3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs

Appraisers estimate value using three primary approaches. The exam tests when each approach fits a property type and how the core calculations work. Memorize the matchups: sales comparison for homes, cost for new or special-purpose buildings, and income for rentals.

Sales Comparison Approach (Market Data)

The sales comparison approach compares the subject to recent comparable sales (comps). It is the most common method for residential property and rests on the principle of substitution.

Steps:

1. Select at least three recent, similar, nearby sold comps.
2. Adjust each comp for differences from the subject.
3. Reconcile the adjusted comp prices into one value indication.

The golden rule: adjust the comparable, never the subject. If a comp is superior to the subject, subtract value from the comp; if a comp is inferior, add value. Remember the mnemonic CIA: Comp Inferior, Add; the reverse means subtract.

Worked Adjustment Example

The subject is 2,000 sq ft with a 2-car garage. A comp is 1,900 sq ft with a 1-car garage and sold for $390,000. Square footage is valued at $100/sq ft and a garage bay at $8,000.

The comp is inferior on both items, so we add to the comp:

• Living area: subject is 100 sq ft larger, so add 100 x $100 = +$10,000
• Garage: subject has one extra bay, so add +$8,000

Adjusted comp value = $390,000 + $10,000 + $8,000 = $408,000.

If instead the comp had a pool the subject lacks (comp superior) worth $15,000, you would subtract $15,000. After adjusting all comps, the appraiser reconciles, giving the most weight to the comp needing the fewest and smallest adjustments.

Cost Approach

The cost approach estimates value as the cost to rebuild the improvements today, minus depreciation, plus the land value. It is most reliable for new construction and special-purpose buildings (schools, churches, libraries) that rarely sell and produce no income.

Formula: Reproduction or Replacement Cost New - Depreciation + Land Value = Value.

Three forms of depreciation, all of which lower value:

• Physical deterioration: wear and tear (a worn roof). Often curable.
• Functional obsolescence: outdated design within the property (a 4-bedroom home with one bath, or no garage).
• External (economic) obsolescence: negative influences outside the property (a new landfill or freeway next door). Always incurable because the owner cannot fix it.

Cost Approach Worked Example

A newly built community center costs $1,200,000 to replace. It has accrued $150,000 in physical depreciation. The land is worth $300,000.

Value = $1,200,000 - $150,000 + $300,000 = $1,350,000.

Note that land is never depreciated in the cost approach; only the improvements lose value over time. The trap on the exam is depreciating the land or forgetting to add it back.

Income Approach

The income approach values property based on the income it produces and is the primary method for rental and investment property. It applies the principle of anticipation: a buyer pays for the expected stream of future income.

The core relationship uses the capitalization (cap) rate:

Value = Net Operating Income (NOI) / Cap Rate.

NOI is gross income minus operating expenses (it excludes mortgage debt service). Rearranged: Cap Rate = NOI / Value, and NOI = Value x Cap Rate. A higher cap rate signals higher perceived risk and a lower value for the same NOI.

Income Approach Worked Example

An apartment building generates $120,000 in net operating income. Investors in this market expect an 8% cap rate.

Value = NOI / Cap Rate = $120,000 / 0.08 = $1,500,000.

If risk rose and buyers demanded a 10% cap rate, value would fall: $120,000 / 0.10 = $1,200,000. The lesson: as the required cap rate rises, value drops even when income is unchanged. For single-family homes, the simpler Gross Rent Multiplier (GRM = Price / Monthly Rent) is sometimes used as a quick screen.

Broker Price Opinions (BPOs)

A Broker Price Opinion is a real estate broker's estimate of a property's likely selling price, prepared for a client such as a lender. Lenders order BPOs for short sales, REO (foreclosed) inventory, and portfolio review when a full appraisal is unnecessary or too slow. A BPO costs less than an appraisal but carries less authority.

Key distinctions:

• A BPO is not an appraisal and may not be used in a federally related transaction in place of one.
• It is prepared by a licensed broker, not a certified appraiser.
• Many states regulate who may charge for a BPO and forbid agents from calling it an appraisal.

Like a CMA, a BPO relies on comparable sales and active listings, but its purpose is lender decision-making rather than helping a seller set a list price.

Worked Cost Approach

The cost approach estimates value as: Reproduction or Replacement Cost New − Accrued Depreciation + Land Value. It is most reliable for new, special-purpose, or unique buildings (schools, churches) that lack comparable sales. Suppose a building costs $200 per square foot to replace, is 2,500 square feet, has accrued depreciation of 20 percent, and sits on land worth $90,000:

• Replacement cost new = 2,500 x $200 = $500,000
• Depreciation = $500,000 x 20% = $100,000
• Depreciated improvement value = $500,000 − $100,000 = $400,000
• Add land = $400,000 + $90,000 = $490,000 indicated value

Depreciation here is accrued depreciation — loss in value from physical deterioration, functional obsolescence (an outdated floor plan), or external obsolescence (a freeway built next door). Land is never depreciated.

Worked Income Approach: GRM and Cap Rate

For income property the income approach dominates. Two tools appear constantly. The Gross Rent Multiplier (GRM) is a quick screen for small residential rentals: GRM = Sale Price / Monthly Gross Rent. If comparables sell at a GRM of 110 and your subject rents for $1,800 per month, indicated value = 110 x $1,800 = $198,000.

For larger income property, use direct capitalization: Value = Net Operating Income / Capitalization Rate. NOI is gross income minus vacancy and operating expenses (but not debt service or depreciation). A building with $60,000 NOI at a 8 percent cap rate is worth $60,000 / 0.08 = $750,000. The IRV triangle ties the three together — I = R x V, R = I / V, V = I / R — so any two values solve for the third. Note the inverse relationship: as the cap rate rises, value falls for the same income.