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

The Three Approaches at a Glance

Every appraisal considers up to three approaches, then reconciles them:

The exam expects you to pick the dominant approach for a property type: a school or library leans on cost, an apartment building on income, and a typical resale house on sales comparison.

Sales Comparison Approach

The appraiser finds recent sales of similar properties (comparables) and adjusts each comp to the subject. The cardinal rule: adjust the comp, never the subject.

• If a comp is superior to the subject, subtract value from the comp.
• If a comp is inferior to the subject, add value to the comp.

Worked example: subject has 3 baths. Comp sold for $400,000 but has 4 baths (a superior feature worth $8,000) and lacks a garage the subject has ($12,000). Adjusted comp value = $400,000 - $8,000 + $12,000 = $404,000. Repeat across comps, then reconcile the adjusted prices.

Cost Approach

The formula is: Reproduction or replacement cost new − Accrued depreciation + Land value = Value.

• Reproduction cost = exact replica using identical materials. Replacement cost = same utility using modern materials (more common).
• Land is valued separately because land does not depreciate.

This approach shines for new construction (little depreciation) and special-purpose buildings (churches, schools) with few comparable sales and no rental income.

The Three Types of Depreciation

Depreciation is loss in value from any cause. Memorize the three forms and whether they are curable:

• Physical deterioration — wear and tear (worn roof, peeling paint). Often curable.
• Functional obsolescence — outdated design within the property (one bathroom, no closets, bedroom only reachable through another). May be curable or incurable.
• External (economic) obsolescence — caused by factors outside the property (new freeway noise, declining neighborhood). Always incurable, because the owner cannot fix it.

Worked example: replacement cost $280,000, accrued depreciation $40,000, land $95,000. Value = 280,000 - 40,000 + 95,000 = $335,000.

Income Approach and the GRM

For income property, the direct capitalization formula is Value = Net Operating Income ÷ Capitalization Rate (the IRV triangle: I ÷ R = V, so I = R × V and R = I ÷ V).

Worked example: a building has NOI of $60,000 and the market cap rate is 8%. Value = 60,000 ÷ 0.08 = $750,000. Raise the cap rate and value falls; investors demand higher returns for riskier deals.

For small residential rentals, appraisers use the Gross Rent Multiplier: GRM = Sales Price ÷ Monthly Gross Rent. If comps show a GRM of 110 and the subject rents for $2,000/month, value ≈ 110 × $2,000 = $220,000.

Building NOI: From Gross Rent to Net Operating Income

Before you can capitalize, you must compute NOI correctly. The path is:

• Potential Gross Income (PGI) — rent if 100% occupied.
• Minus vacancy and collection loss → Effective Gross Income (EGI).
• Minus operating expenses (taxes, insurance, management, repairs, utilities, reserves) → Net Operating Income (NOI).

Crucial exam trap: NOI excludes mortgage debt service (principal and interest) and excludes income taxes and depreciation. Those are financing and ownership items, not property operating expenses. Worked example: PGI $120,000, vacancy 5% ($6,000), expenses $40,000. EGI = $114,000; NOI = $74,000. Do not subtract the loan payment.

Choosing GRM vs. Cap Rate, and Reading the Numbers

Use the GRM as a quick screen for small one-to-four-unit rentals where detailed expense data is thin — it works off gross rent and ignores operating costs. Use direct capitalization for larger income property where NOI can be reliably built from the rent roll and expense statement.

Relationships to memorize for the exam: a higher cap rate signals higher risk and a lower price, while a lower cap rate signals a safer, pricier asset. Holding NOI constant, value moves inversely with the cap rate. If two buildings each earn $50,000 NOI but one sells at a 5% cap ($1,000,000) and one at a 10% cap ($500,000), the market views the second as far riskier.

Reconciling the Three Approaches

When all three approaches are run, the appraiser reconciles them by judging reliability, not by averaging. The approach with the most and best data for that property type carries the most weight.

• Resale single-family home — sales comparison leads; ample comps exist.
• Brand-new or special-purpose building — cost approach leads; few comps, no income.
• Apartment or commercial rental — income approach leads; the buyer is buying a cash-flow stream.

A common trap presents three indications and asks for the value of a 12-unit apartment building; the correct answer leans on the income figure, never the arithmetic mean.

CMAs and BPOs — What Licensees Can Do

A Comparative Market Analysis (CMA) is a licensee's informal estimate of likely sale price using comparable listings and sales, given to help a seller price a home. A Broker Price Opinion (BPO) is a more formal written opinion, often ordered by lenders for short sales or REOs.

Neither is an appraisal, and neither requires an appraiser's license, though many states regulate BPO compensation and prohibit their use for federally related mortgage origination. Always disclose to clients that a CMA/BPO is not an appraisal of value. A licensee selecting comps for a CMA applies the same logic as sales comparison — adjusting recent, nearby, similar sales toward the subject — but stops short of the formal, USPAP-compliant analysis an appraiser performs.