Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- In the sales comparison approach, adjust the COMPARABLE, never the subject: if a comp is superior, subtract; if inferior, add (CIA / CBS).
- The cost approach value equals land value plus replacement (or reproduction) cost of improvements minus accrued depreciation.
- The income approach uses the IRV formula: Value = Net Operating Income divided by the capitalization rate.
- Depreciation falls into physical deterioration, functional obsolescence, and external (economic) obsolescence; external is always incurable by the owner.
- A CMA and a BPO are licensee value tools for pricing and lender decisions and must never be presented as a formal appraisal.
1. 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 (comparables, or comps). It rests on the principle of substitution and is the most reliable approach for single-family homes.
The single most-tested rule: you adjust the comparable, never the subject. The subject is the unknown you are solving for. Each comp's sale price is adjusted up or down to make it equivalent to the subject. Two memory aids say the same thing:
- CBS: Comp Better, Subtract.
- CIA: Comp Inferior, Add.
So if a comp has an extra garage the subject lacks, the comp is superior, subtract the garage's value from the comp's price. If a comp lacks a finished basement the subject has, the comp is inferior, add value to the comp.
Sales Comparison Worked Example
The subject sold nothing yet; you are estimating its value. A comparable sold for $400,000. Compared to the subject:
| Feature | Difference | Adjustment to comp |
|---|---|---|
| Comp has extra half-bath subject lacks | Comp superior | Subtract $8,000 |
| Comp lacks deck subject has | Comp inferior | Add $6,000 |
| Comp has smaller lot | Comp inferior | Add $10,000 |
Adjusted comp value = $400,000 − $8,000 + $6,000 + $10,000 = $408,000.
The adjusted price is the comp's indication of the subject's value. With several comps adjusted this way, the appraiser reconciles them, giving more weight to the comps needing the fewest and smallest adjustments, since those are most similar to the subject.
A subject home is being appraised. A comparable sold for $350,000 but has a swimming pool the subject lacks (pool value $20,000) and one fewer bedroom than the subject (bedroom value $15,000). What is the comparable's adjusted value?
2. The Cost Approach
The cost approach is built on the idea that a buyer will pay no more for a property than the cost to build an equivalent one. It is most useful for new, special-purpose, or unique properties (schools, churches, libraries) where comps are scarce. The formula:
Value = Land Value + (Cost of Improvements − Accrued Depreciation)
Note that land is valued separately and is never depreciated, only the improvements depreciate. Two cost measures appear:
- Reproduction cost: cost to build an exact replica, including outdated features.
- Replacement cost: cost to build equivalent utility with current materials and standards. Replacement cost is more commonly used.
Worked example: Land value $120,000; replacement cost of the building $300,000; accrued depreciation $45,000. Value = $120,000 + ($300,000 − $45,000) = $375,000.
Three Types of Depreciation
Depreciation in appraisal means any loss in value from any cause. The exam tests three categories and whether each is curable.
| Type | Cause | Example | Curable? |
|---|---|---|---|
| Physical deterioration | Wear, tear, age | Worn roof, peeling paint | Often curable |
| Functional obsolescence | Outdated design or features | Only one bathroom; bedroom you walk through | Sometimes curable |
| External (economic) obsolescence | Forces outside the property | New highway noise; declining neighborhood | Always incurable by owner |
The key distinction: external obsolescence is always incurable by the owner because the cause is off-site and outside the owner's control. A nearby factory lowering values is external obsolescence, the homeowner cannot fix the factory.
A homeowner's property lost value because a new wastewater treatment plant was built two blocks away, creating odor. Which type of depreciation is this, and is it curable by the owner?
3. The Income Approach
The income approach values property by the income it produces. It is the best approach for income-producing properties: apartments, office buildings, shopping centers. The central tool is capitalization, captured by the IRV formula:
Income = Rate × Value, rearranged to Value = Income ÷ Rate
- I = Net Operating Income (NOI): effective gross income minus operating expenses (but not debt service / mortgage payments).
- R = capitalization (cap) rate, the investor's required rate of return.
- V = the value we solve for.
Worked example: a building produces NOI of $90,000 and the market cap rate is 9% (0.09). Value = $90,000 ÷ 0.09 = $1,000,000.
The inverse relationship is heavily tested: as the cap rate rises, value falls; as the cap rate falls, value rises. If investors demand 10% instead of 9% on the same $90,000 NOI, value drops to $900,000.
GRM, GIM, and BPOs / CMAs
For small residential rentals, appraisers may use the Gross Rent Multiplier (GRM), a quick screening tool that uses gross rent without subtracting expenses:
Value = Gross Monthly Rent × GRM
Example: comparable rentals sell at a GRM of 120 and the subject rents for $2,500/month. Estimated value = $2,500 × 120 = $300,000. (The Gross Income Multiplier, GIM, uses annual income instead.) GRM is rougher than full capitalization because it ignores expenses and vacancy.
Agent value tools
Finally, the exam tests where licensee tools fit:
- A CMA is a salesperson's pricing analysis of recently sold, active, and expired listings to recommend a list price or offer. It loosely mirrors sales comparison but is not an appraisal.
- A BPO is a broker's opinion of likely sale price, frequently ordered by lenders for short sales, REO, or loan decisions, cheaper and faster than an appraisal.
Neither a CMA nor a BPO may be presented as an appraisal, and only a licensed or certified appraiser may perform an appraisal for a federally related transaction.
An apartment building generates net operating income (NOI) of $144,000 per year. Investors in this market require a 12% capitalization rate. Using the income approach, what is the indicated value?