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

1. Sales Comparison Approach

Also called the market data approach, this method estimates value by comparing the subject to recently sold, similar properties (comparables or "comps") and adjusting their prices for differences. It is grounded in substitution and is the primary approach for single-family homes.

The Golden Rule of Adjustment

Adjust the comparable, never the subject. Then:

• If the comp is better than the subject, subtract value from the comp.
• If the comp is worse than the subject, add value to the comp.

The mnemonic: CBS — Comp Better, Subtract. (And comp inferior, add.)

Worked Example

Subject has 3 bedrooms and a 2-car garage. A comp sold for $320,000 with 4 bedrooms (the extra bedroom is worth $15,000) and a 1-car garage (the missing garage bay is worth $8,000).

Adjusted comp value = $320,000 − $15,000 + $8,000 = $313,000. With several comps, the appraiser reconciles the adjusted prices into one indicated value.

Good comps are recent (typically within six months), nearby, and genuinely similar in size, age, and style. Adjustments should be few and small; a comp needing huge adjustments is a weak comp. Time/market-conditions adjustments correct for price changes between the comp's sale date and the effective date, and financing concessions (a seller paying points or closing costs) are stripped out so the figure reflects cash-equivalent value.

2. Cost Approach

The cost approach estimates value as:

Value = (Reproduction or Replacement Cost of improvements − Depreciation) + Land Value

• Reproduction cost — exact replica using the same materials (rare, historic).
• Replacement cost — equivalent utility using modern materials and methods (more common).

Best used for new construction and special-purpose properties (churches, schools, libraries) where comps and income data are scarce.

The Three Types of Depreciation

Depreciation here means loss in value from any cause, classified three ways:

External obsolescence is the exam's favorite "incurable" answer because the owner cannot fix what is outside the property line.

Worked Cost-Approach Example

A newly built community center:

• Replacement cost of the building = $900,000
• Accrued depreciation (physical + functional) = $120,000
• Land value = $250,000

Value = ($900,000 − $120,000) + $250,000 = $780,000 + $250,000 = $1,030,000.

Note the order: depreciate the improvements first, then add land (land does not depreciate in this method).

3. Income Approach

For income-producing property, value flows from the income the property generates (the principle of anticipation). Two tools:

A. Gross Rent Multiplier (GRM) — a quick method for small residential rentals.

• GRM = Sale Price / Gross Monthly Rent
• Value = GRM × Subject's Gross Monthly Rent

If comps sell at a GRM of 110 and the subject rents for $2,000/month: Value = 110 × $2,000 = $220,000. (A Gross Income Multiplier, GIM, uses annual income instead.)

Derive the GRM from sold comps first. If a comparable sold for $264,000 and rented for $2,400/month, its GRM is $264,000 / $2,400 = 110. The GRM is a gross figure: it ignores vacancy and operating expenses, which is why it is only a quick screen for small rentals, not a substitute for direct capitalization on larger income property.

B. Direct Capitalization — the core commercial method:

Value = Net Operating Income (NOI) / Capitalization Rate

NOI is effective gross income minus operating expenses (it does not subtract debt service/mortgage payments or income taxes/depreciation).

Worked Capitalization Example

An office building generates:

• Potential gross income $200,000, minus 5% vacancy ($10,000) = Effective gross income $190,000
• Operating expenses $70,000
• NOI = $190,000 − $70,000 = $120,000

Market cap rate = 8% (0.08).

Value = $120,000 / 0.08 = $1,500,000.

The inverse relationship is heavily tested: holding NOI constant, a higher cap rate produces a lower value, and a lower cap rate produces a higher value. If the cap rate rose to 10%, value would fall to $120,000 / 0.10 = $1,200,000.

Broker Price Opinions (BPOs)

A BPO is a real estate licensee's written opinion of likely sale price or value, typically ordered by lenders for short sales, foreclosures, REO, or loan review. It is faster and cheaper than an appraisal but is not a certified appraisal. For most federally related transactions above the de minimis threshold, a licensed/certified appraiser, not a BPO, is required. Several states restrict when a BPO may be charged for, and a licensee should never present a BPO as an appraisal.

Choosing and Reconciling the Approaches

No single approach is "the" answer; the appraiser develops the relevant approaches and reconciles. For a tract home, sales comparison leads and the cost approach is a check. For a brand-new fire station with no comps and no rent, the cost approach leads. For an apartment building, the income approach leads. A question that asks "which approach is most reliable" is really asking you to identify the property type first.

Finally, remember the inverse cap-rate relationship and the adjustment direction, because those two mechanics generate most of the math errors in this domain. Subtract from a superior comp, add to an inferior one, and never adjust the subject. Divide NOI by the cap rate, and know that a rising cap rate signals more risk and a lower value even when income is unchanged.