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

The Three Approaches to Value

Appraisers and licensees rely on three methods. Knowing which fits which property is the most-tested idea in this section:

• Sales Comparison Approach — best for single-family homes and vacant land; grounded in substitution.
• Cost Approach — best for new, unique, or special-purpose properties (schools, churches, libraries) where comparable sales are scarce.
• Income Approach — best for income-producing property (apartments, office, retail) where value flows from rent.

Sales Comparison Approach

The appraiser finds recent comparable sales ("comps") and adjusts each comp to the subject property. The cardinal rule:

Adjust the COMP, 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.

Worked example: A comp sold for $300,000. Compared to the subject:

Adjusted comp value = 300,000 − 5,000 + 8,000 − 10,000 = $293,000. The subject's indicated value tracks the adjusted comps.

Cost Approach

Formula:

Value = Land Value + (Replacement/Reproduction Cost of Improvements − Accrued Depreciation)

Distinguish the two cost types: reproduction cost recreates an exact replica; replacement cost builds equivalent utility with modern materials. Then subtract accrued depreciation in three forms:

• Physical deterioration — wear and tear (curable or incurable).
• Functional obsolescence — outdated design (e.g., a 4-bedroom house with one bath).
• External (economic) obsolescence — caused by factors outside the property (a freeway next door); always incurable.

Worked example: Land $90,000; replacement cost of improvements $250,000; accrued depreciation $40,000. Value = 90,000 + (250,000 − 40,000) = $300,000.

Income Approach and the GRM

For large income property, appraisers use direct capitalization:

Value = Net Operating Income (NOI) ÷ Capitalization Rate

Worked example: A building's NOI is $60,000 and the market cap rate is 8% (0.08). Value = 60,000 ÷ 0.08 = $750,000. Note the inverse relationship: a higher cap rate yields a lower value.

For small residential rentals, a quicker tool is the Gross Rent Multiplier (GRM):

GRM = Sales Price ÷ Monthly Gross Rent, so Value = GRM × Monthly Rent

If comps show a GRM of 120 and the subject rents for $2,000/month, value = 120 × 2,000 = $240,000. (A Gross Income Multiplier, GIM, uses annual income instead.)

BPOs and the Salesperson's Role

A Broker Price Opinion (BPO) is an estimate of likely sales price prepared by a licensee, often ordered by lenders for short sales, REOs, or portfolio reviews. It typically uses an abbreviated sales comparison method. A CMA serves the same function when pricing a listing for a seller.

Critical limits to remember:

• A BPO/CMA is not an appraisal and must never be labeled one.
• BPOs generally cannot be used in place of an appraisal for a new federally related mortgage origination.
• The licensee's opinion is grounded in substitution and recent comps, mirroring the sales comparison approach in simplified form.

Trap watch: if a question pairs a single-family home with the income approach, that is the wrong fit — homes are valued by sales comparison; income property is valued by capitalization.

Worked Example: Sales Comparison Adjustments

The sales comparison approach adjusts comparable sales to the subject. The rule the exam tests: adjust the comparable, never the subject — CIA (Comparable Inferior, Add; comparable superior, subtract).

A subject home has 3 bedrooms and a garage. A comparable sold for $300,000 but has only 2 bedrooms (the market values the extra bedroom at $15,000) and no garage (worth $10,000).

• Comp is inferior by one bedroom: add $15,000.
• Comp is inferior by lacking a garage: add $10,000.
• Adjusted comparable value = $300,000 + $15,000 + $10,000 = $325,000.

If instead the comp were superior (a pool the subject lacks, worth $20,000), you would subtract $20,000 from the comp.

Worked Example: GRM and the Income Approach

The gross rent multiplier (GRM) is a quick income tool for small residential rentals: GRM = sale price / monthly gross rent. If comparable rentals sell at a GRM of 125 and the subject rents for $2,400 per month, indicated value = 125 x $2,400 = $300,000.

For commercial income property the exam uses the capitalization formula: Value = Net Operating Income / Cap Rate. With an NOI of $48,000 and a market cap rate of 8%, Value = $48,000 / 0.08 = $600,000. Note that higher cap rates produce lower values (more risk, less price) — a relationship the exam loves to test in reverse: raise the cap rate to 10% and the same NOI supports only $480,000.

Cost Approach: Reproduction, Replacement, and Depreciation

The cost approach estimates value as land value + (cost to build new - accrued depreciation). It is most reliable for new or special-purpose properties (schools, churches, libraries) that rarely sell and produce little income. The exam separates reproduction cost (an exact replica, same materials) from replacement cost (equivalent utility with modern materials) — replacement cost is the practical standard.

Accrued depreciation comes in three forms the exam tests by example:

Worked Example: Cost Approach Total

A site is worth $90,000. Replacement cost new of the building is $300,000. Accrued depreciation is $45,000 (physical) + $15,000 (functional) = $60,000.

• Depreciated building value = $300,000 - $60,000 = $240,000.
• Indicated value = land $90,000 + $240,000 = $330,000.

External obsolescence is the trap answer for "incurable" — an owner cannot fix the freeway next door, so that loss is permanent and is measured by the market's reaction, not by a repair cost.