3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- The sales comparison approach adjusts comparables to the subject and is most reliable for residential property.
- Adjust comparables to match the subject: add to an inferior comp, subtract from a superior comp.
- The cost approach equals land value plus replacement cost new minus depreciation; best for new or special-purpose property.
- The income approach uses Value = Net Operating Income / Capitalization Rate (IRV) for income-producing property.
The 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 grounded in the principle of substitution and is the most reliable approach for owner-occupied residential property.
The critical exam skill is the direction of adjustment. You always adjust the comparable, never the subject:
- If the comparable is superior to the subject (has a feature the subject lacks), subtract from the comp's price.
- If the comparable is inferior to the subject (lacks a feature the subject has), add to the comp's price.
A memory aid: CBS / CIA — Comparable Better, Subtract; Comparable Inferior, Add.
Worked Example: Adjusting a Comparable
A comparable sold for $400,000. Compared to the subject:
| Feature | Difference | Adjustment |
|---|---|---|
| Comp has an extra bathroom subject lacks | Comp superior | −$8,000 |
| Comp lacks the garage the subject has | Comp inferior | +$15,000 |
| Comp has a smaller lot | Comp inferior | +$5,000 |
Adjusted price = $400,000 − $8,000 + $15,000 + $5,000 = $412,000. After adjusting several comps this way, the appraiser reconciles them into an indicated value for the subject.
A comparable sold for $350,000. It has a finished basement worth $20,000 that the subject lacks, and the subject has a pool worth $12,000 that the comparable lacks. What is the adjusted sale price of the comparable?
The Cost Approach
The cost approach estimates value as the cost to replace the improvements, less depreciation, plus the land value. It is most reliable for new construction and special-purpose properties (schools, churches, libraries) that rarely sell and produce no income.
The formula:
Value = Land Value + (Replacement Cost New − Accrued Depreciation)
Two cost concepts differ:
- Reproduction cost — cost to build an exact replica with the same materials.
- Replacement cost — cost to build a functional equivalent with modern materials; more common in practice.
Three Kinds of Depreciation
Depreciation is loss in value from any cause. The exam tests three types:
| Type | Cause | Curable? |
|---|---|---|
| Physical deterioration | Wear and tear, age, damage | Often curable (paint, roof) |
| Functional obsolescence | Outdated design or features (e.g., one bathroom, no closets) | Sometimes curable |
| External (economic) obsolescence | Outside factors (busy highway, declining area) | Incurable — outside the property |
External obsolescence is always incurable because the owner cannot fix what is off-site.
Worked Example: Cost Approach
Land value is $120,000. Replacement cost new is $300,000. Total accrued depreciation is $45,000.
Value = $120,000 + ($300,000 − $45,000) = $120,000 + $255,000 = $375,000.
Note that land is not depreciated; only the improvements lose value to depreciation.
A property sits next to a newly built loud highway interchange that has reduced its value. What type of depreciation is this, and is it curable?
The Income Approach
The income approach estimates value based on the income a property produces. It is the most reliable approach for income-producing investment property such as apartment buildings, office space, and retail centers.
The core formula is IRV:
Value = Net Operating Income (NOI) ÷ Capitalization Rate
Rearranged: Income = Value × Rate, and Rate = Income ÷ Value. A common memory triangle places I on top, with R and V on the bottom.
Building the NOI
Net operating income is calculated before debt service:
- Start with potential gross income (full occupancy).
- Subtract vacancy and collection losses to get effective gross income.
- Subtract operating expenses (taxes, insurance, maintenance, management).
- The result is NOI. Do not subtract mortgage payments — NOI excludes debt service and income taxes.
Worked Example: Capitalization
A building generates $96,000 NOI. Investors in the market require an 8% cap rate.
Value = $96,000 ÷ 0.08 = $1,200,000.
Notice the inverse relationship: if the required cap rate rises to 10%, value falls to $96,000 ÷ 0.10 = $960,000. Higher cap rate = lower value; higher perceived risk pushes the cap rate up and the price down.
Gross Rent Multiplier
For small residential rentals, appraisers use a quicker tool, the gross rent multiplier (GRM):
GRM = Sale Price ÷ Gross Monthly Rent
If comparable rentals sell at a GRM of 120 and the subject rents for $2,000 per month, estimated value = 120 × $2,000 = $240,000. A gross income multiplier (GIM) uses annual income instead of monthly rent.
Broker Price Opinions and the Salesperson's Role
A broker price opinion (BPO) is a written estimate of value prepared by a real estate broker or salesperson, often for a lender evaluating a short sale, foreclosure, or portfolio. It uses comparable sales and listings much like a CMA, but it is not an appraisal.
Key exam points on BPOs and CMAs:
- A licensee may prepare a CMA or BPO but must not call it an appraisal or imply USPAP compliance.
- A BPO cannot substitute for an appraisal in a federally related transaction that requires a certified appraiser.
- A licensee may be compensated for a BPO where state law permits, but must disclose that it is not an appraisal.
- A CMA helps a seller set a realistic list price using active, pending, sold, and expired comparables.
Choosing the Right Approach
Reconciliation requires matching the approach to the property type:
| Property type | Primary approach |
|---|---|
| Single-family owner-occupied home | Sales comparison |
| Brand-new or special-purpose building | Cost |
| Apartment, office, retail (income property) | Income |
| Vacant land | Sales comparison |
A frequent trap pairs an income property with the cost approach, or a unique church with sales comparison. Read the property type first, then select the approach the exam expects an appraiser to weight most heavily.
An apartment building produces $144,000 in net operating income. Investors require a 9% capitalization rate. Using the income approach, what is the indicated value?