3.3 Valuation Approaches (Sales Comparison, Cost, Income) and BPOs
Key Takeaways
- Match the approach to the property: sales comparison for typical homes, cost for unique/special-purpose buildings, income for rentals.
- In sales comparison, always adjust the comp, never the subject: Comp Better, Subtract; comp inferior, add.
- Cost approach = Land + (Cost New − Depreciation); external obsolescence is always incurable.
- Income approach: Value = NOI ÷ Cap Rate, an inverse relationship; GRM uses gross rent and ignores expenses.
- A BPO is a licensee's structured price estimate for default scenarios and cannot replace a USPAP appraisal in federally related lending.
Three Approaches, Three Property Types
Appraisers develop value through three approaches, and the exam tests which one fits a given property. The right tool depends on what the property is and what data exists.
- Sales comparison approach — best for typical single-family homes; built on the principle of substitution.
- Cost approach — best for new, special-purpose, or unique properties (schools, churches, libraries) with few comparable sales.
- Income approach — best for income-producing property such as apartment buildings, offices, and retail centers.
A single appraisal may apply more than one, then reconcile. But when a question names a property type, you should match it to its dominant approach.
Sales Comparison: Adjusting Comps
The sales comparison approach values the subject by adjusting recent comparable sales to account for differences. The cardinal rule: adjust the comparable, never the subject.
- If the comp is superior to the subject, subtract value from the comp.
- If the comp is inferior to the subject, add value to the comp.
The memory aid is CBS: "Comp Better, Subtract."
Worked example. The subject is 2,000 sq ft with a 2-car garage. A comp is 1,900 sq ft with a 1-car garage and sold for $390,000. Square footage is worth $100/sq ft; a garage bay is worth $8,000. The comp is smaller (inferior, +100 x $100 = +$8,000) and has less garage (inferior, +$8,000). Adjusted comp value: $390,000 + $8,000 + $8,000 = $406,000.
Cost Approach: A Full Worked Calculation
Apply the formula Land + (Replacement Cost New − Depreciation) = Value end to end.
A 2,400 sq ft building costs $160/sq ft to replace new. The land is worth $90,000. The structure is 10 years old with a 50-year economic life and shows only normal wear (straight-line physical depreciation).
- Replacement cost new = 2,400 × $160 = $384,000
- Straight-line depreciation rate = 1 / 50 = 2% per year; 10 years = 20%
- Accrued depreciation = 20% × $384,000 = $76,800
- Depreciated improvement value = $384,000 − $76,800 = $307,200
- Value = $90,000 + $307,200 = $397,200
Distinguish reproduction cost (an exact replica, same materials) from replacement cost (equivalent utility with modern materials). Replacement cost is used far more often because exact replicas are rarely practical.
GRM and Cap-Rate Cross-Checks
Deriving a GRM: if a comparable rental sold for $240,000 and rented for $2,000/month, GRM = $240,000 / $2,000 = 120. Apply it to a subject renting at $2,100/month: value = $2,100 × 120 = $252,000.
Cap-rate sensitivity: a property with $48,000 NOI valued at an 8% cap rate is worth $48,000 / 0.08 = $600,000. If investors demand a 10% return (higher risk), value falls to $48,000 / 0.10 = $480,000. The inverse relationship — higher cap rate, lower value — is a guaranteed exam point. Remember the three variables rotate: Value = NOI ÷ Rate, so NOI = Value × Rate and Rate = NOI ÷ Value.
A comparable sold for $420,000 and has a finished basement worth $20,000 that the subject lacks. The comp is otherwise identical. What is the adjusted value of the comparable?
Cost Approach and Depreciation
The cost approach estimates value as:
Land Value + (Cost to Build New − Depreciation) = Property Value
The appraiser values the land separately, estimates the current cost to construct the improvements (reproduction or replacement cost), then subtracts accrued depreciation. The three forms of depreciation are heavily tested:
| Type | Source | Curable? | Example |
|---|---|---|---|
| Physical deterioration | Wear and tear, age | Often curable | Worn roof, peeling paint |
| Functional obsolescence | Outdated design within the property | Sometimes curable | One bath in a 4-bedroom house |
| External obsolescence | Negative forces outside the property | Incurable | New highway next door |
External (economic) obsolescence is always incurable because the owner cannot control off-site factors.
A home loses value because a noisy industrial plant was built across the street. Which type of depreciation is this, and is it curable?
Income Approach: Cap Rate and GRM
For income property, value is tied to the income the property generates. The primary method uses the capitalization (cap) rate:
Value = Net Operating Income (NOI) ÷ Cap Rate
NOI is gross income minus operating expenses, before mortgage payments and income taxes. If a building produces $60,000 NOI and investors expect an 8% cap rate, value = $60,000 ÷ 0.08 = $750,000. Note the inverse relationship: a higher cap rate yields a lower value.
For small residential rentals, appraisers may use the gross rent multiplier (GRM):
Value = Monthly Gross Rent × GRM
GRM uses gross rent (not NOI), so it ignores expenses and is a quicker, rougher estimate.
Broker Price Opinions (BPOs)
A Broker Price Opinion is a written estimate of likely selling price prepared by a licensed real-estate broker or agent, typically ordered by a lender during a short sale, foreclosure, or REO disposition. It is more structured than a casual CMA but far less formal than a USPAP appraisal and is not a substitute for one in a federally related mortgage loan.
Key BPO points the exam tests:
- Prepared by a licensee, not an appraiser.
- Cheaper and faster than an appraisal.
- Commonly used for default-related decisions where a full appraisal is not required.
- Cannot be used as the valuation for most federally related new-purchase mortgages, where an appraisal is mandated.
An apartment building generates $90,000 in net operating income. Investors in the area expect a 9% capitalization rate. Using the income approach, what is the indicated value?