3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Sales comparison adjusts comparable sales to the subject: adjust the COMP, not the subject — subtract for superior comp features, add for inferior ones.
- The cost approach = land value + (reproduction or replacement cost of improvements − accrued depreciation); it is best for new or special-purpose properties.
- Depreciation in appraisal has three forms: physical deterioration, functional obsolescence, and external (economic) obsolescence.
- The income approach capitalizes net operating income: Value = NOI ÷ Capitalization Rate; the GRM/GIM methods use gross income for smaller properties.
- A BPO or CMA estimates price for marketing decisions and is not an appraisal; it may not be used in place of an appraisal for most federally related loans.
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 the most reliable approach for single-family homes and the one buyers and agents rely on most.
The golden rule of adjustments: adjust the comparable, never the subject. If a comparable is superior to the subject (it has a feature the subject lacks), you subtract that feature's value from the comp's price. If the comparable is inferior, you add value. The memory aid is CIA / CBS: Comp Inferior → Add; Comp Better → Subtract.
Good comparables share three traits: they sold recently, they are near the subject, and they are physically similar in size, age, and style. Appraisers also make adjustments for financing concessions and conditions of sale — a comp sold under duress or with seller-paid points is adjusted toward a cash-equivalent price before its features are compared.
Worked Sales Comparison Adjustment
The subject has a two-car garage and no pool. A comparable sold for $300,000 and has a three-car garage (worth $8,000 more) and a pool (worth $12,000).
| Feature | Comp vs. subject | Adjustment to comp |
|---|---|---|
| Garage | Comp superior (3-car) | −$8,000 |
| Pool | Comp superior (has one) | −$12,000 |
Adjusted comp value = $300,000 − $8,000 − $12,000 = $280,000. Because the comparable had two features the subject lacks, we subtract both to reflect what the subject would have sold for. If instead the comp had been inferior — say, no garage — we would have added the garage's value to the comp.
Sales-comparison adjustment direction
The single rule that resolves most sales-comparison questions: adjust the comparable, never the subject. If the comparable is superior (it has a feature the subject lacks), subtract value from the comp. If the comparable is inferior, add value.
Example: the subject has a garage; comp A (sold $300,000) has none, worth $15,000. Because comp A is inferior, add $15,000 -> adjusted $315,000. Comp B (sold $330,000) has a pool the subject lacks, worth $20,000; because comp B is superior, subtract $20,000 -> adjusted $310,000. The two adjusted comps bracket the subject near $310,000-$315,000.
Income-approach and depreciation review
| Term | Formula / definition | Exam trap |
|---|---|---|
| NOI | Effective gross income − operating expenses | Excludes debt service and income tax |
| Cap rate | NOI ÷ Value | Higher rate = lower value (more risk) |
| GRM (monthly) | Price ÷ monthly gross rent | Uses gross rent, not NOI |
| Physical deterioration | Wear and tear | Often curable |
| Functional obsolescence | Outdated design (one-car garage) | Internal to the property |
| External obsolescence | Off-site cause (freeway noise) | Always incurable by the owner |
A property with $60,000 NOI at an 8% cap rate is worth $60,000 ÷ 0.08 = $750,000. A broker price opinion (BPO) may estimate likely sale price for a listing or short sale but, in most states and for most federally related mortgages, cannot substitute for a USPAP appraisal.
A comparable sold for $260,000 and has a finished basement worth $15,000 that the subject property lacks. What is the adjusted value of the comparable?
The Cost Approach and Depreciation
The cost approach estimates value as:
Land value + (Reproduction or Replacement cost of improvements − Accrued depreciation) = Value
Land is always valued separately because land does not depreciate. Reproduction cost recreates an exact replica; replacement cost builds a functional equivalent with modern materials. The cost approach is most reliable for new construction and special-purpose properties (schools, churches, libraries) that rarely sell and produce no income.
Worked example: Land = $80,000; replacement cost of the house = $250,000; accrued depreciation = $40,000. Value = $80,000 + ($250,000 − $40,000) = $290,000.
The Three Forms of Depreciation
Depreciation is loss in value from any cause. The exam tests three categories, and which are curable:
- Physical deterioration — wear and tear (worn roof, peeling paint). Often curable.
- Functional obsolescence — outdated or poor design (a four-bedroom home with one bathroom; a bedroom only reachable through another bedroom). May be curable or incurable.
- External (economic) obsolescence — loss caused by factors outside the property line (a new highway, a nearby landfill, a declining neighborhood). Always incurable, because the owner cannot fix what is off-site.
Trap: if the cause of value loss is located off the property, it is external obsolescence — never physical deterioration.
A home loses value because a noisy landfill opened on the adjacent parcel. Which type of depreciation is this?
The Income Approach, GRM, and BPOs
The income approach values property by the income it produces — the right method for apartment buildings, offices, and retail. The core formula is the IRV relationship:
Value = Net Operating Income (NOI) ÷ Capitalization Rate
NOI is gross income minus vacancy and operating expenses (but before mortgage payments and depreciation). Worked example: NOI = $60,000 and the market cap rate = 8% (0.08). Value = $60,000 ÷ 0.08 = $750,000. Note the inverse relationship: a higher cap rate yields a lower value for the same income.
GRM/GIM and Broker Price Opinions
For small residential rentals, appraisers use the Gross Rent Multiplier (GRM), a shortcut based on gross rent rather than NOI:
- GRM = Sale Price ÷ Monthly Gross Rent. If comparables sell at a GRM of 150 and the subject rents for $2,000/month, value ≈ 150 × $2,000 = $300,000.
- The Gross Income Multiplier (GIM) uses annual income instead of monthly rent.
A Broker Price Opinion (BPO) or Comparative Market Analysis (CMA) is an agent's estimate of likely sale price, prepared for listing or offer decisions. It is not an appraisal, uses no USPAP framework, and — under federal law — generally cannot replace an appraisal for a federally related mortgage loan. Lenders may use a BPO for tasks like loss mitigation or pre-listing pricing, but not as the loan-collateral valuation.
An apartment building produces net operating income of $90,000 per year. Investors in the market expect a 9% capitalization rate. Using the income approach, what is the indicated value?