3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- The sales comparison approach adjusts comparable sales to the subject: adjust the COMP, never the subject (subtract for superior features, add for inferior)
- The cost approach = land value + (reproduction/replacement cost − accrued depreciation); best for new and special-purpose property
- Depreciation has three forms: physical deterioration, functional obsolescence, and external (economic) obsolescence — external is incurable
- The income approach uses the IRV formula: Value = Net Operating Income ÷ Capitalization Rate
- A higher cap rate produces a lower value; cap rate and value move in opposite directions
3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Appraisers develop value using three approaches. Each rests on a different principle, fits a different property type, and shows up with numeric questions on the exam.
Sales comparison approach
The sales comparison approach (also called the market data approach) estimates value by comparing the subject to recently sold, similar properties and adjusting for differences. It is built on the principle of substitution and is the most reliable approach for residential, owner-occupied homes.
The golden rule, and the most common error students make: adjust the comparable, never the subject.
- If the comparable is superior to the subject (it has an extra bathroom), subtract that value from the comparable's price.
- If the comparable is inferior (it lacks a garage the subject has), add value to the comparable's price.
Sales comparison — worked example
A comparable home sold for $300,000. Compared to the subject:
| Difference | Adjustment to comp | Amount |
|---|---|---|
| Comp has an extra bathroom (superior) | Subtract | −$8,000 |
| Comp lacks a garage the subject has (inferior) | Add | +$15,000 |
| Comp has a larger lot (superior) | Subtract | −$5,000 |
Adjusted sale price = $300,000 − $8,000 + $15,000 − $5,000 = $302,000.
The adjusted figure is an indicated value for the subject. An appraiser uses several comparables, adjusts each, and reconciles them. Remember: the direction of the adjustment is always relative to the comparable's features, never the subject's.
A comparable sold for $250,000. It has a finished basement the subject lacks (worth $12,000) and is missing a deck the subject has (worth $6,000). What is the adjusted sale price of the comparable?
Cost approach
The cost approach is based on the principle of substitution applied to construction: a buyer would pay no more than the cost to build an equivalent property. The formula is:
Value = Land Value + (Reproduction or Replacement Cost of Improvements − Accrued Depreciation)
Land is added separately because land does not depreciate. Reproduction cost recreates an exact replica; replacement cost builds a structure of equal utility with modern materials. The cost approach is most reliable for new construction and special-purpose properties (schools, churches, libraries) that rarely sell and produce no rent.
The three types of depreciation
Accrued depreciation is loss in value from any cause. The exam tests three forms and whether each is curable:
| Type | Cause | Curable? |
|---|---|---|
| Physical deterioration | Wear and tear, age, deferred maintenance | Often curable (new roof, paint) |
| Functional obsolescence | Outdated design or features (one bathroom, no closets, awkward layout) | Sometimes curable |
| External / economic obsolescence | Negative factors outside the property (nearby landfill, busy highway, declining area) | Always incurable — the owner cannot fix off-site causes |
External obsolescence being incurable is a favorite test point: you cannot cure something you do not control.
Cost approach — worked example
Land value is $80,000. Replacement cost of the house is $220,000. Accrued depreciation totals $35,000.
Value = $80,000 + ($220,000 − $35,000) = $80,000 + $185,000 = $265,000.
Notice the depreciation is subtracted only from the improvements, never from the land. If a question subtracts depreciation from the land too, it is wrong.
Income approach and the IRV formula
The income approach values property by the income it produces, making it the primary method for rental and investment property (apartments, office, retail). It uses the IRV formula:
Income = Rate × Value, rearranged to Value = Net Operating Income (NOI) ÷ Capitalization Rate
NOI is income after operating expenses but before mortgage payments (debt service is not an operating expense). The capitalization rate reflects the return an investor requires.
Worked example: a building has an NOI of $60,000 and the market cap rate is 8% (0.08).
Value = $60,000 ÷ 0.08 = $750,000.
Key relationship: cap rate and value move inversely. If investors demand a 10% return instead, Value = $60,000 ÷ 0.10 = $600,000 — a higher cap rate yields a lower value.
An apartment building produces $90,000 in net operating income. Investors in this market expect a 9% capitalization rate. Using the income approach, what is the indicated value?
Broker Price Opinions (BPOs) and the GRM
For smaller residential income property, appraisers and brokers sometimes use the Gross Rent Multiplier (GRM): Value = Monthly Gross Rent × GRM. If similar properties sell at a GRM of 120 and the subject rents for $2,000/month, value ≈ $240,000. GRM is a quick screen, not a full income analysis, because it ignores expenses and vacancy.
A Broker Price Opinion (BPO) is a licensee's opinion of probable selling price, frequently ordered by lenders for short sales, REO, or loan-servicing decisions when a full appraisal is not required. A BPO often resembles a CMA in method but, like a CMA, it is not an appraisal and may not be represented as one. Knowing the boundary between a licensee's BPO/CMA and a certified appraiser's USPAP appraisal is essential exam knowledge.
Which approach dominates — a final review
The exam consistently tests matching the right approach to the right property type. Lock in this table:
| Property type | Primary approach | Why |
|---|---|---|
| Single-family owner-occupied home | Sales comparison | Plenty of similar sales; principle of substitution |
| New construction | Cost | Cost data is fresh; little depreciation to estimate |
| Special-purpose (church, school) | Cost | Rarely sells, produces no rent, no comparables |
| Apartment / office / retail | Income | Buyers buy for the income stream; IRV applies |
Reconciliation then weights these indicated values; it never simply averages them. For a duplex or small rental, an appraiser may blend the sales comparison and income approaches. Mastering both the formulas and the judgment of which approach leads is what separates a passing score from a near miss on the value portion of the national exam.
An appraiser is valuing a newly built public library that has never been sold and generates no rental income. Which valuation approach should the appraiser rely on most heavily?