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

The Three Approaches at a Glance

Every appraisal considers up to three approaches, each rooted in a value principle:

The sales comparison approach is most reliable for residential property because abundant comparable sales reflect real buyer behavior — which is why most exam math lives here.

Sales Comparison — Adjust the COMP, Not the Subject

The golden rule: adjust the comparable, never the subject.

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

Worked example. Subject has 3 bedrooms and a garage. A comp sold for $300,000 with 4 bedrooms (worth +$15,000) and no garage (garage worth $10,000).

• Comp has an extra bedroom (superior) → subtract $15,000.
• Comp lacks a garage the subject has (inferior) → add $10,000.
• Adjusted comp value: $300,000 − $15,000 + $10,000 = $295,000.

Cost Approach — The Formula and Depreciation

The cost approach formula:

Land value + (Reproduction/Replacement cost of improvements − Accrued depreciation) = Property value

Land is added back after depreciating only the improvements (land does not depreciate). The three forms of accrued depreciation:

• Physical deterioration — wear and tear (curable or incurable).
• Functional obsolescence — outdated design inside the property (one bathroom, no closets, a bedroom only reachable through another).
• External (economic) obsolescence — a negative outside the property line (a new highway, a nearby landfill); always incurable because the owner cannot fix it.

Replacement cost = a building of equal utility with modern materials; reproduction cost = an exact replica.

Cost Approach — Worked Numeric

Given:

• Replacement cost of the building: $280,000
• Building has depreciated 20%
• Land value: $90,000

Steps:

1. Depreciation = $280,000 × 20% = $56,000
2. Depreciated improvement value = $280,000 − $56,000 = $224,000
3. Add land = $224,000 + $90,000 = $314,000

The cost approach shines for new construction and special-purpose buildings (a fire station, a church) where comparable sales and income data barely exist.

Income Approach — GRM and Capitalization (Worked Numerics)

For residential rentals, appraisers often use the Gross Rent Multiplier (GRM):

GRM = Sale price ÷ Monthly gross rent. A home that sold for $240,000 renting at $2,000/month has a GRM of 120. Apply that GRM to a subject renting at $2,100/month: $2,100 × 120 = $252,000.

For commercial property, use direct capitalization:

Value = Net Operating Income (NOI) ÷ Capitalization rate.

Example: a building with NOI of $90,000 and a market cap rate of 9%: $90,000 ÷ 0.09 = $1,000,000. Note the inverse relationship — a higher cap rate produces a lower value (more risk demanded by investors).

BPOs and CMAs — What a Licensee May Do

A Broker Price Opinion (BPO) is an estimate of likely sale price prepared by a licensed broker/salesperson, frequently for lenders evaluating short sales, foreclosures, or loan decisions. A Comparative Market Analysis (CMA) is a similar comparison used to advise sellers on listing price.

Key exam distinctions:

• A BPO/CMA is not an appraisal and must not be represented as one.
• BPOs generally may not be used in place of an appraisal for origination of a federally related mortgage.
• Both rely on the same comparable-adjustment logic as the sales comparison approach but are produced faster and cheaper than a full appraisal.

Choosing and Sequencing Comparables

Good comps share the subject's location, are recent sales (not listings or pending deals), and need few adjustments. The exam stresses arm's-length transactions — a sale between unrelated parties under no duress. Exclude foreclosures, sales between relatives, and estate liquidations, because those prices do not reflect market value.

Adjust for the major elements of comparison in this typical order: financing terms, conditions of sale, market (date), location, then physical features. A sale six months ago in a rising market needs an upward time adjustment to the comp. After adjusting each comp, the appraiser weights the least-adjusted comparables most heavily — fewer adjustments mean fewer chances for error.

Reconciling Within the Income Approach

The income approach has two layers students confuse. GRM uses gross rent and suits small residential rentals where expenses are similar across properties. Direct capitalization uses Net Operating Income — gross income minus vacancy and operating expenses, but before mortgage debt service and before income tax.

Work NOI carefully: start with potential gross income, subtract a vacancy/collection allowance to get effective gross income, then subtract operating expenses (taxes, insurance, maintenance, management). Do not subtract the mortgage payment — financing is a buyer choice, not a property characteristic. A fact pattern that buries the mortgage payment in the expense list is testing whether you exclude it before dividing by the cap rate.

When Each Approach Is Weakest

Knowing the limits of each approach earns reconciliation points:

• Sales comparison fails when there are no recent comparable sales — common for unique or rural properties.
• Cost approach becomes unreliable for older buildings because estimating accrued depreciation is highly subjective; it is most accurate for new construction.
• Income approach is inappropriate for owner-occupied homes that generate no rent, and is sensitive to the cap rate — a small rate change swings value sharply.

Because a 1-percentage-point cap-rate move from 8% to 9% drops a $120,000-NOI value from $1,500,000 to about $1,333,000, the exam wants you to see that the cap rate reflects investor risk: higher perceived risk demands a higher rate and yields a lower price.