3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
The sales comparison approach adjusts comparables to the subject; adjust the comp, never the subject, and subtract for superior comp features.
The cost approach equals reproduction or replacement cost minus depreciation plus land value, and is best for new or special-purpose properties.
Depreciation has three forms: physical deterioration, functional obsolescence, and external (economic) obsolescence.
The income approach uses capitalization: Value = Net Operating Income / Capitalization Rate; the GRM is a quick screening tool for residential rentals.
A BPO is an agent's price opinion for listing or lending, narrower and cheaper than a formal appraisal.
The Three Approaches to Value
Appraisers use up to three approaches, each rooted in the principle of substitution. The most appropriate approach depends on the property type:
- Sales comparison - best for homes and land (active markets with comps).
- Cost - best for new, unique, or special-purpose buildings (schools, churches).
- Income - best for income-producing property (apartments, offices, retail).
Sales Comparison Approach (SCA)
The SCA values the subject by comparing recently sold, similar properties (comparables or comps) and adjusting for differences. The golden rule: adjust the comparable, not the subject.
- If the comp is superior (e.g., it has an extra bathroom the subject lacks), subtract from the comp's price.
- If the comp is inferior, add to the comp's price.
Worked example - subject sold price unknown:
| Feature | Comp A sold price | Adjustment |
|---|---|---|
| Base sale price | $400,000 | - |
| Comp has extra garage bay (superior) | -$8,000 | |
| Subject has updated kitchen (comp inferior) | +$10,000 | |
| Comp has larger lot (superior) | -$5,000 | |
| Adjusted indicated value | $397,000 |
We start at $400,000, subtract $8,000 and $5,000 for the comp's superior features, and add $10,000 because the comp is inferior on the kitchen, indicating $397,000 for the subject.
Reconciliation and the right approach for the property
After completing the applicable approaches, the appraiser reconciles — weighting the most reliable approach for the assignment, never averaging. The weighting follows the property type:
| Property | Most reliable approach | Why |
|---|---|---|
| Typical single-family home | Sales comparison | Active market, many comps |
| New or special-purpose (school, church, library) | Cost | Few/no comparable sales |
| Apartment, office, retail | Income | Buyers pay for the income stream |
| Vacant residential land | Sales comparison | Comps of similar lots |
Effective age, economic life, and the age-life method
Depreciation in the cost approach is often estimated by the age-life (straight-line) method: accrued depreciation = (effective age / total economic life) x reproduction or replacement cost of improvements. A building with an effective age of 12 years (how old it acts, after renovations) and a total economic life of 60 years has depreciated 12/60 = 20%. On $300,000 of improvement cost, that is $60,000 of depreciation, leaving $240,000 before land is added back at full value.
Note effective age can be lower than actual age when a building is well maintained or renovated, or higher when it is neglected — a frequent exam distinction.
A comparable sold for $350,000. It has a finished basement the subject lacks, worth $15,000, and the subject has a deck the comp lacks, worth $6,000. What is the adjusted value indication for the subject?
$329,000
$341,000
$359,000
$371,000
Cost Approach
The cost approach reasons that a buyer would pay no more than the cost to build an equivalent. The formula is:
Value = (Reproduction or Replacement Cost - Depreciation) + Land Value
- Reproduction cost rebuilds an exact replica (same materials).
- Replacement cost rebuilds equivalent utility with modern materials and is more commonly used.
Worked example:
| Item | Amount |
|---|---|
| Replacement cost of improvements | $320,000 |
| Less: accrued depreciation | -$48,000 |
| Depreciated improvement value | $272,000 |
| Plus: land value (always added at full value, land does not depreciate) | +$90,000 |
| Indicated value | $362,000 |
The cost approach shines for new construction and special-purpose properties where comps are scarce. A trap: land is never depreciated - depreciation applies only to improvements.
The Three Types of Depreciation
Depreciation in appraisal means loss in value from any cause. There are three categories:
| Type | Cause | Curable? | Example |
|---|---|---|---|
| Physical deterioration | Wear, tear, age | Often curable | Worn roof, peeling paint |
| Functional obsolescence | Outdated design or features | Sometimes curable | One-car garage, no central air, bedroom only reachable through another |
| External (economic) obsolescence | Factors outside the property | Incurable | New landfill nearby, declining neighborhood, high interest rates |
The key distinction: external obsolescence comes from outside the property line and is always considered incurable because the owner cannot fix it.
Income Approach
For income-producing property, value derives from the income it generates. The core formula uses direct capitalization:
Value = Net Operating Income (NOI) / Capitalization Rate
NOI is effective gross income minus operating expenses (it excludes debt service and depreciation). Worked example:
| Item | Amount |
|---|---|
| Effective gross income | $96,000 |
| Less: operating expenses | -$36,000 |
| Net operating income (NOI) | $60,000 |
| Capitalization rate | 8% (0.08) |
| Value = $60,000 / 0.08 | $750,000 |
Note the inverse relationship: a higher cap rate yields a lower value (more risk demanded), and a lower cap rate yields a higher value. If the cap rate rose to 10%, value would fall to $600,000.
Gross Rent Multiplier (GRM)
For small residential rentals, appraisers use a quick screening tool, the gross rent multiplier:
GRM = Sale Price / Gross Monthly Rent
If comparable rentals sell at a GRM of 150 and the subject rents for $2,000/month, the estimated value is 150 x $2,000 = $300,000. The GRM uses gross rent (not net), ignores expenses, and is a rough indicator only - never a substitute for full capitalization. A variant, the gross income multiplier (GIM), uses annual income.
Broker Price Opinions and CMAs
A broker price opinion (BPO) is a licensed agent's or broker's estimate of likely sale price, often ordered by lenders for short sales, foreclosures, or portfolio reviews. A comparative market analysis (CMA) is similar but typically prepared to help a seller set a list price.
Both rely mainly on comparable sales but are not appraisals: they are faster, cheaper, performed by licensees rather than appraisers, and may not be used in place of an appraisal for a federally related transaction. Many states bar agents from calling a BPO an 'appraisal' or charging appraisal-style fees for one.
An apartment building has a net operating income of $84,000. Investors in the market expect a 7% capitalization rate. Using direct capitalization, the indicated value is:
$588,000
$1,200,000
$1,176,000
$1,000,000
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