Sales Comparison: Basics and Adjustments

Chapter 5: Sales Comparison: Basics and Adjustments

The Sales Comparison Approach (SCA), also known as the Market Approach, is a cornerstone of real estate appraisal. It relies on the principle of substitution, which posits that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. Therefore, the value of a property can be estimated by analyzing the sale prices of similar properties in the same market area. This chapter will delve into the fundamental concepts of the SCA, focusing on the identification and application of adjustments to comparable sales data.

5.1. Principles Underlying the Sales Comparison Approach

The validity of the SCA rests on several key economic and real estate principles:

• Principle of Substitution: As mentioned above, this principle forms the very foundation of the SCA. A buyer will not overpay for a property if a similar, more affordable option exists. This creates a competitive environment that directly influences property values.

• Principle of Supply and Demand: The relative scarcity of a particular property type and the demand for it will directly impact its market value. An excess of similar properties available for sale will generally depress prices, while high demand with limited supply will increase prices.

• Principle of Conformity: Properties tend to achieve maximum value when they conform to the surrounding neighborhood in terms of style, size, quality, and amenities. Properties that deviate significantly from the norm may require adjustments to reflect their lack of conformity.

• Principle of Contribution: The value of a specific component of a property is measured by its contribution to the overall value, not by its individual cost. For example, the value added by a swimming pool is determined by how much more buyers are willing to pay for a property with a pool, not the cost of building the pool itself.

• Principle of Anticipation: Value is influenced by the expectation of future benefits. For example, a property located near a planned transit expansion might experience an increase in value due to the anticipation of improved accessibility.

5.2. The Sales Comparison Process: A Step-by-Step Guide

The SCA involves a systematic process:

1. Research the Market Area: This initial step involves gathering information about the neighborhood, including demographics, economic trends, zoning regulations, and market conditions. This information helps to identify relevant market segments and comparable properties.

2. Identify Potentially Comparable Sales: The goal is to find properties that are as similar as possible to the subject property. Key characteristics to consider include location, property type, size, age, condition, features, and date of sale. Public records, MLS (Multiple Listing Service) data, and interviews with local real estate professionals are valuable sources.

3. Verify the Data: Confirm the accuracy of the information obtained about the comparable sales. This may involve contacting the buyer, seller, real estate agent, or other parties involved in the transaction. It’s crucial to verify the sale price, date of sale, and any unusual conditions of sale.

4. Select Relevant Elements of Comparison: Not all differences between the subject property and the comparables will significantly impact value. Select the key characteristics that are likely to influence buyer behavior in the specific market. These elements could include:

   • Property Rights Conveyed: Fee simple, leasehold, etc.
   • Financing Terms: Cash, conventional mortgage, seller financing, etc.
   • Conditions of Sale: Arm’s-length transaction, distressed sale, etc.
   • Market Conditions: Changes in price levels over time.
   • Location: Neighborhood characteristics, proximity to amenities, etc.
   • Physical Characteristics: Site size, view, building size, age, condition, quality of construction, features (e.g., number of bedrooms, bathrooms, garage, fireplace).

5. Adjust Comparable Sale Prices: This is the most critical and challenging step. Adjustments are made to the comparable sale prices to account for differences between the comparables and the subject property. Adjustments are always made to the comparable, not the subject. This involves quantifying the value of each significant difference and adding or subtracting that amount from the comparable’s sale price.

6. Reconcile the Adjusted Sale Prices: After making all necessary adjustments, you will have a range of indicated values for the subject property. Reconciliation involves analyzing these adjusted values and arriving at a single, best estimate of value. This is not a simple averaging process; it requires careful consideration of the reliability of each comparable and the magnitude of the adjustments made.

5.3. Understanding Adjustments: Theory and Practice

The core of the SCA lies in the adjustments made to comparable sale prices. Adjustments aim to simulate the price a comparable property would have sold for if it were identical to the subject property.

5.3.1. Types of Adjustments

Adjustments can be categorized as either quantitative or qualitative.

• Quantitative Adjustments: These adjustments are based on measurable differences and can be expressed in dollar amounts or percentages. The most common types of quantitative adjustments include:

  • Dollar Adjustments: A fixed dollar amount is added or subtracted from the comparable’s sale price. This is appropriate for features like a garage or a finished basement, where the value difference is relatively consistent.
  • Percentage Adjustments: A percentage of the comparable’s sale price is added or subtracted. This is often used for market conditions adjustments, where overall price levels have changed over time.
  • Paired Data Analysis: A common method to identify the appropriate quantitative adjustments. This involves finding pairs of comparable sales that are identical except for one specific feature. The difference in their sale prices represents the value of that feature. For example, if two identical houses sold for $200,000 and $210,000, respectively, and the only difference was that the second house had a swimming pool, the paired data analysis would suggest that a swimming pool contributes $10,000 to value.

• Qualitative Adjustments: These adjustments are used when the differences are difficult to quantify precisely. Instead of assigning a specific dollar amount, the appraiser uses descriptive terms to indicate the relative superiority or inferiority of the comparable. Common qualitative adjustments include:

  • Relative Comparison Analysis: The appraiser ranks the comparable properties relative to the subject property for a given characteristic. For example, the appraiser might rate Comparable 1 as “Superior,” Comparable 2 as “Similar,” and Comparable 3 as “Inferior” in terms of location.
  • Ranking Analysis: Similar to relative comparison, but involves ranking all the comparables in order of desirability for a specific feature.

5.3.2. The Order of Adjustments

The order in which adjustments are applied is crucial for accuracy. A generally accepted sequence is:

1. Property Rights Conveyed: Adjustments for differences in property rights, such as leasehold vs. fee simple.
2. Financing Terms: Adjustments for non-market financing, such as below-market interest rates.
3. Conditions of Sale: Adjustments for atypical circumstances surrounding the sale, such as a forced sale or a sale between related parties.
4. Market Conditions (Time): Adjustments for changes in market conditions between the date of the comparable sale and the date of the appraisal.
5. Location: Adjustments for differences in neighborhood desirability, proximity to amenities, etc.
6. Physical Characteristics: Adjustments for differences in site size, view, building size, age, condition, quality of construction, features, etc.

This order aims to address the most fundamental aspects of the sale first, ensuring that subsequent adjustments are applied to a more accurate base value.

5.3.3. Mathematical Representation of Adjustments

Let:

• VS = Value of the Subject Property (what we are trying to estimate)
• VCi = Sale Price of Comparable i
• Ai = Net Adjustment for Comparable i

Then, the Indicated Value for the subject property based on Comparable i is:

VSi = VCi + Ai

The net adjustment Ai is the sum of all individual adjustments:

Ai = Arights + Afinancing + Aconditions + Atime + Alocation + Aphysical

Where each A represents the dollar or percentage adjustment for each element of comparison.

For example, consider a comparable sale with a sale price of $250,000. The appraiser makes the following adjustments:

• Financing: +$5,000 (for favorable financing)
• Market Conditions: +2% (market appreciation since the sale)
• Site Size: -$3,000 (smaller lot than the subject)
• Building Size: +$8,000 (larger building than the subject)

Then:

Afinancing = +$5,000
Atime = 0.02 * $250,000 = +$5,000
Alocation = $0
Aphysical = -$3,000 + $8,000 = +$5,000

Therefore, Ai = $5,000 + $5,000 + $5,000 = +$15,000

And VSi = $250,000 + $15,000 = $265,000

The indicated value of the subject property, based on this one comparable, is $265,000. This process would be repeated for each comparable sale, and the results reconciled to arrive at a final value estimate.

5.3.4. Practical Considerations & Examples from Provided Data

The provided PDF offers real-world examples of the application of SCA. Let’s analyze some of them:

• Example 1: Site Size Adjustment (Page 232)

  • Subject: 1.25 acres
  • Comparable 1: 1.0 acre, Adjustment: +$10,000
  • Comparable 2: 0.75 acre, Adjustment: +$15,000

  This suggests that, in this market, larger sites command a premium. The incremental value appears to be roughly $20,000 per acre ([$15,000 - $10,000] / [1.0 - 0.75] = $20,000/0.25 acres). This “rule of thumb” could be verified using additional comparable sales. Experiment: If you had access to more sales data, a regression analysis could be performed to determine a statistically significant relationship between site size and sale price.

• Example 2: Construction Quality Adjustment (Page 232)

  • Subject: Wood/Frame/Avg.
  • Comparable 1: Masonry/Frame, Adjustment: -$10,000
  • Comparable 2: Frame/Masonry, Adjustment: -$10,000

  This indicates that masonry construction is considered superior in this market, commanding a higher price. The consistent -$10,000 adjustment implies a relatively uniform market preference.

• Example 3: Above-Ground Building Area (AGLA) Adjustment (Page 232)

  • Subject: 2,943 sq ft
  • Comparable 2: 4,200 sq ft, Adjustment: -$55,000

  This highlights the need to adjust for significant differences in living area. While the grid does not provide the implied per-square-foot adjustment, it is important to calculate this value ($55,000/(4,200 - 2,943) = $42.40/sq ft) and compare it to the overall price/AGLA to check for reasonableness. (Comparable 2 sold for $525,000 so the price/AGLA is $125/sq ft.) In this example, the overall price/AGLA might be too high, so a square foot adjustment of $42.40/sq ft might not be appropriate. This adjustment rate might assume the market will not pay a high price for this overimprovement.

• Example 4: Market Conditions Adjustment (Page 234)

  • The example mentions annual appreciation rates being calculated. Appraisers will often need to adjust for market conditions.

  • Market conditions change over time. To adjust for these change, appraisers often calculate a monthly appreciation rate which can be used to derive the overall time adjustment.

    • Monthly Appreciation Rate = Annual Rate / 12

    • Time Adjustment = (Month Difference between subject sale date and comparable sale date) * Monthly Appreciation Rate

    • Adjusted Sale Price = Sale Price + Time Adjustment

• Example 5: Functional Overimprovements (Page 234)

  • The example states that the subject property has overimprovements. It also notes that low AGLA adjustments and basement adjustments gave “some consideration to the lack of a deep market for this very large home in a small town.” This is an important comment and demonstrates that real estate isn’t always a set of hard numbers and adjustments. The appraiser needs to consider market context and how “overimprovements” affect valuation.

5.3.5. Potential Experiment: Testing Adjustment Accuracy

A controlled experiment can be designed to assess the accuracy of different adjustment techniques. Select a sample of properties that have sold multiple times within a relatively short period. For each property, treat the first sale as the “subject” and the subsequent sale(s) as the “comparable(s).” Apply different adjustment methods (e.g., dollar adjustments, percentage adjustments, regression analysis) to estimate the “subject’s” sale price based on the “comparable’s” sale price. Compare the estimated sale price to the actual sale price to evaluate the accuracy of each method.

5.4. Reconciliation and Final Value Estimate

Reconciliation is the final step in the SCA. It involves analyzing the adjusted sale prices of the comparable properties and arriving at a single, best estimate of value for the subject property.

• Weighing the Comparables: Not all comparables are created equal. The appraiser must carefully consider the reliability of each comparable and the magnitude of the adjustments made. Comparables with smaller adjustments and more reliable data should be given greater weight.

• Considering the Range of Values: The adjusted sale prices will typically fall within a range. The appraiser must determine where within that range the subject property’s value is most likely to fall. This requires considering the characteristics of the subject property relative to the comparables.

• Avoiding Simple Averaging: A simple average of the adjusted sale prices is rarely the best estimate of value. It’s important to understand the strengths and weaknesses of each comparable and to give greater weight to the most reliable indicators.

• Documenting the Reconciliation Process: The appraiser must clearly explain the reasoning behind the final value estimate, including the rationale for weighing certain comparables more heavily than others.

5.5. Challenges and Limitations of the Sales Comparison Approach

While the SCA is a powerful valuation tool, it is not without its challenges:

• Data Availability: Finding truly comparable sales can be difficult, especially in specialized markets or when dealing with unique properties.

• Subjectivity: Adjustments involve a degree of judgment, and different appraisers may arrive at different value estimates.

• Changing Market Conditions: Rapidly changing market conditions can make it difficult to rely on historical sales data.

• Complexity: The SCA can be complex and time-consuming, requiring significant research and analysis.

Despite these limitations, the Sales Comparison Approach remains the most widely used and accepted method for valuing real estate, particularly residential properties. A thorough understanding of its underlying principles and the proper application of adjustments is essential for any real estate appraiser. This chapter provides the groundwork for mastering this vital appraisal technique.