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

Approach 1: Sales comparison (the market approach)

The sales comparison approach estimates value by comparing the subject to recently sold, similar properties (comparables, or "comps") and adjusting their sale prices for differences. It rests on the principle of substitution and is the most reliable approach for single-family homes.

The golden rule of adjustments

Always adjust the comparable, never the subject. Then:

• If the comp is superior to the subject in a feature, subtract that feature's value from the comp.
• If the comp is inferior to the subject, add value to the comp.

Mnemonic: CBS / CIA — Comp Better, Subtract; Comp Inferior, Add. You are answering: what would this comp have sold for if it were just like the subject?

Worked example: sales comparison adjustment

The subject has 3 bedrooms, 2 baths, and a 2-car garage. A comparable sold for $300,000 with 4 bedrooms (worth +$12,000), 2 baths, and a 1-car garage (a garage bay is worth $8,000).

Adjusted comp value: $300,000 − $12,000 + $8,000 = $296,000.

The comp's extra bedroom was a feature the subject lacks, so we strip its value out (subtract). The comp's smaller garage made it inferior, so we add the missing bay's value. The indicated value from this comp is $296,000.

Approach 2: The cost approach

The cost approach says a buyer will pay no more than the cost to acquire the land and build an equivalent structure. The formula:

Value = Land Value + (Cost to Reproduce/Replace Improvements − Accrued Depreciation)

• Reproduction cost = cost to build an exact replica (same materials/design).
• Replacement cost = cost to build a functional equivalent using current materials/methods (used more often).
• Accrued depreciation = total loss in value from all causes since construction.

Three forms of depreciation

1. Physical deterioration — wear, tear, age (curable or incurable).
2. Functional obsolescence — outdated design, a one-car garage, a bedroom only reachable through another bedroom.
3. External (economic) obsolescence — loss from outside the property line (a freeway, a closed factory). External obsolescence is always incurable because the owner cannot fix it.

Worked example

Land value $90,000; replacement cost of the house $250,000; accrued depreciation $40,000.

Value = $90,000 + ($250,000 − $40,000) = $300,000.

The cost approach is most reliable for new construction and special-purpose property (schools, libraries, churches) where comps and income data are scarce.

Approach 3: The income approach

For income-producing property (apartments, retail, office), value flows from the income stream. The core relationship is IRV:

Income = Rate × Value, rearranged to Value = Income (NOI) ÷ Rate (cap rate).

First find Net Operating Income (NOI):

• Potential gross income − vacancy/collection loss = effective gross income
• Effective gross income − operating expenses = NOI (debt service is not an operating expense and is excluded)

Worked example

A building has potential gross income of $120,000, 5% vacancy, and operating expenses of $44,000. The market cap rate is 8%.

• Vacancy loss: $120,000 × 0.05 = $6,000 → effective gross income $114,000
• NOI: $114,000 − $44,000 = $70,000
• Value: $70,000 ÷ 0.08 = $875,000

Cap-rate trap: at the same NOI, a higher cap rate gives a lower value (more risk). At a 10% cap rate the value would be $70,000 ÷ 0.10 = $700,000. Raising the rate from 8% to 10% dropped value $175,000.

Broker price opinions (BPOs) and choosing the approach

A BPO is a written estimate of probable selling price prepared by a real estate licensee, frequently ordered by lenders for short sales, REO disposition, or loan-default servicing where a full appraisal is not required. It uses the same comparison logic as a CMA but is documented for a third party. A BPO is not an appraisal and cannot replace one for most federally related loan decisions.

Which approach leads for which property?

Reconciliation (from 3.2) then weights these. The exam reward is recognizing that approach selection follows property type and data availability — not personal preference.

Reconciling the three approaches into one opinion

After deriving an indicated value from each applicable approach, the appraiser reconciles them — and this is a heavily tested step because candidates assume it means averaging. It does not. The appraiser weighs each approach by its reliability for this property type and the quantity and quality of data behind it.

Worked reconciliation

Suppose a single-family home yields these indicated values:

The appraiser gives the most weight to sales comparison ($298,000) and reports a final opinion close to it, perhaps $300,000 — not the simple average of $293,333. The reasoning, not the arithmetic, earns the point.

Effective age vs. actual age and depreciation

The cost approach often turns on effective age (the age the condition suggests) rather than actual age (chronological). A well-maintained 30-year-old home may have an effective age of 15. Annual straight-line depreciation = cost ÷ economic life; a home with a $200,000 improvement cost and a 50-year economic life loses $4,000 per year, so 10 years of effective age yields $40,000 of accrued depreciation. Recognizing which "age" the problem supplies is the trap the exam sets.