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

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:

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:

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.

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:

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:

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:

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.