Adjustments in Sales Comparison

Chapter: Adjustments in Sales Comparison

Introduction to Adjustments in Sales Comparison

The sales comparison approach relies on the principle of substitution, which states that a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. However, perfectly identical properties rarely exist. Thus, adjustments are necessary to reconcile differences between comparable sales and the subject property. These adjustments are vital for accurately estimating the market value of the subject property. This chapter will delve into the scientific underpinnings and practical application of these adjustments.

The Theoretical Basis for Adjustments

The fundamental theory behind adjustments in the sales comparison approach is based on marginal utility and regression analysis.

• Marginal Utility: This economic principle dictates that the added satisfaction a consumer gets from one additional unit of a good or service declines as more of it is consumed. In real estate, this translates to the idea that the value of an additional feature (like a fireplace or an extra bathroom) diminishes as more similar features are already present. The magnitude of an adjustment should reflect the market’s perception of this marginal utility.

• Regression Analysis: This statistical technique is used to model the relationship between a dependent variable (e.g., sales price) and one or more independent variables (e.g., size, location, age). It helps to isolate the contribution of each independent variable to the overall price. While appraisers rarely conduct formal regression analyses in every appraisal, the underlying principles of statistical significance and variable correlation should inform the adjustment process.

Types of Adjustments

Adjustments are generally categorized into quantitative and qualitative adjustments. We will focus on quantitative adjustments initially, as they are more readily subject to scientific analysis.

Quantitative Adjustments

Quantitative adjustments involve assigning a specific dollar amount or percentage to the difference between the comparable and the subject property. They include:

1. Property Rights Conveyed: This considers the legal rights transferred in the sale. Fee simple, leased fee, and leasehold interests each have different values.
2. Financing Terms: Unusual financing terms can artificially inflate or deflate a sale price. Adjustments are made to bring the comparable sale to a cash-equivalent basis.
   • Example: A comparable sale involved seller financing at a below-market interest rate. We need to determine the present value of the difference between the actual loan payments and what the payments would have been at the prevailing market rate.
   • Formula: Adjustment = PV(Market Rate, Nper, PMT_Market) - PV(Contract Rate, Nper, PMT_Contract), where PV is present value, Nper is the number of periods, PMT_Market is the market-rate loan payment, and PMT_Contract is the contract loan payment. This difference is then added to the comparable’s sale price if the financing was beneficial to the buyer.
3. Conditions of Sale: Adjustments are made if the sale was not an arm’s-length transaction (e.g., a sale between family members). Distressed sales (foreclosures, short sales) also require adjustment.
4. Market Conditions (Time Adjustment): Real estate values fluctuate over time due to changes in supply, demand, and economic factors. Adjustments are made to reflect these changes.
   • Example: Comparable sale occurred six months ago. The market is appreciating at a rate of 0.5% per month. The time adjustment is 3% (6 months * 0.5%).
   • Formula: Adjusted Price = Sale Price * (1 + Appreciation Rate)^(Time Difference), where Time Difference is expressed in years. If using monthly appreciation, convert the annual rate to a monthly rate: Monthly Rate = (1 + Annual Rate)^(1/12) - 1.
   • Experiment: Track sales of similar properties over time to determine the actual appreciation or depreciation rate in a given market segment. Statistical analysis, such as regression on sales price vs. sale date, can quantify this trend.
5. Location: Location significantly influences value due to factors such as proximity to amenities, schools, and transportation.
6. Physical Characteristics: Differences in lot size, building size, age, condition, and features (e.g., number of bedrooms, bathrooms, garage spaces) require adjustments.
   • Example: The comparable has an extra bedroom, and market analysis indicates that each bedroom contributes \$5,000 to value. The adjustment is -\$5,000 to the comparable.
   • Unit of Comparison: This involves analyzing sales data based on a common unit, such as price per square foot. This can help to identify trends and patterns in the market.

Qualitative Adjustments

Qualitative adjustments involve a subjective assessment of the differences between the comparable and the subject property. They are typically used when quantitative data is scarce or unreliable. Methods include:

1. Relative Comparison: This involves ranking the comparables relative to the subject property (e.g., “superior,” “inferior,” or “equal”). The appraiser then considers the magnitude of the differences to arrive at an opinion of value.

2. Bracketing: This involves selecting comparables that are both superior and inferior to the subject property with respect to key characteristics. The subject’s value should fall within the range indicated by these comparables.

The Adjustment Process: A Step-by-Step Guide

1. Identify Elements of Comparison: Determine the key characteristics that influence value in the subject’s market (e.g., location, size, age, condition).
2. Select Comparable Sales: Gather data on recent sales of properties that are similar to the subject property.
3. Verify the Data: Confirm the accuracy of the sales data through reliable sources.
4. Make Quantitative Adjustments: Apply dollar or percentage adjustments for differences in property rights, financing terms, conditions of sale, and market conditions.
5. Make Qualitative Adjustments: Consider relative quality and feature differences if quantifying them is not reasonably possible or reliable.
6. Reconcile the Indicated Values: Analyze the adjusted sale prices of the comparables and arrive at a final value❓ opinion for the subject property. Give more weight to the comparables that required the fewest and smallest adjustments and are most similar to the subject.

Common Pitfalls and Considerations

• Over-Adjusting: Avoid making excessive adjustments, as this can introduce more error into the analysis.
• Compounding Adjustments: Avoid applying multiple adjustments to the same element of value (e.g., adjusting for both size and number of bedrooms when size already reflects bedroom count).
• Ignoring Paired Sales Analysis: Whenever possible, use paired sales analysis (comparing two sales that are nearly identical except for one feature) to quantify the value of specific property characteristics.
• Lack of Data Support: All adjustments should be supported by market data and logical reasoning.
• Subjectivity: While some subjectivity is unavoidable, appraisers should strive for objectivity and transparency in their adjustment process.

Examples of Practical Applications and Related Experiments

Example 1: Time Adjustment Experiment

• Objective: Determine the monthly appreciation rate in a specific neighborhood.
• Procedure:
  1. Identify at least 10 properties that have sold twice within the past two years in the target neighborhood. Ensure the properties had minimal or no renovations between sales.
  2. Record the sale dates and sale prices for each transaction.
  3. Calculate the holding period for each property (in months).
  4. Calculate the percentage change in price for each property.
  5. Divide the percentage change in price by the holding period (in months) to obtain the monthly appreciation rate for each property.
  6. Calculate the average monthly appreciation rate across all properties.
• Analysis: The average monthly appreciation rate provides an estimate of the time adjustment needed for comparables in the sales comparison approach.
• Mathematical Analysis: Use linear regression with “Sale Price” as the dependent variable and “Months Since Initial Sale” as the independent variable. The slope of the regression line represents the average monthly appreciation.

Example 2: Size Adjustment Application

A comparable sale of a 1,800 sq ft house sold for $360,000. The subject property is 2,000 sq ft. Paired sales analysis (comparing similar houses that differ only in size) suggests that each additional square foot contributes \$100 to value.

• Calculation:
  • Size difference: 2,000 sq ft - 1,800 sq ft = 200 sq ft
  • Adjustment: 200 sq ft * \$100/sq ft = \$20,000
  • Adjusted Sale Price: \$360,000 + \$20,000 = \$380,000 (to the comparable, as the subject is larger).

Conclusion

Adjustments in the sales comparison approach are a critical component of the valuation process. A thorough understanding of the underlying scientific principles, coupled with careful analysis of market data, is essential for developing credible and reliable value opinions. By applying these adjustments systematically and transparently, appraisers can ensure that their valuations accurately reflect the market realities and provide a solid foundation for informed decision-making.