3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Sales comparison fits residential, cost fits new/special-purpose, income fits income-producing property.
- In sales comparison, adjust the comp only: Comp Better Subtract, Comp Inferior Add.
- Cost approach = replacement cost new - depreciation + land; external obsolescence is always incurable.
- Income approach: Value = NOI / cap rate; NOI excludes mortgage and depreciation, and value falls as cap rate rises.
- GRM (Value = Monthly Rent x GRM) is a quick gross-rent shortcut for 1-4 unit rentals; BPOs/CMAs are licensee tools, not appraisals.
Three Approaches, One Goal
Appraisers develop value through three approaches and then reconcile them. Each rests on the principle of substitution - a buyer pays no more than the cost of an equally desirable alternative. The exam wants you to match property type to the most reliable approach:
- Sales comparison - best for typical residential homes
- Cost - best for new, special-purpose, or unique properties (schools, churches, libraries) with few comparable sales
- Income - best for income-producing property (apartments, offices, retail)
Knowing the best-fit approach is worth more exam points than any single calculation.
Sales Comparison Approach
The sales comparison approach values the subject by analyzing recent sales of similar properties (comparables, or "comps") and adjusting for differences. The single most-tested rule:
Adjust the COMPARABLE, never the subject. If the comp is superior, SUBTRACT from the comp's price. If the comp is inferior, ADD to the comp's price.
Memory aid: CBS / CIA - Comp Better, Subtract; Comp Inferior, Add. You are mathematically transforming each comp into a clone of the subject so its adjusted sale price reflects what the subject should bring.
Worked Adjustment Example
Subject: 2,000 sq ft, 2-car garage. Comparable sold for $390,000; it has 1,900 sq ft and a 1-car garage. Living area is valued at $100/sq ft; a garage bay is worth $8,000.
| Feature | Subject | Comp | Difference | Adjustment to Comp |
|---|---|---|---|---|
| Living area | 2,000 | 1,900 | +100 sq ft | + $10,000 |
| Garage | 2 bays | 1 bay | +1 bay | + $8,000 |
The comp is inferior on both features, so we ADD: $390,000 + $10,000 + $8,000 = $408,000 indicated value for the subject. Trap: never adjust the subject's own figures; only the comp moves.
Worked Example: Each Approach in Numbers
Sales comparison approach. The appraiser adjusts comparable sales to the subject. Rule: adjust the comparable, never the subject; if the comp is superior, subtract; if inferior, add. A comp sold for $600,000 but has an extra garage worth $20,000 the subject lacks, so subtract: $600,000 - $20,000 = $580,000 indicated value.
Cost approach. Value = land value + (reproduction or replacement cost of improvements - accrued depreciation). If land is worth $300,000, the building costs $400,000 new, and it has lost $90,000 to depreciation, the indicated value is $300,000 + ($400,000 - $90,000) = $610,000. The cost approach is most reliable for new or special-purpose buildings (schools, churches) that rarely sell.
Income approach. For income property, Value = net operating income / capitalization rate. With NOI of $48,000 and a market cap rate of 8%, value = $48,000 / 0.08 = $600,000. A broker price opinion (BPO) is a less formal value estimate a licensee may prepare, but it is not an appraisal and may not be called one.
A comparable sold for $420,000 and has a swimming pool worth $20,000; the subject has no pool. All else is equal. What is the indicated value of the subject?
Cost Approach
The cost approach estimates value as: land value + cost to rebuild the improvements new - accrued depreciation. It shines for new construction and special-purpose buildings that rarely sell. The formula:
Value = Reproduction/Replacement Cost New - Depreciation + Land Value
Two cost types: reproduction cost rebuilds an exact replica (same materials), while replacement cost builds a functional equivalent using modern materials. Land is valued separately by sales comparison because land does not depreciate.
Three Types of Depreciation
Depreciation in the cost approach is loss in value from any cause. Three categories appear on the exam:
- Physical deterioration - wear and tear (worn roof, peeling paint); often curable.
- Functional obsolescence - outdated design inside the property line (a 4-bedroom house with one bath, no closets).
- External (economic) obsolescence - value loss from outside forces (a freeway built behind the lot, a declining job market); always incurable because the owner cannot fix what is off-site.
Memory hook: external is the only type the owner cannot cure on the property itself.
A home loses value because a new sewage-treatment plant was built next door. This is an example of:
Income Approach
The income approach converts a property's income stream into value. For larger commercial property, appraisers use direct capitalization:
Value = Net Operating Income (NOI) / Capitalization Rate
NOI is gross income minus operating expenses (but not mortgage payments or depreciation). Example: a building with $60,000 NOI and a market cap rate of 8% (0.08) is worth $60,000 / 0.08 = $750,000. Note the inverse relationship: as the cap rate rises, value falls. A higher cap rate signals higher perceived risk.
GRM for Small Residential Rentals
For 1-4 unit rentals, appraisers often use the Gross Rent Multiplier (GRM), a quick income shortcut:
Value = Monthly Gross Rent x GRM, where GRM = Sale Price / Monthly Rent
Example: comparable rentals sell at a GRM of 120. The subject rents for $2,500/month. Estimated value = $2,500 x 120 = $300,000. GRM uses gross rent and ignores expenses, so it is a rough indicator, not a substitute for full capitalization. Some texts use a Gross Income Multiplier (GIM) based on annual income - read the units carefully.
A commercial property has a net operating income of $90,000 and the market capitalization rate is 9%. What is its indicated value?
BPOs and the Licensee's Role
A Broker Price Opinion (BPO) is a value estimate prepared by a real estate licensee, typically for a lender deciding on a short sale, foreclosure, or loan workout. It is faster and cheaper than an appraisal but carries less weight and is not USPAP-governed. A CMA serves the same analytic purpose for setting a listing or offer price. Critical rule: a licensee must never present a BPO or CMA as an appraisal, and most states bar charging a separate appraisal-style fee without an appraiser credential. Use the right tool, label it correctly, and stay within license scope.