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

The three approaches

Appraisers develop value through up to three approaches, then reconcile. Each fits certain property types best.

Sales comparison approach

This is the dominant approach for homes and rests on substitution: a buyer pays no more than the cost of an equal substitute. The appraiser selects recently sold comparables (comps) and adjusts them to match the subject.

The golden rule: you adjust the comps, never the subject. The subject's features are fixed; you make each comp look like the subject by adding or subtracting dollar amounts.

• If the comp is inferior to the subject (smaller, no garage), add value to the comp.
• If the comp is superior to the subject (extra bath, pool), subtract value from the comp.

A memory hook: CIA — Comp Inferior, Add (and the reverse, comp superior, subtract).

Worked example: adjusting a comp

The subject has 3 bedrooms and a 2-car garage. A comp sold for $300,000 but has only 2 bedrooms and a 1-car garage. Market-derived adjustments: a bedroom is worth $10,000; a garage bay is worth $6,000.

The comp is inferior on both features, so we add to the comp:

• Missing bedroom: + $10,000
• Missing garage bay: + $6,000
• Total upward adjustment: + $16,000

Adjusted comp value: $300,000 + $16,000 = $316,000.

If instead the comp were superior (had an extra bedroom the subject lacks), you would subtract that $10,000. Reversing the direction of adjustment is the most common arithmetic trap in this approach.

Cost approach

The cost approach answers: what would it cost to replace the building today, less wear, plus the land? The formula:

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

• Reproduction cost = exact replica with same materials. Replacement cost = a functional equivalent with modern materials.
• Depreciation comes in three forms: physical deterioration (wear and tear), functional obsolescence (outdated design, e.g., one bathroom in a large home), and external/economic obsolescence (off-site causes such as a new highway or factory next door — usually incurable).

Worked example: replacement cost $250,000; total depreciation $40,000; land value $90,000.

Value = $90,000 + ($250,000 − $40,000) = $90,000 + $210,000 = $300,000.

The cost approach is most reliable for new construction and special-purpose buildings (schools, churches) that rarely sell and have little income.

Income approach: the IRV formula

For income-producing property, value flows from net income. The capitalization formula is IRV:

• I = Net Operating Income (NOI)
• R = capitalization (cap) rate
• V = Value

Arranged three ways: V = I / R, I = V × R, R = I / V. The triangle: cover the one you want.

• NOI = effective gross income − operating expenses (do not subtract mortgage debt service or income taxes).

Worked example: NOI = $48,000; cap rate = 8% (0.08).

Value = I / R = $48,000 / 0.08 = $600,000.

Note the inverse relationship: a higher cap rate produces a lower value (more perceived risk), and a lower cap rate produces a higher value. The exam tests this direction directly.

GRM, GIM, and the difference from a CMA/BPO

For small rentals appraisers often use a Gross Rent Multiplier (GRM), based on monthly rent, or a Gross Income Multiplier (GIM), based on annual income:

• GRM = Sale Price / Monthly Rent, so Value = GRM × Monthly Rent.

Worked example: comps show a GRM of 120; subject rents for $2,500/month. Value = 120 × $2,500 = $300,000.

Finally, keep the licensee tools distinct from appraisals:

A CMA and a BPO rely mainly on comparable sales and listings, similar in spirit to the sales comparison approach, but they are not USPAP appraisals and a licensee must not present them as such.

Choosing and weighting approaches

After developing the approaches, the appraiser reconciles them, giving the most weight to the approach best suited to the property. For a typical resale home, the sales comparison approach carries the most weight because abundant comparable sales reflect real buyer behavior. For a brand-new or special-purpose building, the cost approach is most reliable. For an apartment or commercial building bought for its cash flow, the income approach dominates. Recognizing the property type usually tells you which approach the question expects you to emphasize, and prevents you from mechanically averaging unrelated numbers.

One more numeric trap to retire: do not confuse the cap rate with the GRM. A cap rate works on net operating income (after operating expenses), while a GRM works on gross rent (before expenses). Using gross rent with a cap rate, or net income with a GRM, produces a wildly wrong value. Match the multiplier to the income figure the question hands you, then solve.