Operating Income (NOI): NOI = EGI - Operating Expenses

6. Determine Capitalization Rate (R): The capitalization rate can be extracted from comparable sales of income-producing properties.

   • R = NOI / Sales Price (for comparable properties)
   • The band of investment method can also be used.

7. Calculate Property Value (VIncome): Apply the formula VIncome = NOI / R.

For residential properties (1-4 units), a simplified version using the Gross Rent Multiplier (GRM) is often used.

Property Value = Gross Monthly Rent (GMR) * GRM

Where:

• GMR – Gross Monthly Rent, typically of a subject.

• GRM – Gross Rent Multiplier, is derived from market comparables using the following formula:

  GRM = Sale Price / Gross Monthly Rent (for comparables)

C. Example:

A rental house generates a potential gross income of $24,000 per year. Vacancy and collection losses are estimated at 5%. Operating expenses are $8,000 per year. Comparable sales indicate a capitalization rate of 8%.

1. PGI = $24,000
2. Vacancy & Collection Losses = $24,000 * 0.05 = $1,200
3. EGI = $24,000 - $1,200 = $22,800
4. Operating Expenses = $8,000
5. NOI = $22,800 - $8,000 = $14,800
6. Capitalization Rate (R) = 0.08
7. Property Value (VIncome) = $14,800 / 0.08 = $185,000

Alternatively, using the GRM:

Subject’s Gross Monthly Rent = $2000
Comparable Sales Indicate GRM = 92.5

Subject Value = $2000 * 92.5 = $185,000

D. Related Experiments:

• NOI Calculation: Construct a detailed operating statement for a rental property, including all relevant income and expenses.
• Capitalization Rate Extraction: Analyze market data to extract capitalization rates from comparable sales.
• GRM Derivation: Analyze market rentals to obtain a typical GRM.

V. Conclusion

This chapter provides a comprehensive overview of the three primary valuation methodologies used in residential construction appraisal: the cost approach, the sales comparison approach, and the income approach. Each approach offers a unique perspective on value and is more suitable for certain types of properties or market conditions. An appraiser needs to understand the strengths and weaknesses of each method and reconcile the results to arrive at a final, well-supported value estimate. The reconciliation of these values is explored in further chapters.
These three approaches provide practical knowledge and essential terminology to understand the building process, enhance your property assessment skills, and make informed decisions about home construction and renovation. Elevate your understanding of residential structures and unlock new opportunities in the world of real estate and construction