3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Sales comparison is the primary approach for homes; adjust the comparable, never the subject.
- Cost approach: reproduction/replacement cost minus depreciation plus land value; best for new or special-purpose property.
- Income approach for one figure uses value equals net operating income divided by capitalization rate (IRV).
- A lower cap rate produces a higher value; a higher cap rate produces a lower value.
- A CMA or BPO is an agent's pricing opinion, not a certified appraisal.
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. It rests on the principle of substitution and is the most reliable approach for single-family homes.
The golden rule: adjust the comparable, never the subject.
- If a comparable is superior (it has a feature the subject lacks), subtract value from the comparable.
- If a comparable is inferior, add value to the comparable.
Worked example: A comparable sold for $400,000 but has an extra garage worth $15,000 that the subject lacks. The garage makes the comparable superior, so subtract $15,000, giving an adjusted indication of $385,000 for the subject.
Good comparables are recent, nearby, and similar in size, age, and condition. Appraisers also screen for arm's-length sales — transactions between unrelated parties without unusual pressure. A sale between family members or a forced foreclosure is excluded because it does not reflect typical market behavior.
Elements of Comparison
Appraisers adjust comparables across a standard set of factors. Memorize the categories, not every dollar figure.
| Element | Why it matters |
|---|---|
| Financing terms | Seller concessions or buy-downs inflate price |
| Conditions of sale | Was it arm's-length and unpressured? |
| Market conditions (time) | A sale six months ago may need a time adjustment |
| Location | A better block commands more |
| Physical features | Size, bedrooms, baths, lot, condition |
When several comparables are adjusted, the appraiser leans on the one needing the fewest and smallest adjustments, because it is the most similar to the subject and therefore the most reliable indicator of value.
A comparable lacks the finished basement that the subject property has. The basement is valued at $20,000. How should the appraiser adjust?
The Cost Approach
The cost approach assumes a buyer will pay no more than the cost to build an equivalent property. The formula:
Value = Reproduction or Replacement Cost - Depreciation + Land Value
- Reproduction cost rebuilds an exact replica; replacement cost rebuilds equivalent utility with modern materials.
- Land value is added separately because land does not depreciate.
Three forms of depreciation:
| Type | Cause | Curable? |
|---|---|---|
| Physical deterioration | Wear and tear | Often curable |
| Functional obsolescence | Outdated design (e.g., one bathroom) | Sometimes curable |
| External obsolescence | Off-site factors (busy highway) | Incurable |
The cost approach is most useful for new construction and special-purpose buildings (schools, churches) that rarely sell.
The Income Approach
The income approach values income-producing property based on the return it generates. The core relationship is IRV:
Income = Rate x Value, rearranged to Value = Net Operating Income / Capitalization Rate.
Net operating income (NOI) is effective gross income minus operating expenses — it does not subtract debt service (mortgage payments).
Worked example: A small apartment building produces $60,000 NOI and the market cap rate is 8% (0.08).
- Value = $60,000 / 0.08 = $750,000.
Notice the inverse relationship: if the cap rate rose to 10%, value would fall to $600,000. A lower cap rate yields a higher value; a higher cap rate yields a lower value.
A rental property generates $90,000 in net operating income and the market capitalization rate is 9%. What is the indicated value using the income approach?
Building Net Operating Income
Because the income approach depends on NOI, the exam tests how it is built.
- Start with potential gross income (rent if fully leased).
- Subtract vacancy and collection loss to get effective gross income.
- Subtract operating expenses (taxes, insurance, management, repairs, reserves).
- The result is net operating income.
Do not subtract mortgage payments (debt service), depreciation, or capital improvements — those are excluded from NOI. Example: $100,000 potential gross income, 5% vacancy ($5,000), and $35,000 operating expenses give NOI of $60,000. Mixing debt service into this calculation is the single most common income-approach error.
Gross Rent and Gross Income Multipliers
For smaller residential rentals, appraisers use a shortcut. The gross rent multiplier (GRM) uses monthly rent; the gross income multiplier (GIM) uses annual income.
- GRM = Sale Price / Monthly Rent, so Value = GRM x Monthly Rent.
Example: Comparable rentals show a GRM of 120. The subject rents for $2,500/month.
- Value = 120 x $2,500 = $300,000.
The multiplier is quick but crude because it ignores expenses, vacancy, and condition — which is why full income property relies on the cap-rate method instead.
Choosing and Reconciling the Approaches
No single approach fits every property. Match the approach to the asset.
| Property type | Best approach |
|---|---|
| Owner-occupied home | Sales comparison |
| New construction | Cost |
| Special-purpose (church, school) | Cost |
| Apartment or office building | Income |
| Vacant land | Sales comparison |
After applying the relevant approaches, the appraiser reconciles the indications into one opinion by weighting the most reliable for that property — not by averaging. For a duplex held as a rental, the income approach carries the most weight; for a brand-new custom home, the cost approach may anchor the conclusion.
CMAs and BPOs (the Agent's Tools)
Agents do not perform appraisals. They produce pricing opinions:
- A comparative market analysis (CMA) compares active, pending, sold, and expired listings to recommend a list or offer price.
- A broker price opinion (BPO) is a similar opinion, often ordered by lenders for short sales, foreclosures, or portfolio review — typically for a fee and on a standard form.
Neither is a USPAP appraisal, and neither may substitute for one in a federally related transaction. The exam frequently offers a CMA or BPO as a wrong answer where an appraisal is legally required.
Trap: A lender deciding a high-value mortgage needs an appraisal, not a BPO; a homeowner setting a list price needs a CMA.