Sales Comparison: Adjustments & Reconciliation

Chapter 5: Sales Comparison: Adjustments & Reconciliation

5.1 Introduction to Adjustments in Sales Comparison

The Sales Comparison Approach (SCA) hinges on the principle of substitution. We find the value❓ of a subject property by comparing it to similar properties that have recently sold. However, rarely are comparable properties identical to the subject. This is where adjustments come in. Adjustments are the process of quantifying and applying monetary or percentage modifications to the sale prices of comparables to account for differences between them and the subject property. These adjustments aim to simulate a scenario where the comparables are identical to the subject, thus providing a more accurate indication of the subject’s value.

5.2 Underlying Scientific Principles

The adjustment process is rooted in several economic and statistical principles:

• Principle of Contribution: The value of a component is measured by the amount it adds to the total value of the property. An adjustment reflects the contributory value of a specific feature or characteristic.
• Principle of Supply and Demand: Relative scarcity and buyer demand influence value. If a particular feature is highly sought after but scarce, its contributory value (and therefore the adjustment) will be higher.
• Law of Diminishing Returns: At some point, adding more of a feature will not proportionately increase value. The adjustment should reflect this. For example, a second fireplace might add less value than the first.
• Regression Analysis: A statistical technique used to model the relationship between a dependent variable (sale price) and one or more independent variables (property characteristics). Adjustments can be informed by regression analysis, especially in markets with sufficient data.

5.3 Types of Adjustments

Adjustments can be broadly classified as:

• Quantitative Adjustments: These adjustments are expressed as a fixed dollar amount or percentage. They are typically used when there is sufficient market data to support a precise calculation.
• Qualitative Adjustments: These are used when there is insufficient data for quantitative analysis. They involve ranking the comparables relative to the subject (e.g., superior, similar, inferior) and making adjustments based on the appraiser’s informed judgment and experience.

5.4 The Adjustment Process: A Step-by-Step Approach

1. Identify Differences: Carefully analyze the subject property and each comparable sale to identify all relevant differences that could affect value. These differences may relate to:

   • Property rights conveyed (e.g., fee simple vs. leasehold)
   • Financing terms (e.g., seller concessions, interest rate buy-downs)
   • Conditions of sale (e.g., arm’s-length transaction, motivated seller)
   • Market conditions (e.g., date of sale)
   • Location (e.g., neighborhood amenities, proximity to undesirable features)

   • Physical characteristics (e.g., site size, view, building size, condition, features)
     2. Quantify the Differences: The most challenging part. Several methods can be used:

   • paired sales analysis❓❓: Identify pairs of comparable sales that are similar in all respects except for one specific feature. The difference in sale prices represents the market value of that feature. This is considered the most reliable method. For example, two houses identical except for one having a garage. The sale price difference reflects the market value of the garage.

   • Cost Approach Extraction: Estimate the cost to add or remove a feature (e.g., a swimming pool). This method is most appropriate for features with readily available cost data and little functional obsolescence.
   • Income Capitalization: For income-producing properties, estimate the change in net operating income (NOI) attributable to a specific feature. Capitalize this change in NOI to arrive at an adjustment amount.
   • Statistical Analysis (Regression): If sufficient data is available, regression analysis can estimate the contribution of each variable to the sale price.

   • Expert Opinion/Market Surveys: Consult with other appraisers, real estate agents, or contractors to gather information about market perceptions of value.
     3. Apply the Adjustments:

   • Rule: If the comparable is superior to the subject, subtract from the comparable’s sale price. If the comparable is inferior to the subject, add to the comparable’s sale price.

   • Sequence of Adjustments: While there is no universally accepted sequence, a common order is:
     • Financing terms
     • Conditions of sale
     • Market conditions (time)
     • Location
     • Physical characteristics
   • Dollar vs. Percentage Adjustments: Dollar adjustments are typically used for features with a fixed cost or value (e.g., a garage). Percentage adjustments are used for market conditions and other factors that affect the overall price level.
   • Cumulative Adjustments: Adjustments are cumulative. Each adjustment is applied to the adjusted sale price from the previous adjustment.

5.5 Mathematical Formulations for Adjustments

Let:

• S = Sale price of comparable
• Adj_i = Adjustment for the ith characteristic
• V_Ind = Indicated value of the subject property

The adjusted sale price of the comparable can be calculated as:

V_Ind = S + Adj₁ + Adj₂ + … + Adj_n

Where Adj_i can be positive (if the comparable is inferior) or negative (if the comparable is superior).

For percentage adjustments applied sequentially:

V_Ind = S * (1 + P₁) * (1 + P₂) * … * (1 + P_n)

Where P_i is the percentage adjustment for the ith characteristic (expressed as a decimal). Note that P_i can be positive or negative, depending on whether the comparable is inferior or superior, respectively.

Example:

A comparable sold for $500,000. It requires the following adjustments:

• Market conditions (time): +5%
• Site size: -$10,000
• Building size: +$15,000

V_Ind = $500,000 * (1 + 0.05) - $10,000 + $15,000

V_Ind = $525,000 - $10,000 + $15,000 = $530,000

5.6 Reconciliation

Reconciliation is the final step in the Sales Comparison Approach. After adjustments have been made to each comparable, the appraiser will have several “indicated values” for the subject property. Reconciliation is the process of analyzing these indicated values and arriving at a single, final value opinion. This is not a simple averaging process.

Key Considerations in Reconciliation:

• Reliability of Data: Give more weight to comparables with the most reliable data sources and the fewest necessary adjustments.
• Market Relevance: Comparables located closest to the subject property, sold most recently, and most similar in characteristics should be given more weight.
• Consistency of Adjustments: Scrutinize the adjustment process for internal consistency. Are the adjustments logically consistent with market behavior?
• Range of Indicated Values: Analyze the range of indicated values. A wide range might suggest inconsistencies in the data or the adjustment process. Investigate outliers.

Reconciliation Methods:

• Quantitative Reconciliation: Weighted averaging, where each comparable is assigned a weight based on its reliability and relevance. This can be expressed mathematically as:

  Final Value Estimate = w₁ V_Ind1 + w₂ V_Ind2 + … + w_n V_Indn

  Where w_i is the weight assigned to the ith comparable (0 ≤ w_i ≤ 1) and the sum of all weights equals 1.

• Qualitative Reconciliation: A narrative discussion of the strengths and weaknesses of each comparable and a justification for the final value opinion. This is often used in conjunction with quantitative methods.

5.7 Practical Applications and Examples (Based on PDF Excerpts)

Example 1: Site Size Adjustment (PDF Page 232)

The subject property has a site size of 1.25 acres. Comparable 1 has 1.0 acres and requires an adjustment of +$10,000. Comparable 2 has 0.75 acres and requires an adjustment of +$15,000.

• This suggests a decreasing marginal utility of land. The first 0.25 acre difference is valued at $10,000, but the next 0.25 acre difference (between 1.0 and 0.75 acres) is valued at only $5,000 ($15,000 - $10,000).

Example 2: Above Ground Living Area (AGLA) Adjustment (PDF Page 232, 234, 235)

Comparable 3 on page 232 has a significantly larger AGLA (4,200 sq ft) than the subject (2,943 sq ft), resulting in a substantial negative adjustment of -$55,000. The commentary on page 234 suggests the price per square foot of GLA is low, reflecting that the market will not pay a high price for this overimprovement. This is due to the Law of Diminishing Returns.

Example 3: Basement Finish Adjustment (PDF Page 232)

Comparable 2 has 500 sq.ft. of basement finish, requiring a positive adjustment of +$5,000. This tells us what the market prices each sq. ft. of basement finish at.

Example 4: Financing Adjustments & Cash Equivalency (Not Explicitly Shown in PDF Excerpts but Highly Relevant)

Seller financing or favorable financing terms must be adjusted to reflect a cash-equivalent sale. To do this, calculate the present value of the financing advantage to the buyer. For example, calculate the amount that a comparable sale was sold at over market value by calculating the future value (using the difference in interest rates), and accounting for the balloon payment (if there is any, and its effect on the price).

Example 5: Time Adjustments (PDF Pages 233-236)

The examples demonstrate the application of time adjustments based on market appreciation rates. On page 233, Sale 1 appreciates at 0.855% annually. This is used to adjust the price of a past sale to its estimated current value. The rate may be calculated as follows:

R = [(P_present / P_past) ^(1/t)] - 1

Where:

• R = Annual appreciation rate
• P_present = Price in the present
• P_past = Price in the past
• t = Time in years between the past and present sales

R = [($200,000 / $195,000) ^(1/3.083)] - 1

Where 3.083 years is 3 years and 1 month.

Example 6: Overimprovements (PDF Pages 234)

As mentioned earlier, the example on page 234 explicitly addresses the concept of overimprovements, where the adjustments are smaller than what might be expected based on a per-square-foot analysis. This highlights the importance of considering market demand and the principle of diminishing returns.

Example 7: Bilevel/Raised Ranch Design (PDF Pages 235)

The example of the bilevel design highlights the need to correctly identify the market’s perception of the property type. If the market views the bilevel as equivalent to a ranch with a finished basement, the adjustments should reflect this. If it’s perceived as a two-story, the adjustments will be different. This reinforces the importance of understanding the local market.

5.8 Related Experiments

To solidify understanding of adjustments, consider these practical exercises:

1. Simulated Paired Sales Analysis: Provide students with sets of hypothetical property data and ask them to conduct paired sales analysis to determine adjustment amounts for specific features (e.g., garage, fireplace, updated kitchen).
2. Time Adjustment Sensitivity Analysis: Give students a set of comparable sales with different dates of sale and varying appreciation rates. Have them analyze the impact of different appreciation rates on the final value opinion.
3. Reconciliation Scenario: Present students with a set of adjusted comparable sales with varying reliability and relevance. Challenge them to justify their final value opinion and explain the weighting they assigned to each comparable.

5.9 Cautions and Considerations

• Subjectivity: Adjustments, especially qualitative ones, involve a degree of subjectivity. Appraisers must support their adjustments with credible market data and sound reasoning.
• Over-Adjusting: Excessive adjustments can lead to an unreliable value opinion. Aim for comparables that require minimal adjustments.
• Correlation: Be aware of correlation between characteristics. For example, house size and the number of bathrooms are often correlated. Adjusting for both independently might overstate the combined impact.
• Documentation: Thoroughly document all adjustments, the data sources used, and the rationale behind each adjustment.

5.10 Conclusion

Accurate adjustments are the cornerstone of a credible Sales Comparison Approach. By understanding the underlying principles, applying a systematic approach, and carefully reconciling the indicated values, appraisers can develop well-supported and defensible value opinions.