3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- In the sales comparison approach you adjust the comparable, never the subject — and you adjust comps the opposite direction of their difference
- The cost approach value equals reproduction/replacement cost minus depreciation plus land value
- Depreciation has three causes: physical deterioration, functional obsolescence, and external (economic) obsolescence — only external is always incurable
- The income approach uses IRV: Value equals Net Operating Income divided by the capitalization rate
- GRM applies to residential rentals and uses gross rent, while cap rate applies to commercial and uses net operating income
Sales comparison approach
This approach estimates value from recent sales of similar properties (comparables, or "comps"). The governing rule is adjust the comparable, never the subject. Determine the direction with one sentence: if the comp is better than the subject, subtract from the comp; if the comp is worse, add to the comp. You are estimating what the comp would have sold for if it were just like the subject.
Worked adjustment
A comp sold for $320,000. It has an extra garage worth +$15,000 and the subject has a finished basement the comp lacks, worth $10,000.
- Comp has a garage the subject lacks (comp superior): subtract $15,000 → $305,000.
- Comp lacks the basement the subject has (comp inferior): add $10,000 → $315,000 adjusted indicated value.
A frequent trap: adjusting the subject property, or adjusting in the wrong direction. Memorize CBS — Comp Better, Subtract.
Cost approach
Used for new, unique, or special-purpose properties where comps are scarce. The formula:
Value = (Reproduction or Replacement Cost − Depreciation) + Land Value
Reproduction cost rebuilds an exact replica using the same materials; replacement cost rebuilds equivalent utility with modern materials. Land is added separately and land does not depreciate.
The three forms of depreciation
| Type | Cause | Curable? |
|---|---|---|
| Physical deterioration | Wear and tear, age | Often curable (paint, roof) |
| Functional obsolescence | Outdated design, poor layout | Sometimes curable |
| External / economic obsolescence | Off-site negatives (highway noise, declining area) | Always incurable |
External obsolescence is the only one always incurable because the cause is outside the property line — the owner cannot fix a neighboring factory.
Worked cost example
Replacement cost $250,000; accrued depreciation $40,000; land value $80,000.
$250,000 − $40,000 = $210,000, then + $80,000 = $290,000 indicated value.
Income approach
Used for income-producing property. Memorize IRV:
Value = Net Operating Income ÷ Capitalization Rate (V = I ÷ R)
Net operating income (NOI) is gross income minus operating expenses (it excludes debt service and depreciation). Rearrange the triangle: I = V × R, and R = I ÷ V.
Worked: a building has NOI of $60,000 and the market cap rate is 8%. Value = $60,000 ÷ 0.08 = $750,000. Note the inverse relationship: a higher cap rate yields a lower value, reflecting higher perceived risk.
Gross rent multiplier
For small residential rentals, the GRM is a shortcut: Value = Gross Rent × GRM. The multiplier uses gross rent (not NOI). If comparable rentals sell at a GRM of 120 and the subject's monthly rent is $2,000, value ≈ $2,000 × 120 = $240,000. GRM uses monthly rent; the gross income multiplier (GIM) uses annual gross income for commercial property.
Broker price opinions (BPOs)
A BPO is a real estate broker's estimate of likely sale price, often ordered by lenders for short sales, foreclosures, or relocation. It is faster and cheaper than an appraisal but is not an appraisal and cannot be used in a federally related transaction where an appraisal is required. A CMA serves the same comparative logic to help a seller price a listing. Both rest on the substitution principle, but only a licensed or certified appraiser may render an appraisal.
Worked Income Approach: IRV and the Cap Rate
The income approach values income property by capitalizing net operating income. Memorize the IRV triangle: Income = Rate × Value, so Value = Income ÷ Rate and Rate = Income ÷ Value.
Worked example for a small apartment building:
- Gross potential income: $90,000.
- Vacancy and collection loss at 5%: −$4,500, giving effective gross income of $85,500.
- Operating expenses: $30,500.
- Net operating income (NOI) = $85,500 − $30,500 = $55,000. (Debt service and depreciation are excluded from NOI.)
- Market capitalization rate: 8%.
- Value = NOI ÷ rate = $55,000 ÷ 0.08 = $687,500.
A higher cap rate produces a lower value for the same NOI, which is why riskier markets carry higher cap rates. If the same building's NOI rose to $60,000 at the same 8% rate, value would climb to $60,000 ÷ 0.08 = $750,000.
GRM vs. GIM and When Each Approach Leads
The gross rent multiplier (GRM) uses monthly gross rent and suits residential rentals: GRM = sale price ÷ monthly rent, and value = GRM × subject monthly rent. The gross income multiplier (GIM) uses annual gross income and suits commercial property. Both are shortcuts that skip expenses, so they are less precise than full income capitalization.
Worked GRM: three comparable rentals show GRMs of 142, 148, and 145, supporting a market GRM near 145. If the subject rents for $1,900 per month, indicated value = 145 × $1,900 = $275,500.
Reconciliation weights the approaches by reliability for the property type: the sales comparison approach usually leads for single-family homes, the income approach for investment property, and the cost approach for new, special-purpose, or rarely traded buildings (schools, churches) where comparable sales are scarce. Knowing which approach dominates for which property type is a recurring exam item.
A comparable sold for $300,000. It has a feature superior to the subject worth $12,000, and it lacks a feature the subject has worth $8,000. What is the adjusted value of the comparable?
An apartment building generates net operating income of $90,000 per year. Investors in this market expect a capitalization rate of 9%. Using the income approach, what is the indicated value?