3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Sales comparison is the primary approach for residential property; the adjustment rule is CBS, Comp is Better Subtract, and add value when the comp is worse
- Cost approach: Value = Land Value + (Reproduction or Replacement Cost - Accrued Depreciation); best for new, unique, or special-purpose property
- Income approach: Value = NOI / Cap Rate, where NOI = effective gross income minus operating expenses; best for income-producing property
- The three depreciation types are physical deterioration, functional obsolescence, and external (economic) obsolescence; external obsolescence is always incurable
- Reconciliation selects the approach with the most reliable data; a BPO or CMA never replaces a formal appraisal in lending
The Three Approaches and When to Use Each
Appraisers develop up to three approaches and reconcile them. The exam rewards matching the right approach to the property.
- Sales comparison approach - for typical residential property with good comparable sales.
- Cost approach - for new construction, churches, schools, and other special-purpose property with few comps.
- Income approach - for income-producing property such as apartments and commercial buildings.
Sales Comparison Approach
The sales comparison approach estimates value by comparing the subject to recently sold, similar properties (comparables, or comps) and adjusting for differences. It rests on the principle of substitution.
The adjustment rule is the part most often missed. You always adjust the comparable, never the subject. Use the memory aid CBS - Comp Better, Subtract:
- If the comp is superior to the subject, subtract value from the comp.
- If the comp is inferior to the subject, add value to the comp.
- If a feature is equal, no adjustment.
Worked Example: Sales Comparison
The subject is a 2,000-square-foot home with a 2-car garage. A comparable sold for $390,000; it has 1,900 square feet and a 1-car garage. The market shows finished living area is worth $100 per square foot and a garage bay is worth $8,000.
The comp is inferior on both features, so we add to the comp:
- Add $10,000 for 100 missing square feet (100 x $100)
- Add $8,000 for the missing garage bay
Adjusted comp value = $390,000 + $10,000 + $8,000 = $408,000.
If instead the comp had a pool worth $15,000 that the subject lacks, the comp would be superior on that feature and you would subtract $15,000. Mixing the direction is the classic trap: superior comp means subtract.
A comparable sold for $415,000. It has an extra bathroom worth $9,000 that the subject lacks, and it lacks a deck worth $4,000 that the subject has. What is the adjusted value of the comparable?
Cost Approach
The cost approach assumes a buyer will pay no more than the cost to acquire the land and build an equivalent improvement, less depreciation. The formula:
Value = Land Value + (Reproduction or Replacement Cost - Accrued Depreciation)
- Reproduction cost - cost to build an exact replica using the same materials.
- Replacement cost - cost to build a structure of equal utility using current materials and methods. Replacement cost is more commonly used.
Three Types of Depreciation
Depreciation is loss in value from any cause. Memorize the three types and whether each is curable:
| Type | Cause | Example | Curable? |
|---|---|---|---|
| Physical deterioration | Wear and tear, age | Worn roof, peeling paint | Often curable |
| Functional obsolescence | Outdated design or layout | One bathroom, no closets, dated floor plan | Sometimes curable |
| External (economic) obsolescence | Negative forces outside the lot | Adjacent freeway, declining area | Always incurable |
Exam Trap: External obsolescence is the only type the owner cannot fix, because the cause is off the property. Think "outside the property line."
Worked Example: Cost Approach
Land value $120,000; replacement cost of improvements $300,000; accrued depreciation $40,000.
Value = $120,000 + ($300,000 - $40,000) = $380,000.
Income Approach
The income approach values property by the income it produces. The core process is direct capitalization.
Step 1 - find Net Operating Income (NOI):
NOI = Effective Gross Income - Operating Expenses
(Operating expenses exclude mortgage payments, depreciation, and capital improvements.)
Step 2 - capitalize the NOI using the capitalization (cap) rate, which is the rate of return an investor requires:
Value = NOI / Cap Rate
Worked Example: Income Approach
Gross annual income $60,000; operating expenses $20,000; cap rate 8%.
NOI = $60,000 - $20,000 = $40,000.
Value = $40,000 / 0.08 = $500,000.
The relationship is inverse: a higher cap rate produces a lower value (more perceived risk), and a lower cap rate produces a higher value. When interest rates rise, cap rates often rise, pushing income-property values down.
Gross Multipliers
For quick estimates, appraisers use multipliers:
- Gross Rent Multiplier (GRM) = Price / monthly gross rent (used for residential rentals).
- Gross Income Multiplier (GIM) = Price / annual gross income (used for commercial).
If comparable properties sell at a GRM of 120 and the subject rents for $2,500 per month, estimated value = 120 x $2,500 = $300,000. Multipliers use gross income and do not subtract expenses, so they are rougher than full capitalization.
A small apartment building generates $90,000 in effective gross income and $30,000 in annual operating expenses. Investors in this market require a 6% cap rate. Using the income approach, what is the indicated value?
BPOs, CMAs, and Reconciliation
After developing the relevant approaches, the appraiser reconciles them, giving the most weight to the approach supported by the most reliable data, and concludes one value. For a typical home that is the sales comparison approach; for an apartment building it is the income approach; for a new church it is the cost approach.
Licensees should keep the formal appraisal separate from their own value tools:
- A Broker Price Opinion (BPO) is a broker's opinion of value, frequently ordered by lenders and asset managers on short sales, foreclosures, and REO (real-estate-owned) property. It is not a formal appraisal and cannot be used where federal rules require a credentialed appraiser.
- A Comparative Market Analysis (CMA) is a licensee's pricing analysis for a seller or buyer, built largely from comparable sales like the sales comparison approach but without USPAP-level rigor.
Exam Trap: Neither a BPO nor a CMA substitutes for an appraisal in a federally related mortgage. Some states also limit when a licensee may charge a separate fee for a BPO.
Quick Approach Selector
- Few comps, unique or new building - cost approach.
- Rental or commercial income property - income approach.
- Standard subdivision home - sales comparison approach.