Applying Valuation Approaches: Cost, Sales Comparison, and Income

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

Introduction

This chapter delves into the practical application of the three fundamental valuation approaches: Cost Approach, Sales Comparison Approach (also known as the Market Approach), and Income Approach. Understanding and competently applying these approaches is crucial for determining the market value of land and improved properties, a central element in identifying the highest and best use, the overarching objective of this course. This knowledge empowers informed investment decisions and maximizes property value, fulfilling the core promise of unlocking lucrative opportunities in real estate appraisal. The separate valuation of a site is often required to complete the cost approach to value.

I. The Cost Approach

• A. Theoretical Basis

  • The Cost Approach is predicated on the Principle of Substitution, which states that a prudent buyer will pay no more for a property than the cost to acquire an equally desirable substitute. In this context, the substitute is the creation of a new property.
  • This approach is particularly relevant when valuing newer properties or properties with specialized improvements where comparable sales data might be limited. It’s also integral in determining the highest and best use of the land by comparing the costs of construction to the future utility of the new improvements.
  • It aligns directly with the course description by providing a structured method to maximize property value by assessing the feasibility of new construction or improvements.
  • Equation: Property Value = Site Value + Cost (New) of Improvements - accrued depreciation❓
    • Where:
      • Site Value: The estimated market value of the land as if vacant (determined using methods discussed later).
      • Cost (New) of Improvements: The current cost to construct a replica or replacement of the existing improvements.
      • Accrued Depreciation: The total loss in value of the improvements from all causes (physical deterioration, functional obsolescence, and external obsolescence).

• B. Steps in the Cost Approach

  1. Estimate Site Value: This is done as if vacant, reflecting its highest and best use. Various land valuation techniques❓ (Sales Comparison, Allocation, etc.) are applied (discussed in Section III).
  2. Estimate Cost of New Improvements: Determine the cost to either reproduce (create an exact replica) or replace (create a structure with similar utility) the existing improvements. Cost estimation methods include:
     • Comparative Unit Method: Cost per square foot or cubic foot based on similar structures. Requires accurate cost data from construction sources.
     • Quantity Survey Method: Detailed inventory of all materials, labor, and overhead. Most accurate but also most time-consuming.
     • Unit-in-Place Method: Cost of individual building components (e.g., walls, roof) based on installed units.
  3. Estimate Accrued Depreciation: This is the most subjective and challenging step. It reflects the difference in value between the cost new and the current value.
     • Types of Depreciation:
       • Physical Deterioration: Loss in value due to wear and tear. (curable or incurable)
       • Functional Obsolescence: Loss in value due to outdated design, inefficient layout, or inadequate equipment. (curable or incurable)
       • External (Economic) Obsolescence: Loss in value due to factors external to the property (e.g., neighborhood decline, zoning changes). (generally incurable)
     • Methods for Estimating Depreciation:
       • Age-Life Method: Depreciation = (Effective Age / Total Economic Life) * Cost New. It is based on the premise that depreciation occurs at a constant rate throughout the asset’s life.
       • Observed Condition (Breakdown) Method: Identifies and quantifies each element of depreciation separately. Most comprehensive, requiring detailed inspection and cost analysis.
  4. Calculate Property Value: Apply the formula: Property Value = Site Value + Cost (New) - Accrued Depreciation.

• C. Practical Application and Example

  • Subject Property: A 10-year-old single-family home.
  • Step 1: Site Value (Sales Comparison Approach): \$150,000
  • Step 2: Cost (New) of Improvements (Comparative Unit Method): 2,000 sq ft * \$150/sq ft = \$300,000
  • Step 3: Accrued Depreciation (Age-Life Method): Effective Age: 10 years, Total Economic Life: 60 years. Depreciation = (10/60) * \$300,000 = \$50,000
  • Step 4: Property Value = \$150,000 + \$300,000 - \$50,000 = \$400,000

• D. Experiment/Exercise

  • Present students with a hypothetical property description (age, size, features, condition).
  • Divide the class into groups.
  • Each group researches local construction costs, and depreciation rates.
  • Each group applies the Cost Approach to estimate the property value, and compares their results, discussing any discrepancies and the reasons for them.

II. The Sales Comparison Approach

• A. Theoretical Basis

  • The Sales Comparison Approach, or Market Approach, relies directly on the Principle of Substitution. A buyer will pay no more for a property than what they would pay for a comparable, substitute property on the open market.
  • This approach is most applicable when there is an active market with plentiful sales data of comparable properties.
  • The sales comparison approach may be summarized by the formula:
    Subject Value = Comparable Sales Price +/- Adjustments

• B. Steps in the Sales Comparison Approach

  1. Identify Comparable Properties: This is crucial. Comparables should be similar to the subject property in terms of:
     • Location
     • Physical Characteristics (size, age, condition, features)
     • Date of Sale (recent sales are more reliable)
     • Property Rights Conveyed
     • Financing Terms
  2. Collect Data: Gather detailed information on the comparable sales, including sales prices, terms of sale, and property characteristics.
  3. Adjust Comparable Sales Prices: This is a critical step. Adjustments are made to the comparable sales prices to account for differences between the comparable and the subject property.
     • Types of Adjustments:
       • Quantitative Adjustments: Dollar amounts or percentages based on market data (e.g., price difference for an extra bathroom).
       • Qualitative Analysis: Relative comparison (e.g., “superior location”) when quantitative data is unavailable.
     • Common Adjustments:
       • Date of Sale (Market Conditions)
       • Location
       • Physical Characteristics (size, features)
       • Financing Terms
       • Conditions of Sale
  4. Reconcile Adjusted Sales Prices: After making adjustments to all comparable sales, reconcile the adjusted prices to arrive at a value indication for the subject property. This is not a simple averaging; it involves weighting the comparables based on their similarity to the subject and the reliability of the data.

• C. Practical Application and Example

  • Subject Property: 3-bedroom, 2-bath home in a suburban neighborhood.
  • Comparable 1: Sold for \$450,000. Similar location, size, but only 1.5 baths. Market data indicates a \$10,000 adjustment for an additional half bath. Adjusted price: \$450,000 + \$10,000 = \$460,000.
  • Comparable 2: Sold for \$470,000. Slightly better location (add \$5,000), but smaller lot (deduct \$2,000). Adjusted price: \$470,000 + \$5,000 - \$2,000 = \$473,000
  • Comparable 3: Sold for \$430,000, six months ago. Market conditions have increased property values by 5% since then. Adjusted Price: \$430,000 * 1.05 = \$451,500
  • Reconciliation: Weighing the comparables, the appraiser concludes a value of \$460,000 for the subject property.

• D. Experiment/Exercise

  • Provide students with a subject property description.
  • Give them a data sheet containing information on several potential comparables.
  • Students individually select the most comparable properties and make appropriate adjustments.
  • Compare results and discuss the rationale behind each adjustment.

III. The Income Approach

• A. Theoretical Basis

  • The Income Approach is based on the Principle of Anticipation: The value of a property is directly related to the income it is expected to generate over its remaining economic life.
  • This approach is most applicable to income-producing properties like apartments, office buildings, retail centers, and leased land. While single-family homes don’t typically generate direct income, they may be valued using the income approach when rentals in the subject property area are common.
  • The greater the income, the greater the value is a basic assumption of the income approach.

• B. Methods within the Income Approach

  1. Gross Rent Multiplier (GRM): Primarily used for residential properties. A simple ratio relating a property’s sale price to its gross rental income.
     • Formula: GRM = Sale Price / Gross Rental Income
     • To value a subject property: Estimated Value = GRM * Subject Property’s Gross Rental Income
  2. Direct Capitalization: Used for commercial properties. Involves dividing the Net Operating Income (NOI) by a capitalization rate (Cap Rate).
     • Formula: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)
  3. Discounted Cash Flow (DCF) Analysis: A more sophisticated method that projects future income streams and expenses over a holding period, then discounts them back to their present value. This incorporates the time value of money.

• C. Steps in the Income Approach (Using Direct Capitalization)

  1. Estimate Potential Gross Income (PGI): The total potential income if the property were 100% occupied.
  2. Estimate Vacancy and Collection Losses: Deduct the estimated losses due to vacancy and unpaid rent.
  3. Calculate Effective Gross Income (EGI): EGI = PGI - Vacancy and Collection Losses
  4. Estimate Operating Expenses: Include all necessary expenses to maintain the property (insurance, taxes, repairs, management, etc.). Do NOT include debt service (mortgage payments).
  5. Calculate Net Operating Income (NOI): NOI = EGI - Operating Expenses
  6. Determine Capitalization Rate (Cap Rate): The Cap Rate is the rate of return an investor expects to receive. It is derived from market data (sales of comparable income-producing properties).
     • Formula: Cap Rate = NOI / Sale Price
  7. Calculate Property Value: Value = NOI / Cap Rate

• D. Practical Application and Example (Using GRM)

  • Subject Property: Single-family rental home with gross monthly rent of \$2,000.
  • Comparable 1: Sold for \$250,000, gross monthly rent \$1,900. GRM = 250,000 / 1,900 = 131.58
  • Comparable 2: Sold for \$240,000, gross monthly rent \$1,850. GRM = 240,000 / 1,850 = 129.73
  • Comparable 3: Sold for \$260,000, gross monthly rent \$2,000. GRM = 260,000 / 2,000 = 130
  • Indicated GRM: approximately 130.
  • Subject property value: $2,000 (rent) * 130 (GRM) = \$260,000

• E. Experiment/Exercise

  • Provide students with a property description and income/expense data.
  • Have them research comparable sales and extract capitalization rates.
  • Students apply the Direct Capitalization method to estimate property value.
  • Discuss the factors that influence the capitalization rate and its impact on value.

IV. Reconciliation of Value Indicators

• A. The Importance of Reconciliation

  • Each of the three approaches (Cost, Sales Comparison, Income) provides an indication of value. Rarely will all three approaches yield the exact same value.
  • Reconciliation is the process of analyzing the results from each approach and arriving at a single, final value estimate.
  • Reconciliation is NOT simple averaging.

• B. Factors to Consider in Reconciliation

  1. Reliability of Data: How accurate and verifiable is the data used in each approach?
  2. Relevance to the Property: How applicable is each approach to the specific type of property being valued? (e.g., the Income Approach is best for income-producing properties).
  3. Market Conditions: Which approach best reflects current market trends and investor behavior?
  4. Intended Use of the Appraisal: The client’s intended use may influence which approach receives the most weight.

• C. Example

  • Cost Approach: \$410,000
  • Sales Comparison Approach: \$460,000

  • Income Approach: \$450,000

  • Analysis: The Sales Comparison Approach is given the most weight due to a robust market and plentiful comparable sales data. The Income Approach is also given significant consideration, as it is aligned with rental rates in the area. The Cost Approach is deemed less reliable, because of the difficulty of accurately estimating depreciation.

  • Final Value Estimate: \$455,000

Conclusion

A proficient understanding and application of the Cost Approach, Sales Comparison Approach, and Income Approach are crucial for accurate land valuation and informed decision-making. By integrating these methods with a thorough analysis of highest and best use, appraisers can effectively unlock the full potential of real estate assets. The careful reconciliation of value indicators allows the appraiser to reach a credible value opinion. This knowledge is fundamental to achieving the course objectives of maximizing property value and unlocking lucrative opportunities in the real estate market.