3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Match the approach to the property: sales comparison for homes, cost for special-purpose, income for rentals.
- In sales comparison, always adjust the comparable, not the subject: superior comp down, inferior comp up.
- Cost approach: Replacement Cost New minus Depreciation plus Land Value; land never depreciates.
- External (economic) obsolescence is always incurable; income approach value = NOI divided by cap rate (IRV).
- As the cap rate rises, value falls; a CMA or BPO is a value opinion, never a substitute for an appraisal.
Three approaches estimate value, and the exam tests both the math and the right tool for each property type. Master the IRV triangle and the adjustment direction rule and you will capture most of these points.
Match the Approach to the Property
| Approach | Core idea | Best for |
|---|---|---|
| Sales comparison | Substitution; adjust recent comparable sales | Single-family homes, condos |
| Cost | Replacement cost new − depreciation + land | New, unique, or special-purpose property (schools, churches) |
| Income | Convert income into value | Rentals, apartments, commercial |
Most residential appraisals lean on sales comparison because plentiful comparable sales make it the most reliable.
Sales Comparison Approach
The appraiser finds recent sales of similar properties (comparables) and adjusts each to the subject. The governing rule:
Always adjust the comparable, never the subject. If a comp is superior (it has a feature the subject lacks), subtract from the comp. If a comp is inferior, add to the comp.
Worked example: The subject has a garage; Comp A sold for $310,000 but lacks a garage worth $12,000. Comp A is inferior, so adjust up: $310,000 + $12,000 = $322,000 indicated value. If Comp B sold for $330,000 with an extra bathroom worth $8,000 the subject lacks, Comp B is superior, so adjust down: $330,000 − $8,000 = $322,000.
Cost Approach
Value = Replacement (or Reproduction) Cost New − Accrued Depreciation + Land Value. Land is added separately because land never depreciates.
Depreciation has three causes:
- Physical deterioration — wear and tear (often curable).
- Functional obsolescence — outdated design, like one bathroom in a four-bedroom home (may be curable).
- External (economic) obsolescence — a negative outside the lot line, like a new landfill nearby. External obsolescence is always incurable because the owner cannot fix it.
Cost-approach worked example: A building's replacement cost new is $420,000. It has $60,000 of physical deterioration and $20,000 of functional obsolescence. The land is worth $90,000.
Value = $420,000 − ($60,000 + $20,000) + $90,000 = $430,000.
Income Approach (IRV)
For income property, value derives from net income through the IRV triangle:
- I = Net Operating Income (NOI) = effective gross income − operating expenses (exclude debt service and depreciation).
- R = capitalization rate.
- V = Value.
The three formulas: V = I ÷ R, I = V × R, R = I ÷ V.
Worked example: A building produces $48,000 NOI and the market cap rate is 8%. V = $48,000 ÷ 0.08 = $600,000. If an investor demands a 10% cap rate instead, V = $48,000 ÷ 0.10 = $480,000 — proving that as the cap rate rises, value falls (inverse relationship).
Gross Multipliers (Shortcuts)
- GRM (gross rent multiplier) uses monthly rent: Value = Monthly Rent × GRM. If comparable homes sell at a GRM of 120 and the subject rents for $2,000/month, value ≈ $240,000.
- GIM (gross income multiplier) uses annual gross income for larger commercial property.
Multipliers ignore expenses, so they are quick screens, not precise tools.
CMAs and BPOs Are Not Appraisals
A salesperson prepares a CMA to help price a listing, and a broker prepares a BPO for a lender's risk decision. Both borrow sales-comparison logic, but neither follows the full USPAP appraisal process, and neither qualifies as the appraisal a lender needs for a federally related loan. When a question gives NOI and a cap rate, use V = I ÷ R; when it gives a comparable sale and a feature difference, adjust the comp; when it asks who may value a property for a mortgage, the answer is a licensed appraiser, not a CMA or BPO.
An apartment building generates $54,000 in net operating income. Investors in this market require a 9% capitalization rate. Using the income approach, what is the indicated value?
An appraiser uses a comparable that sold for $345,000 and includes a finished basement, valued at $15,000, that the subject property lacks. How is the comparable adjusted?
A home appraisal must account for a recently opened landfill next door that buyers strongly dislike. In the cost approach, how is this loss in value classified?
Choosing and Weighting the Approaches
Not every approach fits every property, and the exam rewards picking the most reliable one.
| Property type | Most reliable approach | Why |
|---|---|---|
| Typical single-family home | Sales comparison | Abundant comparable sales |
| Brand-new construction | Cost | Costs are current and depreciation is minimal |
| Special-purpose (church, school, library) | Cost | Few or no comparable sales or income streams |
| Apartment or commercial rental | Income | Value flows from the income produced |
| Vacant land | Sales comparison | Compare to recent land sales |
Effective Gross Income to NOI
Before applying the cap rate, build NOI carefully: start with potential gross income, subtract a vacancy and collection loss, add other income to reach effective gross income, then subtract operating expenses (taxes, insurance, management, repairs) but not debt service or depreciation.
Worked example: Potential gross income $80,000; vacancy 5% = $4,000; effective gross income $76,000; operating expenses $28,000; NOI = $48,000. At a 0.08 cap rate, value = $48,000 / 0.08 = $600,000.
GRM Quick Check
The gross rent multiplier is a fast residential screen: GRM = sale price / monthly rent. If comparable rentals sell at a GRM of 110 and the subject rents for $2,200/month, indicated value is $2,200 x 110 = $242,000. Because GRM ignores expenses, it only screens, it never replaces a full income analysis.
Exam trap: GRM uses monthly rent; GIM uses annual gross income. Match the multiplier to the income period.
Reproduction vs. Replacement Cost
In the cost approach, reproduction cost builds an exact replica using the same materials and design, while replacement cost builds a functionally equivalent structure with modern materials and methods. Replacement cost is used more often because exact reproduction of older construction is rarely practical or relevant to value.
Exam trap: Replacement cost uses modern equivalents; reproduction cost copies the original exactly, the appraiser usually relies on replacement cost.