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

1. The Sales Comparison Approach

The sales comparison approach (also called the market data approach) estimates value by comparing the subject property to recently sold, similar properties (comparables or comps) and adjusting for differences. It rests directly on the principle of substitution and is the most reliable approach for single-family residences.

The golden rule: adjust the COMP, not the subject.

• If the comp is superior (has a feature the subject lacks), subtract from the comp's price.
• If the comp is inferior (lacks a feature the subject has), add to the comp's price.

A memory aid: CIA — Comp Inferior, Add. The subject is the unknown; you bring each comp into alignment with it.

Worked Sales Comparison Example

Subject has 3 bedrooms and a garage. A comp sold for $300,000 but has only 2 bedrooms (a bedroom is worth $15,000) and no garage (worth $10,000).

Because the comp is inferior on both features, we add to its sale price, giving an adjusted indicated value of $325,000 for the subject.

Trap: If a comp had a pool the subject lacks (comp superior), you would subtract the pool's contributory value from the comp.

2. The Cost Approach

The cost approach assumes a buyer will pay no more than the cost to build an equivalent property. The formula:

Value = Land Value + (Reproduction or Replacement Cost - Depreciation)

• Reproduction cost — an exact replica using the same materials.
• Replacement cost — a functional equivalent using modern materials (more common).

It is most reliable for new construction and special-purpose properties (schools, churches, libraries) that rarely sell and produce no income.

The Three Forms of Depreciation

Worked Cost Approach Example

Replacement cost of the building = $400,000. Total accrued depreciation = $60,000. Land value (by comparison) = $120,000.

Value = $120,000 + ($400,000 - $60,000) = $120,000 + $340,000 = $460,000.

Trap: Land is never depreciated in the cost approach — only the improvements lose value. Depreciation here is accrued (actual loss in value from all causes), not the straight-line tax depreciation used for income-tax purposes.

3. The Income Approach

Used for income-producing property (apartments, office, retail). The core relationship is IRV:

Income = Rate x Value, rearranged to Value = Net Operating Income (NOI) / Capitalization Rate.

NOI = effective gross income - operating expenses (it excludes mortgage debt service and income taxes).

Example: A building has NOI of $48,000 and the market cap rate is 8% (0.08). Value = $48,000 / 0.08 = $600,000.

Note the inverse relationship: a higher cap rate produces a lower value (more risk, less price). If the cap rate rose to 10%, value falls to $480,000.

Gross Rent Multiplier (GRM)

For small residential rentals, appraisers use a shortcut: GRM = Sale Price / Monthly Gross Rent. If a comp sold for $240,000 with $2,000 monthly rent, GRM = 120. Apply it to the subject's $2,200 rent: $2,200 x 120 = $264,000. (Annual rent uses a GIM instead.)

Broker Price Opinions (BPOs)

A BPO is a broker's or salesperson's estimate of a property's likely selling price, typically ordered by lenders, servicers, or asset managers for short sales, foreclosures, and REO portfolio decisions. It is faster and cheaper than a full appraisal.

• A BPO is based on comparable sales and market knowledge but is not prepared by a licensed appraiser and does not follow USPAP.
• A BPO may not be used in place of an appraisal for a federally related transaction (a federally regulated mortgage loan).
• Many states allow brokers to charge for BPOs; some restrict them — but on the national exam, treat the BPO as a lender-facing valuation tool, distinct from both the appraisal and the consumer-facing CMA.

Reconciling the Three Approaches

No single approach fits every property, so the appraiser weights the approaches by reliability for the property type:

For an owner-occupied house, the appraiser relies on sales comparison and uses the cost approach only as a check. For a 40-unit apartment building, the income approach dominates because investors buy the cash flow. The cost approach is least useful for older buildings, where estimating accrued depreciation becomes guesswork.

Trap: Reconciliation is judgment, not arithmetic — never average the three figures. The appraiser selects the most supportable indication and reports a single value.

Putting the Income Math Together

The income approach has a logical chain the exam likes to test step by step:

1. Potential Gross Income (PGI) — rent if 100% occupied.
2. Subtract vacancy and collection loss to get Effective Gross Income (EGI).
3. Subtract operating expenses (taxes, insurance, management, repairs, reserves) to get Net Operating Income (NOI).
4. Divide NOI by the cap rate to get value.

Example: PGI = $120,000; vacancy 5% = -$6,000; EGI = $114,000; operating expenses = $42,000; NOI = $72,000. At a 9% cap rate, Value = $72,000 / 0.09 = $800,000.

Trap: Mortgage payments (debt service), depreciation for taxes, and capital improvements are not operating expenses and are never subtracted when computing NOI. NOI measures the property's income before financing.