Topic 16.4: Introduction to the Three Approaches to Value

Learning Objective

After successfully completing this topic, you will be able to differentiate among the three approaches to estimating the value of real property.

Three Methods to Estimate Property Value

There are three principal methods used in estimating real property value:
• sales comparison approach,
• cost approach, and
• income approach.

Most appraisers will use all three approaches to value if they are appropriate. For example, using the income approach to value when appraising a church may not be helpful. 

Sales Comparison Approach 

This approach is based on the theory of substitution. If a buyer can purchase a similar property for a lower price, the buyer will buy that property. The approach used by the appraiser is to value the subject property based on recent sales of similar (comparable) properties in the neighborhood. Differences in the sold properties from the subject property are accounted for by adjusting the sale price of the comparable property, not to the subject property.

CIA-CBS      

The easiest way to remember the way to adjust the comparable is by the acronyms “CIA / CBS.”

If the Comparable is Inferior, Add,       If the Comparable is Better, Subtract.

Theory of method

The sales comparison approach to value lets the market tell the appraiser what prices buyers are paying in the market for similar homes. The purpose of most appraisals is to find the market value of a property. The sales comparison approach comes closest to achieving that purpose.

Steps in the approach

The appraiser should locate the most recent sales in the neighborhood. This is most commonly done by a search of newly recorded deeds in the county clerk’s office. The MLS is also a good source of pending sales. It can also be used to give a better description of a property’s features.

Once the appraiser finds recent sales in the neighborhood, the appraiser will review each one to determine whether it is like the subject. For example, a two-story house is not a great comparable sale if the subject is a 3-bedroom ranch house. The age of the comparable should be roughly the same as the subject property. A 30-year old home is not like the subject property if it is two years old.

Once the comparable properties have been selected, the appraiser will prepare an adjustment grid, listing each of the properties on the grid. The appraiser will adjust each of the comparable sales so that they reflect that characteristic of the subject property. Adjustments are made to the comparable property only, never to the subject property.   

State Exam Tip   
Students should remember that adjustments are made to the comparable property, never to the subject property.

Making adjustments

Assume that the subject property has a living area of 3,000 square feet, while the comparable property had 2,800 square feet. The comparable property sold for $400,000. If the appraiser’s study of the market shows that differences in square footage should have an adjustment of $70 per square foot, the adjustment would be $14,000 (200 x $70).

Adjusted sale price

The $14,000 would be added to the sale price of the comparable property, making the adjusted sale price $414,000. 

How can I remember which way to adjust the comparable sale?

Adjust from the comparable toward the subject. If the comparable is inferior to the subject, add. If the comparable is better than the subject, subtract.

Types of property best suited for this approach

The types of property best suited for this approach are in an active market with several recent sales. The approach would not be used for properties that don’t sell often, like factories, which would be valued using the cost approach. Apartment buildings and office buildings have many dissimilarities. Investors value these properties by their rates of return, and appraisers use the income approach.

Cost Approach

Theory of method

The cost approach is based on the premise that the value of a property can be estimated by the land value and the investment required to reproduce the building new, less depreciation. It is used as a check on the other approaches, and is used as the primary approach for special-purpose buildings, such as hospitals, or schools.

Steps in the Approach

1. Estimate the current cost to reproduce the building new.
2. Estimate the total depreciation of the building and subtract it from the cost to reproduce the building.
3. Estimate the value of the land as if the land were vacant.
4. Add the value of the land to the depreciated value of the structures.

Reproduction vs. replacement cost

Reproduction cost is the cost to exactly reproduce the improvements as of the date of the appraisal.

Replacement cost is the cost required to build a substitute property having the same use as the subject property using modern, updated materials.

Step 1: Estimate the Current Cost to Reproduce the Building New

There are 3 major methods:
• Quantity survey method is a detailed inventory of every item in the building, plus the labor, financing, and builder’s profit. While builders use it on new buildings (so they know what quantities of materials are necessary), many appraisers feel the small additional accuracy of this method does not justify the extra time required.
• Unit-in-place method is a shortcut of the quantity survey method. It is the cost of each item of material plus the labor cost to install the item.
• Comparative square foot method, also called the “unit comparison method” is the most used. If the appraiser knows the cost of a similar building recently constructed, it is called the benchmark, or the standard. By making adjustments for differences in size and materials, etc. the appraiser can closely approximate the cost to reproduce the subject.

Example
Assume an appraiser has determined that the costs per square foot to build a house of average size in an area are as follows: Living area: $160; garage: $90, porch: $65 The subject property has 2,100 square feet interior, 500 square foot garage, and a covered porch of 200 square feet. The appraiser would calculate the reproduction costs as follows:

Living area:	2,100 sq. ft	x	$160	=	$336,000
Garage:	500 sq. ft.	x	$ 90	=	$  45,000
Covered porch:	200 sq. ft.	x	$ 65	=	$  13,000
Total Reproduction Cost					$394,000

Cost estimating manuals

If local building costs are scarce or not available, the appraiser can use one of several cost estimating services. The service shows typical costs of reproduction for many types of structures. The service will also provide multipliers to convert the national costs to the local costs of the appraiser’s area.

Index method

Another method for estimating the current cost to build a similar home is to use the index method. The appraiser would have to know the original cost of building the subject property and apply an index to that cost. This method can be useful if the existing property is not more than 5 or 6 years old.

Estimate depreciation assuming that the subject property’s reproduction cost is $394,000. The property is 10 years old and has an expected useful life of 40 years.

Example Assume an appraiser is estimating the cost of building a house similar to the subject. The owner has the construction contract for the house which was built five years ago for $243,000.   A review of the building costs shows an increase of 31% from the time of building, so the building costs for today would be approximately 131% of the costs five years ago. The appraiser estimates $318,000 for the reproduction cost ($243,000 x 1.31).

Step 2: Estimate Depreciation

The cost of a building is not always its market value because the building may be older or poorly designed, or in a bad location. The appraiser must estimate the loss of value from depreciation, then subtract that depreciation from the building’s cost.

Depreciation as used in real estate appraisals has a different meaning than it has for calculating income taxes. Depreciation used by appraisers is an estimate of the loss of value due to all causes. Tax depreciation is an arbitrary figure to allow investors a tax deduction.

Land is not depreciated. Land is valued at its current use, without regard to its original purchase price.

Depreciation can be classified as either curable or incurable.
• Curable depreciation is a loss of value that can be corrected at a cost less than the resulting increase in property value. An example would be the repair of broken glass.
• Incurable depreciation either cannot be corrected or would cost more than the increase in property value. An example would be a traditional house located in an undesirable industrial area.

The three types of depreciation are

• Physical deterioration is ordinary wear and tear and physical damage. (peeling paint, broken windows, etc.)
• -It is curable depreciation if fixing the defect will add at least as much value as it costs.
• -It is incurable depreciation if fixing a defect will not add at least as much value as it costs.
• Functional obsolescence is anything which is inferior to a new structure of the same type. It may be curable or incurable. A four-bedroom house with one bath is functionally obsolete. A house with large windows on the west side that overheats in summer is functionally obsolete.
• External obsolescence is a loss in value which is caused by problems outside the property. The loss is usually incurable.

Calculating accrued depreciation using age-life method

Estimate depreciation assuming that the subject property’s reproduction cost is $394,000. The property is 10 years old and has an expected useful life of 40 years.

Example Estimated total reproduction cost is $394,000. Depreciation is 25% (10 years ÷ 40 years). Depreciation is $98,500 ($394,000 x .25). Depreciated value of improvements is $295,500 ($394,000 – $98,500).

Step 3: Estimate the Value of the Land as if Vacant

The value of the land is normally estimated using the comparable sales approach. The appraiser tries to find a similar site to the subject property.

Example If a comparable building site in the neighborhood was 100’ x 85’ and sold for $42,000, it sold for 4.94 per square foot.  (100 x 85) = 8,500 square feet. $42,000 ÷ 8,500 = $4.94 per sq. ft. If the subject property’s site measures 105’ x 92’, the value of the site would be $47,720. (105 x 92 = 9,660 square feet x $4.94 per sq. ft).

Step 4: Add the Value of the Land to the Depreciated Value of the Structure

The value of the property as indicated by the cost method is $146,220, say $146,000. ($98,500 + $47,720, rounded)

Application of approach

The cost approach to value is most appropriate for properties that are not typically sold or rented, such as schools, libraries, and town halls. The comparable sales approach and the income approach would not result in any meaningful value. The value estimated by the cost approach sets the maximum value for a property.

Income approach 

The basis for this approach is that values of real property for investors are usually determined by the rate of return available to an investor.

Theory of method

The income approach to value is based on the present value of future income from the property. Appraisers use the principle of substitution to find the rates of return based on market activities.

Steps in the approach

Step 1: Estimate potential gross income (PGI) for the property.
Step 2: Find effective gross income (EGI) by deducting vacancy and adding other income.
Step 3: Estimate property expenses.
Step 4: Find net operating income (NOI) by deducting expenses from effective gross income.
Step 5: Estimate the appropriate capitalization rate.
Step 6: Find value by dividing the NOI by the capitalization rate.

Step 1: Estimate Potential Gross Income (PGI)

Potential gross income is the amount of income the owner would receive if the property were 100% rented. This would be very unusual, because rental properties typically have vacancies.

Example Assume that the property has 70 units that each rent for $1,200 monthly. The monthly potential gross income would be $84,000 (70 x $1,200). The annual potential gross income would be $1,008,000 ($84,000 x 12 months).

Step 2: Estimate Effective Gross Income (EGI)

Effective gross income is the typical amount a property would bring in from rentals, less vacancies and collection losses. Vacancies mean that an apartment is ready for rent, but is vacant. Collection losses occur when the apartment is occupied, but the owner can’t collect the rent.

Example Assume the occupancy rate is 94%. That means there is a 6% vacancy rate. The monthly EGI will be $78,960 ($84,000 x .94).  The annual EGI is $947,520.

Step 3: Estimate Property Expenses

The three types of property expenses are:
• Fixed expenses are those costs that don’t vary based on the occupancy rate. Property taxes and insurance are fixed expenses.
• Variable expenses fluctuate with the rises and falls in the occupancy rate. Examples would be management expense (part of this is commissions on rentals), supplies, maintenance, and garbage collection.
• Reserves for replacement is an amount charged against the income (but not usually set up in a reserve bank account). It is for component parts of the improvements like the roof, HVAC (heating, ventilation, and cooling), and carpeting which wear out faster than the structure itself.

Example Assume that the total operating expenses are 42% of EGI. So, the total expenses are $398,126 (947,920 x .42).

Step 4: Find Net Operating Income

Find net operating income by subtracting expenses from the effective gross income. The NOI for this property is $549,794 ($947,920 – $398,126).

Calculating net operating income

Potential gross income	$1,008,000
Vacancy and collection losses (6%)	– 60,480
Effective Gross Income	$ 947,920
Operating Expenses (42% of EGI)	– 398,126
Net Operating Income	$ 549,794

Step 5: Estimate the Appropriate Capitalization Rate

To find an appropriate capitalization rate, appraisers locate similar income properties that have sold recently. Dividing the net operating income by the sale price results in a capitalization rate that can be applied to the subject property’s net income.

Step 6: Find Value by Dividing the NOI by the Capitalization Rate

To estimate value with this approach, use the basic formula:

I÷ R x V
I = Income (annual net operating income).
R = Rate (of interest). The capitalization rate represents the relationship  between net income and sale price.
V = Value (of property).

To find the formula you need, cover the item you are solving for.

Example—To find the value If an investor for the property shown above wants a 10% rate of return, what is the value? Solution: You are solving for value, so cover the “V” in the IRV formula to get the formula for the solution. NOI is $549,794. V = I ÷ R $549,794 ÷ .10 = $5,497,940

Example—To find the capitalization rate If the investor paid only $4,500,000 for the property, what is the capitalization rate? Solution: Cover the “R” in the formula: I ÷ V $549,794 ÷ $4,500,000 = .12.2 or 12.2%

Example—to find the income If a different property is priced at $2,500,000, with a capitalization rate of 9.5%, what is the income? Solution: Cover the “I” in the formula: R X V .095 X $2,500,000 = $237,500

Applications of approach

The income approach to value is used to value income properties where the rates of return on properties are more important than just the bricks and mortar. Investors make their decision to buy or sell based on the income approach to value.

Reconciliation of the results from the three approaches to value

When more than one approach to value is appropriate, the results from that approach are likely to be different from one or more of the other approaches. The appraiser’s job is to use good judgment to estimate the value of the property.

For example, assume a residential property where the results from the three approaches to value are:

Comparable sales approach	$436,000
Cost approach	$442,000
Income approach	$434,000

The appraiser could simply average the results and get $437,330, say $437,000. Averaging is not appropriate; the appraiser should give serious consideration to the application of each approach to value.

The appraiser could weight the results based on the appraiser’s judgment:

Comparable sales approach	$436,000	x	50%	=	$218,000
Cost approach	$442,00	x	40%	=	$176,800
Income approach	$434,000	x	10%	=	$ 43.400
Total reconciled value					$438,200 [say $438,000]

Or, the appraiser could say that the comparable sales approach is the most appropriate approach to valuing residential property in an active market and use $436,000 as market value.           

Gross Rent Multiplier and Gross Income Multiplier

Gross rent multiplier (GRM) 

The gross rent multiplier is a multiple of the potential gross rent of a property. GRM is derived from the comparable sales approach, using sales of similar rental properties.

Example If a 3-bedroom house rents for $400, and the GRM is 100, what is the value? Solution: $400 X 100 = $40,000

Gross income multiplier (GIM)

Another multiplier is used to estimate the value of larger income properties. It is based on the annual income of the property. 

Example If the potential gross income of an apartment property is $50,000 annually, and the GIM is 5, what is the value of the property? Solution: $50,000 X 5 = $250,000

GRM is not a substitute for the income approach to valuation 

The gross rent multiplier and the gross income multiplier are shortcuts to give a quick estimate of the value of properties, but should not be used as the only approach. The multipliers are based on potential gross income and don’t take into account the property expenses. Because of this weakness an old property could be valued as high as a newer property.