3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Sales comparison adjusts comparable sales to the subject; adjust the comp, never the subject.
- When a comp is superior, subtract from its price; when inferior, add to its price (CBS / CIA rule).
- The cost approach equals reproduction/replacement cost minus depreciation plus land value, and is best for new or special-purpose properties.
- The income approach uses the IRV formula: Value = Net Operating Income divided by the Capitalization Rate.
- A BPO or CMA estimates likely sale price but is not an appraisal and is not USPAP-governed.
Sales Comparison Approach
The sales comparison approach (also called the market data approach) estimates value by comparing the subject to recently sold, similar properties and adjusting for differences. It rests on the principle of substitution and is the primary method for single-family residences.
The golden rule: adjust the comparable, never the subject. Use the mnemonic CBS / CIA:
- Comp Better → Subtract from the comparable's price.
- Comp Inferior → Add to the comparable's price.
Why? If a comp has an extra bathroom the subject lacks, the comp sold for more than the subject would; you subtract that feature's value from the comp to make it equivalent to the subject.
Worked Adjustment Example
A comparable sold for $300,000. Compared to the subject:
| Feature | Difference | Adjustment to comp |
|---|---|---|
| Comp has extra half-bath subject lacks | Comp superior | -$8,000 |
| Subject has a 2-car garage; comp has 1-car | Comp inferior | +$10,000 |
| Comp has a finished basement subject lacks | Comp superior | -$15,000 |
Adjusted value indication: $300,000 - $8,000 + $10,000 - $15,000 = $287,000.
Note how each adjustment makes the comp look like the subject. With several comps, the appraiser reconciles their adjusted prices, giving more weight to comps needing the fewest and smallest adjustments.
A comparable property sold for $250,000. It has a swimming pool worth $20,000 that the subject lacks, and it lacks a fireplace worth $4,000 that the subject has. What is the adjusted value indication for the subject?
Cost Approach
The cost approach estimates value as:
Land Value + (Reproduction or Replacement Cost of Improvements - Depreciation) = Value
Terms to know:
- Reproduction cost — cost to build an exact replica using the same materials.
- Replacement cost — cost to build a functional equivalent using modern materials and methods (more commonly used).
The cost approach is most reliable for new construction and special-purpose properties (schools, churches, libraries) that rarely sell and produce no income, so comparables and rents are scarce.
Three Types of Depreciation
Depreciation is loss in value from any cause. The exam tests three types and whether each is curable:
| Type | Cause | Curable? |
|---|---|---|
| Physical deterioration | Wear, tear, age (worn roof, peeling paint) | Often curable |
| Functional obsolescence | Outdated design/features (one bathroom, no closets) | Sometimes curable |
| External (economic) obsolescence | Outside forces (noisy highway, declining area) | Incurable |
External obsolescence is always incurable because the cause is off-site and beyond the owner's control. Worked example: replacement cost $220,000, accrued depreciation $30,000, land value $80,000 → Value = ($220,000 - $30,000) + $80,000 = $270,000.
Income Approach and the IRV Formula
The income approach values income-producing property (apartments, retail, office) by capitalizing its net income. Memorize the IRV triangle:
Value = Net Operating Income (NOI) / Capitalization Rate
Rearranged: I = R x V, and R = I / V.
First compute NOI: Effective Gross Income minus operating expenses (NOI excludes debt service/mortgage payments and depreciation).
Worked example: a building has NOI of $48,000 and the market cap rate is 8% (0.08). Value = $48,000 / 0.08 = $600,000. Note the inverse relationship: a higher cap rate produces a lower value (more perceived risk), and a lower cap rate produces a higher value.
An apartment building generates net operating income of $90,000 per year. An investor requires a capitalization rate of 9%. Using the income approach, what is the indicated value?
Depreciation Methods in the Cost Approach
The cost approach lives or dies on estimating depreciation, and the exam tests two ways to measure it. The straight-line (age-life) method spreads loss evenly over the improvement's economic life: Annual depreciation = Improvement cost / Economic life; accrued depreciation = annual figure x effective age.
Worked example: a building cost $300,000 to reproduce, has a 50-year economic life, and an effective age of 10 years.
- Annual depreciation = $300,000 / 50 = $6,000/year
- Accrued depreciation = $6,000 x 10 = $60,000
- Depreciated improvement value = $300,000 - $60,000 = $240,000; add land separately.
The breakdown (observed-condition) method instead totals the three depreciation types (physical, functional, external) item by item. Remember that effective age reflects condition and updates, not the literal year built (chronological age) — a well-renovated older home can have a low effective age.
Gross Rent Multiplier and BPOs
For small residential rentals, appraisers may use the Gross Rent Multiplier (GRM): Value = Gross Monthly Rent x GRM. If similar properties sell at 120 times monthly rent and the subject rents for $2,000/month, value = $2,000 x 120 = $240,000. The Gross Income Multiplier (GIM) uses annual income instead.
Finally, the Broker Price Opinion (BPO) estimates a likely sale price for lenders or asset managers, typically in short-sale or REO contexts. A BPO and a CMA are valuation opinions by licensees, are usually faster and cheaper than an appraisal, and are not governed by USPAP. They may not be substituted for an appraisal where federal law requires a licensed appraiser.
A final exam reminder ties the three approaches together. The appraiser does not pick one approach and ignore the rest; all applicable approaches are developed, then reconciled by weighting the most reliable for that property type. For a typical single-family home, sales comparison leads, the cost approach supports it, and the income approach is usually omitted. For a brand-new church, the cost approach leads. For an apartment building, the income approach leads. Match the approach to the property and you will answer most valuation questions correctly.