8.2 Sales Comparison & Cost-Depreciation Approaches to Value

Sales Comparison & Cost-Depreciation Approaches to Value

Quick Reference: Real estate appraisers utilize three core valuation approaches: (1) Sales Comparison Approach (best for single-family homes and vacant land), (2) Cost-Depreciation Approach (best for new construction, unique properties, and special-purpose public buildings), and (3) Income Capitalization Approach (best for income-producing commercial and multi-family assets).

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1. The Sales Comparison Approach (Market Data Approach)

The Sales Comparison Approach (historically called the Market Data Approach) estimates market value by comparing the subject property with recently sold, similar properties in the same or competing submarket. It is universally recognized as the most reliable and heavily weighted approach for single-family residential homes, condominiums, and vacant residential building sites.

The Fundamental Law of Adjustments

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|                        GOLDEN RULE OF ADJUSTMENTS                           |
|                                                                             |
|       1. NEVER adjust the Subject Property! (It is the benchmark)           |
|       2. ALWAYS adjust the COMPARABLE Sales Prices:                         |
|                                                                             |
|          * CBS Rule: Comparable BETTER  --->  SUBTRACT from Comp            |
|          * CIA Rule: Comparable INFERIOR --->  ADD to Comp                   |
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1. Subject Property Stays Fixed: The subject property is the unvarying target being appraised; its physical characteristics and historical purchase price are never adjusted.
2. CBS Rule (Comparable Better $\rightarrow$ Subtract): If a comparable property has a superior feature or amenity that the subject lacks (e.g., comparable has a pool, subject has no pool), subtract the market value of that feature from the comparable's sale price. $\text{Adjusted Comp Price} = \text{Comp Sale Price} - \text{Contributory Value of Feature}$
3. CIA Rule (Comparable Inferior $\rightarrow$ Add): If a comparable property lacks a feature or amenity that the subject possesses (e.g., subject has an extra bathroom, comparable lacks it), add the market value of that feature to the comparable's sale price. $\text{Adjusted Comp Price} = \text{Comp Sale Price} + \text{Contributory Value of Feature}$

Systematic Order of Adjustments

Appraisal methodology mandates that adjustments be applied in a specific chronological sequence to account for transactional and market timing factors before physical characteristics:

1. Real Property Rights Conveyed: Fee simple vs. leasehold interest, life estate, or encumbered title.
2. Financing Terms (Cash Equivalency): Adjusts for non-market financing, seller-paid discount points, or creative interest rate buydowns.
3. Conditions of Sale: Adjusts for non-arm's length pressures, such as distress sales, foreclosure liquidations, or transfers between relatives.
4. Market Conditions (Date of Sale / Time Adjustment): Adjusts for appreciation or depreciation in the local market between the comparable's contract date and the subject's valuation date.
5. Location / Neighborhood: Adjusts for differences in neighborhood quality, school districts, traffic exposure, view, or waterfront access.
6. Physical Characteristics: Adjusts for gross living area (GLA), lot size, bedroom/bathroom count, pool, garage capacity, age, and condition.

Paired Sales Analysis (Matched Pairs Technique)

Appraisers determine the exact dollar adjustment for a specific feature using paired sales analysis. This technique compares two sales that are identical in all aspects except for one single characteristic, thereby isolating the market value contributed by that variable.

Paired Sales Example:

• Sale 1: 2,000 sq. ft., 3 bedrooms, 2 baths, 2-car garage, no pool $\rightarrow$ Sold for $380,000
• Sale 2: 2,000 sq. ft., 3 bedrooms, 2 baths, 2-car garage, has in-ground pool $\rightarrow$ Sold for $410,000
• Contributory Market Value of Swimming Pool: $$410,000 - $380,000 = \mathbf{$30,000}$

Step-by-Step Sales Comparison Adjustment Problem

Subject Property: 2,200 sq. ft., 3 bedrooms, 2 bathrooms, 2-car garage, has a swimming pool.

Comparable Sales Data:

• Comparable 1: Sold for $430,000; 2,200 sq. ft., 3 bedrooms, 2 bathrooms, 2-car garage, no pool.
• Comparable 2: Sold for $475,000; 2,200 sq. ft., 4 bedrooms (extra bedroom worth $15,000), 2 bathrooms, 2-car garage, has a pool.
• Comparable 3: Sold for $415,000; 2,200 sq. ft., 3 bedrooms, 2 bathrooms, 1-car garage (subject 2-car garage has $10,000 superior value), has a pool.
• Contributory value of a swimming pool derived from market = $25,000.

Reconciliation of Adjusted Values

An appraiser never averages the adjusted values mathematically. Instead, the appraiser assigns percentage weights based on which comparable required the fewest adjustments, the lowest gross adjustment percentage, and the highest degree of physical/locational similarity:

• Comp 1 (Weight: 50% - most similar, single amenity adjustment): $$455,000 \times 0.50 = $227,500$
• Comp 2 (Weight: 30% - recent sale, same subdivision): $$460,000 \times 0.30 = $138,000$
• Comp 3 (Weight: 20% - older sale date): $$425,000 \times 0.20 = $85,000$
• Indicated Value via Reconciliation: $$227,500 + $138,000 + $85,000 = \mathbf{$450,500}$

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2. The Cost-Depreciation Approach

The Cost-Depreciation Approach (also known as the Cost Approach or Summation Approach) is based on the principle that the value of an improved property equals the value of the land (as if vacant) plus the current cost to construct the improvements new, less all accrued depreciation.

Primary Applicability

The Cost-Depreciation Approach is the most reliable and primary valuation method for:

1. New Construction: Where physical deterioration is zero or negligible.
2. Special-Purpose / Institutional Properties: Buildings rarely bought or sold on the open market, such as public schools, churches, courthouses, libraries, fire stations, and specialized industrial plants.
3. Unique Architectural Properties: Structures with no comparable market sales and no income-producing capacity.

The Cost Approach Formula

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|                        COST APPROACH VALUATION FORMULA                      |
|                                                                             |
|      Estimated Land Value (Estimated separately via Sales Comparison)       |
|   +  Reproduction or Replacement Cost New of Primary Building Structure    |
|   -  Accrued Depreciation (Physical + Functional + External)                |
|   +  Depreciated Value of Site Improvements (Paving, landscaping, fences)  |
|   =  INDICATED PROPERTY VALUE                                               |
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Critical Exam Rule: LAND NEVER DEPRECIATES! Land is always valued separately using the Sales Comparison Approach based on its highest and best use as if vacant. Accrued depreciation is subtracted strictly from the cost new of the physical improvements.

Reproduction Cost vs. Replacement Cost

Cost Estimating Methods

1. Comparative-Unit (Square-Foot) Method: The most common method used by appraisers. Multiplies the gross living area (square footage) of the structure by a verified regional cost per square foot for that specific construction class (e.g., $180 per sq. ft. $\times$ 2,500 sq. ft. = $450,000).
2. Unit-in-Place Method: Calculates the cost of structural components installed in place (cost per square foot of concrete foundation, cost per square foot of framing, cost per square foot of roofing, cost per linear foot of plumbing).
3. Quantity Survey Method: The most detailed, exhaustive, and precise method. An itemized engineering breakdown of every raw material item (board feet of lumber, linear feet of conduit, bags of cement), labor hours, permit fees, contractor overhead, and entrepreneurial profit.

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3. The Three Types of Accrued Depreciation

Accrued Depreciation is the total loss in property value resulting from any cause relative to its reproduction or replacement cost new.

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|                       THREE TYPES OF ACCRUED DEPRECIATION                   |
+-----------------------------------------------------------------------------+
| 1. PHYSICAL DETERIORATION  --> Wear & tear, decay, weathering               |
|    * Curable:   Cost to repair <= Value added (e.g., peeling paint)         |
|    * Incurable: Cost to repair > Value added / structural (e.g., foundation)|
|                                                                             |
| 2. FUNCTIONAL OBSOLESCENCE --> Design flaws, outdated layout within boundary|
|    * Curable:   Economically practical to modernize (e.g., fixtures)        |
|    * Incurable: Impractical/excessive cost to fix (e.g., 4-bed/1-bath, layout)|
|                                                                             |
| 3. EXTERNAL OBSOLESCENCE   --> Outside property boundaries                  |
|    * ALWAYS INCURABLE by property owner (e.g., flight path, toxic dump)     |
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1. Physical Deterioration

Loss in value caused by normal wear and tear, physical decay, deferred maintenance, aging of materials, and exposure to the elements:

• Curable: An item where the expenditure required to cure the defect is less than or equal to the resulting increase in property value (e.g., repainting peeling exterior siding, replacing worn carpet, repairing a broken window sash).
• Incurable: An item where the cost to repair exceeds the resulting value added, or structural components not scheduled for replacement during the building's economic life (e.g., deteriorating foundation footings, weakened internal load-bearing framing).

2. Functional Obsolescence

Loss in value resulting from structural, architectural, or design deficiencies, outdated technology, or over-improvements located within the property boundaries:

• Curable: Outmoded or deficient features that can be economically replaced or modernized (e.g., outdated plumbing fixtures, inadequate electrical service outlets, converting an obsolete lighting system).
• Incurable: Deficiencies that are structurally unfeasible or economically impractical to reconfigure (e.g., a four-bedroom house with only one bathroom; a tandem floor plan where accessing one bedroom requires walking through another; residential ceilings only 7 feet high in a modern executive submarket).

3. External (Economic / Locational) Obsolescence

Loss in value caused by negative economic, governmental, environmental, or social conditions located outside the property boundaries:

• Always Incurable: External obsolescence is always incurable by the individual property owner because the owner has no legal control over off-site factors.
• Examples: Property adjacent to a newly constructed expressway, residential home beneath a major airport jet landing flight path, nearby chemical plant emissions, zoning change permitting an adjacent industrial landfill, or severe neighborhood economic decline.

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4. The Age-Life Depreciation Method

The Age-Life Method (also called the Straight-Line Depreciation Method) assumes that a building depreciates at a uniform, linear rate over its total estimated economic life.

Key Definitions

• Chronological Age: The actual calendar age of the structure based on the date of original construction.
• Effective Age: The age indicated by the structure's physical condition, maintenance, and utility. Effective age may be substantially less than chronological age if the building has been well-maintained or modernized.
• Total Economic Life: The total estimated number of years the improvement will contribute value to the land.
• Remaining Economic Life: The remaining period of time over which improvements are anticipated to generate economic utility ($Total\ Economic\ Life - Effective\ Age$).

Age-Life Formulas

$\text{Depreciation Rate per Year} = \frac{1}{\text{Total Economic Life}}$

$\text{Depreciation Percentage} = \frac{\text{Effective Age}}{\text{Total Economic Life}}$

$\text{Accrued Depreciation (\$)} = \left(\frac{\text{Effective Age}}{\text{Total Economic Life}}\right) \times \text{Reproduction / Replacement Cost New}$

$\text{Depreciated Value of Structure} = \text{Cost New} - \text{Accrued Depreciation}$

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5. Comprehensive Worked Mathematical Problems

Problem 1: Full Cost-Depreciation Approach Valuation

Property Facts:

• Subject building measures 3,000 square feet.
• Current construction replacement cost is $160 per square foot.
• Chronological age is 20 years; effective age is determined by the appraiser to be 12 years.
• Total estimated economic life of the building is 60 years.
• Accrued external obsolescence due to adjacent highway noise is estimated at $18,000.
• Depreciated value of on-site improvements (driveway, fence, landscaping) is $24,000.
• Estimated market value of the land parcel (via Sales Comparison) is $110,000.

Step-by-Step Solution:

1. Calculate Replacement Cost New: $\text{Cost New} = 3,000\text{ sq. ft.} \times \$160/\text{sq. ft.} = \mathbf{\$480,000}$
2. Calculate Age-Life Accrued Depreciation: $\text{Depreciation Ratio} = \frac{12\text{ years Effective Age}}{60\text{ years Total Economic Life}} = 0.20\text{ (or }20\%\text{)}$ $\text{Age-Life Depreciation} = \$480,000 \times 0.20 = \mathbf{\$96,000}$
3. Calculate Total Accrued Depreciation: $\text{Total Depreciation} = \$96,000\text{ (Age-Life)} + \$18,000\text{ (External)} = \mathbf{\$114,000}$
4. Calculate Depreciated Value of Building Improvements: $\text{Depreciated Building} = \$480,000 - \$114,000 = \mathbf{\$366,000}$
5. Add Depreciated Site Improvements: $\text{Total Depreciated Improvements} = \$366,000 + \$24,000 = \mathbf{\$390,000}$
6. Add Estimated Land Value: $\text{Indicated Property Value} = \$390,000 + \$110,000 = \mathbf{\$500,000}$

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