7.3 THE THREE APPROACHES TO VALUE

The Sales Comparison Approach
In the sales comparison approach (also known as the market data approach) , an estimate of value is obtained by comparing the property being appraised (the subject property) with recently sold comparable properties (properties similar to the subject, called comps). Because no two parcels of real estate are exactly alike, each comparable property must be analyzed for differences and similarities between it and the subject property. The elements of comparison for which adjustments must be made include the following:

• Property rights: An adjustment must be made when less than fee simple, the full legal bundle of rights, is involved. This includes land leases, ground rents, life estates, easements, deed restrictions, and encroachments.
• Financing concessions: The financing terms must be considered, including adjustments for differences such as mortgage loan terms and owner financing.
• Market conditions: Interest rates, supply and demand, and other economic indicators must be analyzed.
• Conditions of sale: Adjustments must be made for motivational factors that would affect the sale, such as foreclosure, a sale between family members, or some nonmonetary incentive.
• Market conditions since the date of sale: An adjustment must be made if economic changes occur between the date of sale of the comparable property and the date of the appraisal.
• Location or area preference: Similar properties might differ in price from neighborhood to neighborhood or even between locations within the same neighborhood.
• Physical features and amenities: Physical features, such as the structure’s age, size, and condition, may require adjustments.

The sales comparison approach is considered the most reliable of the three approaches in appraising single-family homes, where the intangible benefits might be difficult to measure otherwise. Most appraisals include a minimum of three comparable sales reflective of the subject property.

Whenever possible, the comparables should be recent (less than six months) and close by (less than a mile) to the subject property.

Two condos in the same neighborhood, one that sold and one that is the subject of an appraisal, are very similar.

The comp sold for $145,000 and has a garage valued at $9,000. The subject property has no garage, but it has a fireplace valued at $5,000. What is the indicated value of the property?

$145,000 The comp sale price

–  $9,000 (The Comp is Better, Subtract—CBS)

+ $5,000 (The Comp is Poorer, Add —CPA)

$141,000 The indicated value of the subject property

Take the selling price of the comp and add or subtract for any differences, one at a time, from the subject property.

The rules are CBS and CPA.

• CBS = if the Comp is Better,
• CPA = if the Comp is Poorer, Add

The Cost Approach
The cost approach to value also is based on the principle of substitution. The cost approach consists of five steps:

1. Estimate the value of the land as if it were vacant and available to be put to its highest and best use.
2. Estimate the current cost of constructing the buildings and improvements.
3. Estimate the amount of accrued depreciation resulting from the property’s physical deterioration, functional obsolescence, and external depreciation.
4. Deduct the accrued depreciation (Step 3) from the current construction cost (Step 2).
5. Add the estimated land value (Step 1) to the depreciated cost of the building and site improvements (Step 4) to arrive at the total property value.

Current cost of construction = $185,000 Accrued depreciation = $30,000

Value of the land = $55,000

$185,000 – $30,000 + $55,000 = $210,000

In this example, the total property value is $210,000.

There are two ways to look at the construction cost of a building for appraisal purposes: reproduction cost and replacement cost.

1. Reproduction cost is the construction cost at current prices of an exact duplicate of the subject improvement, including both the benefits and the drawbacks of the property.
2. Replacement cost is the cost to construct an improvement similar to the subject property using current construction methods and materials, but not necessarily an exact duplicate. Replacement cost is more frequently used in appraising older structures because it eliminates obsolete features and takes advantage of current construction materials and techniques.

Determining reproduction or replacement cost

An appraiser using the cost approach computes the reproduction or replacement cost of a building using one of the following four methods:

• Square-foot method – This is the most common and easiest method of cost estimation. The cost per square foot of a recently built comparable structure is multiplied by the number of square feet (using exterior dimensions) in the subject building.
• Unit-in-place method. In the unit-in-place method, the replacement cost of a structure is estimated based on the construction cost per unit of measure of individual building components, including material, labor, overhead, and builder’s profit. The sum of the components is the cost of the new structure.

• Quantity-survey method. The quantity and quality of all materials (such as lumber, brick, and plaster) and the labor are estimated on a unit cost basis. These factors are added to indirect costs (e.g., building permit, survey, payroll, taxes, and builder’s profit) to arrive at the total cost of the structure. Because it is so detailed and time-consuming, this method is usually used only in appraising historical properties. It is, however, the most accurate method of appraising new construction.
• Index method. A factor representing the percentage increase of construction costs up to the present time is applied to the original cost of the subject property. Because it fails to take into account individual property variables, this method is useful only as a check of the estimate reached by one of the other methods.

Depreciation
In a real estate appraisal, depreciation is a loss in value due to any cause compared with today’s cost of replacement. It refers to a condition that adversely affects the value of an improvement to real property.

Land does not depreciate, it retains its value indefinitely, except in such rare cases as downzoned urban parcels, improperly developed land, or misused farmland. Depreciation is the result of a negative condition that affects real property.

Depreciation is considered to be curable or incurable, depending on the contribution of the expenditure to the value of the property. For appraisal purposes, depreciation is divided into three classes, according to its cause:

Physical deterioration.
A curable item is one in need of repair, such as painting (deferred maintenance), that is economically feasible and would result in an increase in value equal to or exceeding the cost. An item is incurable if it is a defect caused by physical wear and tear and if its correction would not be economically feasible or contribute a comparable value to the building, such as a crack in the foundation. The cost of a major repair may not warrant the financial investment.

Functional obsolescence.

Obsolescence means a loss in value from the market’s response to the item. Outmoded or unacceptable physical or design features that are no longer considered desirable by Purchasers are considered curable. Such features could be replaced or redesigned at a cost that would be offset by the anticipated in­crease in ultimate value.

Incurable obsolescence includes undesirable physical or design features that cannot be easily remedied because the cost of cure would be greater than its resulting increase in value.

External obsolescence.
If caused by negative factors not on the subject property, such as zoning, environmental, social, or economic forces, the depreciation is always incurable. The loss in value cannot be reversed by spending money on the property.

The cost approach is most helpful in the appraisal of newer or special-purpose buildings such as schools, churches, and public buildings. Such properties are difficult to appraise using other methods because there are seldom enough local sales to use as comparables and because the properties do not ordinarily generate income.

The income Approach
The income approach to value is based on the present value of the rights to future income. It assumes that the income generated by a property will determine the property’s value.

The income approach is used for valuation of income-producing properties such as apartment

buildings, office buildings, and shopping centers. In estimating value using the income approach, an appraiser must take five steps:

1. Estimate annual gross income. Current rental income may not reflect the current market rental rates, especially in the case of short-term leases or leases about to terminate so current rental income may be adjusted by an investor. Income also includes other income to the property from such sources as vending machines, parking fees, and laundry machines.
2. Deduct an appropriate allowance for vacancy and rent loss, based on the appraiser’s experience, and arrive at effective gross income.
3. Deduct the annual operating expenses, from the effective gross income to arrive at the annual net operating income (N0I). Management costs are always included, even if the current owner manages the property. Mortgage payments (principal and interest) are debt service and not considered operating expenses. Replacement of Capital items is handled by an allowance (reserve) representing the annual usage of each major capital item and included in the operating expenses.
4. Estimate the price a typical investor would pay for the income produced by this particular type and class of property. This is done by estimating the rate of return (or yield) that an investor will demand for the investment of capital in this type of building. This rate of return is called the capitalization (or “cap”) rate and is determined by comparing the relationship of net operating income to the sales prices of similar properties that have sold in the current market.
5. Apply the capitalization rate to the property’s annual net operating income to arrive at the estimate of the property’s value.

With the appropriate capitalization rate and the projected annual net operating income, the appraiser can obtain an indication of value by the income approach.

This formula and its variations are important in dealing with income property:

Income ÷ Rate = Value
Income ÷ Value = Rate
Value x Rate = Income
As the cap rate goes down, the value increases
As the cap rate goes up, the value decreases