Sales Comparison, Cost Depreciation, and Income Approaches
Intended Learning Outcomes
- Describe the assumptions underlying the sales comparison approach
- Construct a sales comparison adjustment grid using the proper sequence of adjustments
- Distinguish among normal sale price, market conditions-adjusted normal sale price, and final adjusted sale price
- Describe considerations regarding the applicability of the cost-depreciation approach
- Apply the steps in the cost-depreciation approach
- Distinguish among the three types of accrued depreciation the methods of estimating accrued depreciation
- Perform a GIM analysis
- Develop a reconstructed operating statement
- Calculate a market-derived capitalization rate and estimate value using the income approach formula
Sales Comparison Approach
In the SALES COMPARISON APPROACH, the appraiser examines other properties that are similar to the property being appraised. The comparables should be similar in construction quality, location, and size and should have sold recently. The sales comparison approach is relied upon heavily when appraising residential homes, vacant land, and small investment properties. The underlying assumption in the Sales Comparison Approach is based upon the principle of substitution which states that a knowledgeable buyer will pay no more for a property than the cost of obtaining an equally desirable substitute property.
There are three steps required in the Sales Comparison Approach:
1. Data collection for comparable properties that have sold recently
2. Adjustment of the comparables’ sales prices
3. Reconciliation of the adjusted sales price into a final value conclusion
Obtaining data on sales of comparable properties requires the appraiser to gather information about, not only the property but also the transaction itself. Property data includes physical factors such as size, number of bedrooms and baths, age, architecture, and zoning. Transactional characteristics include such items as financing terms, market conditions (sale date), and condition of sale (arm’s length transaction). This data can be collected from public records and the MLS system of the local Association of REALTORS®. The minimum number of comparables to be used is three, however, between eight and ten are recommended.
Once the proper comparables have been gathered, the appraiser then adjusts the comparables to be as similar to the SUBJECT PROPERTY as possible. Only the comparables are adjusted, not the subject property being appraised. If the comparable is better than the subject, the appraiser must deduct the value difference from the comparable to make it like the subject. If the comparable is inferior, the value must be added to the comparable to make it like the subject.
In the adjustment process, there is a specific sequence that must be followed. Transactional characteristics are adjusted first, followed by the adjustment of property characteristics follows.
The final step in the sales comparison approach is the value conclusion process. This process is known as RECONCILIATION which is a weighted averaging that gives more validity (weight) to those properties more like the subject and less validity to those less similar.
Elements of comparison-transactional and property characteristics
These adjustments vary from transaction to transaction and include the following:
1. Conditions of Sale:
In order for a comparable sale price to be useful, the appraiser must confirm that the sale was an ARM’S LENGTH TRANSACTION. That is, the appraiser must ascertain that the parties were not related to each other, that neither party was under duress, and neither party had an advantage over the other party. If the transaction was not arm’s length, the appraiser must ascertain a dollar value to the condition of sale and then either add or subtract that value to the purchase price. If the conditions of sale resulted in a lower than expected purchase price, the dollar value of the condition must be added to the purchase price actually paid.
2. Adjusting for Financing Terms:
If the comparable sale included financing terms more favorable than market rates, the appraiser must assign a value to the financing and subtract it from the purchase price actually paid. Types of non-market financing include mortgage assumption, seller financing, contract for deed, and wrap-around loan. To adjust for financing, there are typically two different methods. One method is called market abstraction. In this method, the appraiser locates several comps, some of which have typical financing while others have atypical financing. By comparing the difference in prices between these properties, the appraiser can estimate a dollar value for the financing situations.
The other method used for placing a dollar value on atypical financing is called the CASH EQUIVALENCY METHOD. Under this method, the appraiser calculates the present value of cash inflows or outflows by discounting them at the appropriate discount rates. After applying the discount procedure, the resulting values are expressed in terms of their cash equivalencies.
3. Adjusting for Market Conditions:
Because property values can increase over time, the appraiser must make adjustments for appreciation. The appraiser determines a “time adjustment” value and adds it to the comp’s purchase price. The process is also used in the event of depreciation. Adjusting for market conditions would be necessary in a neighborhood when values have risen or fallen since the time of the comp sale. The difference in value over time could be attributed to a number of market factors, including supply and demand, interest rates, and the local economy.
Under the successive sales analysis, the history of a property’s sales over a specified period of time is monitored to understand the overall, average rate of appreciation (or depreciation). This analysis results in determining a property’s overall monthly rate of change, calculated as follows:
1. Resale price – Original Sale Price = Total Value change
2. Total Value change ¸ Original Sale Price = Percentage change
3. Percentage change ¸ # of months between sales = monthly rate of change
Once the monthly rate of change is determined, that number is multiplied by the purchase price of the property to determine the dollar amount of appreciation (or depreciation). The monthly dollar amount is then multiplied by the number of months since the property was purchased by the current owner.
Example: A property was purchased 42 months ago for $220,000 and recently sold of $275,000. What is the monthly rate of change?
1. $275,000 – $220,000 = $55,000
2. $55,000 ¸ $220,000 = .25
3. .25 ¸ 42 = .00595
Once the monthly rate of change for a neighborhood is determined, the appraiser can then use that number to adjust comps in the neighborhood.
Example: A comp sold for $249,000 seven months ago in a neighborhood that has a monthly rate of change of .00595. What is the adjusted value of this comp so that it reflects current values?
1. .00595 x 7 months = .04165
2. $249,000 x .04165 = $10,370.85
3. $249,000 + $10,370.85 = $259,370.83
Adjusting for Property Characteristics
These adjustments are concerned with how the subject property and the comparable property differ from one another physically. Examples of differences could include size, condition, number of bedrooms, number of bathrooms, and other physical features. Adjustments for property characteristics include the following:
1. Adjusting for Personal Property: If the comparable purchase price included furniture or other personal property, the appraiser must ascertain a dollar value for those items and subtract that number from the comparable’s purchase price. Additionally, if a comp sale had significant fixtures that were included in the purchase price, a dollar value for the fixtures should be subtracted from the sale price.
A fixture is an item of personal property that has been installed or affixed so that it is considered to be part of the real property. Many fixtures are considered betterments and add value to the property. Once installed, fixtures must remain as part of the real property that is bought or sold, unless the item is a trade fixture installed by a commercial tenant. Trade fixtures are defined as an item that has been installed at a business location for business use, such as shelving, display cases, or appliances necessary for a business operation. The law provides that a commercial tenant may remove these trade fixtures at the termination of the lease even though the trade fixtures were permanently attached. However, the tenant is responsible for restoring the premises to its original condition.
2. Adjusting for Location: If the comparable’s location is superior, a dollar value is assigned to that difference, and the amount is subtracted from the comparable’s purchase price. If the comparable’s location is inferior, the dollar amount of that difference is added to the comparable’s purchase price.
By utilizing a method known as the “paired sales analysis”, an appraiser can determine the difference in value because of a location and determine a location “premium” that is added to a property’s value. This technique requires locating two comps that are nearly identical so that their only difference is location.
Method of Adjustment
In order to determine what the comparable property would sell today, the price paid for the comparable is adjusted toward the subject property. If the comparable has a feature superior to the subject, that difference (in terms of dollars) is subtracted from the comp’s purchase price. If the comparable has a feature that is inferior to the subject, that difference is added to the comp’s purchase price. Remember: CBS (comp better subtract) and CIA (comp inferior add). Types of adjustments include the following:
1.Dollar and Percentage:
Adjustments for property differences are made by adding or subtracting the dollar amount of the differences. Adjustments are made only to the comp, never on the subject property. Dollar adjustments are used if the market evidence indicates that buyers and sellers conceive of differences in terms of dollars. Other adjustments, such as appreciation, are almost always expressed as a percentage. For example, a comp that sold 6 months ago for $225,000 with a 1% appreciation rate for the neighborhood would be adjusted to $238,500 for a current value ($225,000 x 6% = $13,500 appreciation).
For dollar adjustments, a feature (such as a bedroom) receives a specific dollar value. For example, a four-bedroom home would carry a slightly higher value than a three-bedroom home regardless of the square footage.
2.Sequence of Adjustment:
The appraiser should first identify the comp’s purchase price. That amount is then adjusted for any conditions of sale (e.g. the seller and buyer were siblings) to arrive at the Normal Sales Price. This is the price that more accurately reflects market value if the transaction had been at arm’s length.
The Normal Sales Price is next adjusted for market conditions (e.g. appreciation, which is a time adjustment) to determine the Market Conditions Adjusted Normal Sale Price which is the price we would expect the comp to sell for in today’s market.
The Market Conditions Adjusted Normal Sale Price is then adjusted for physical differences (e.g. square footage) to arrive at the Final Adjusted Sale Price. Once the Final Adjusted Sale Price has been determined, it will be compared to other comps used in the process to arrive at an overall range of values determined through the process of RECONCILIATION in which the various comps are weighted and averaged.
The cost depreciation approach is based on the premise that a potential buyer will pay no more for a property than the cost of acquiring a comparable lot and constructing a new improvement of equal utility. Therefore, new construction of equal utility tends to set the upper limits of value. The cost depreciation approach to value is based on the principle of substitution and is relied upon extensively when appraising unusual or special purpose properties (no comps available).
There are several steps in the cost depreciation approach: estimating reproduction cost, estimating accrued depreciation, subtracting depreciation from reproduction cost, estimating land value (comparable sales approach), estimating the value of any other improvements, and adding the site value and other improvement value to the depreciated value of the building.
The value of the land is generally determined by using the comparable sales approach.
Applicability of the Approach
An appraiser has important tools to use with the three approaches to value. These are the Sales Comparison Approach, the Cost-depreciation Approach, and the Income Approach. The approach an appraiser chooses will depend upon the particular property for which he is determining the value. For example, if the subject property is a residential home, he will probably not be able to use an income approach because the home does not have income.
On the other hand, if an appraiser is looking to find the value of a property that has income, he may be able to use all three approaches if there are similar properties currently on the market or that have been sold in the last year. Every broker should understand how value is determined by an appraiser and the approaches used so that brokers can teach their sales staff to price property so it will sell and appraise for a loan. The sales staff can also help to explain to both buyers and sellers the importance of the appraisal because of its impact on the loan, due to FIRREA.
Steps in the Cost-Depreciation Approach
Steps involved in the Cost Approach:
Step 1: Determine either the replacement or reproduction cost of the building.
Step 2: Deduct all accrued depreciation from the replacement cost.
Step 3: Estimate the value of the land alone as if vacant.
Step 4: Add the estimated land value to the depreciated replacement or reproduction cost.
Reproduction or Replacement Cost
Reproduction cost is the amount of money required to construct a new building that is an exact replica of the structure being appraised. Do not confuse reproduction cost with replacement cost. Replacement cost refers to the expense of building a property of equal utility that is similar but not identical. The appraiser determines reproduction cost, not replacement cost.
This approach is used on buildings which do not have market data because they are unusual properties (school, post office, library, etc.) or buildings without income).
Reproduction cost: To replace with the same materials as original construction (much more expensive!). Example: Historical building would usually be restored using the original materials as much as possible.
Replacement cost: To replace with current materials and methods with utility and function similar to original. Example: If a modern house burned, it would be rebuilt using current materials and methods of construction.
Cost can be determined by one of three methods:
1. 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 (for example, building permit, survey, payroll, taxes, and builders profit) to arrive at the total cost of the structure. Because of the detail and the time consumed, this method is usually used only in appraising historical properties. It is, however, the most accurate method of appraising new construction.
2. 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. Most components are measured in square feet, although items such as plumbing fixtures are estimated by cost. The sum of the components is the cost of the new structure.
3. Comparative-unit method (or square-foot or cubic-foot method). Using outside measurement, how many square feet times a cost for either replacement or reproduction.
Depreciation is a loss in value due to any cause; any condition that adversely affects the value of an improvement. The three types of depreciation are:
1. Physical deterioration. A reduction in utility, usefulness or value resulting from a physical condition. The deterioration can be divided into either curable (painting/routine maintenance) or incurable types (installing siding on a building which also needs major interior repairs). This form of depreciation is caused by the action of the physical elements, such as wind or snow, or just ordinary wear and tear. Fixing a broken window is curable physical deterioration!
2. Functional obsolescence. A loss of value of an improvement due to functional inadequacies, often caused by age or poor design. Outmoded plumbing fixtures, inadequate closet space, poor floor plan, excessively high or low ceilings, or antiquated architecture are all examples of functional obsolescence. Functional obsolescence may be curable, such as putting in a new electric stove instead of a wood-burning stove. Functional obsolescence may be incurable, as in the case of wide columns in a building that cannot be removed. Cold, breezy windows are an example of functional obsolescence! The insulation of the windows is not up to current standards.
3. External obsolescence. A loss of value (typically incurable) resulting from factors that exist outside of the property itself; a type of depreciation caused by environmental, social, or economic forces over which an owner has little or no control. This can also be called locational, economic or environmental obsolescence. This type of obsolescence is almost always INCURABLE. A convenience store locating next to your home is external obsolescence.
Appraisers using these methods of depreciation are using the BREAKDOWN METHOD of depreciation which gives a property an ECONOMIC LIFE (how long it should last with no maintenance) and an effective age (how old the improvement looks). The effective age, which considers maintenance, represents the amount of depreciation that has accrued to the building. The remaining balance of time represents the depreciated value of the building.
Another method is the Market Extraction method, which compares the depreciation of similar properties. The appraiser compares the cost of reproduction as if both properties were new and sold at current market value.
The third type of depreciation is based on the Lump-sum age-life method, which uses effective life divided by economic life and which results in accrued depreciation.
The INCOME CAPITALIZATION APPROACH to value suggests that the cash flows from rental properties have value. The income approach to value is based on the principle of anticipation and is relied upon heavily when appraising commercial and investment properties. All calculations in this approach should be annualized.
There are five steps in the income capitalization approach to value:
1. Estimate potential gross income (PGI)
2. Estimate and subtract vacancy & collection losses (V&C)
to determine effective gross income (EGI)
3. Estimate and subtract operating expenses to calculate net operating income (NOI)
4. Estimate a capitalization rate (market generated)
5. Apply the IRV formula to get value (income div. by rate = value)
Potential Gross Income
– Vacancy and collection losses
+ Other Income
Effective Gross Income
– Operating Expenses (including reserves)
Net Operating Income
Potential gross income (PGI) is considered to be the maximum revenue a property can generate under the best conditions with full occupancy. PGI is determined in two ways:
1. MARKET RENT is calculated by using the rents of comparable properties. This method is the most common used by appraisers.
2. CONTRACT RENT is used when an investment property has current tenants under long term leases (more than one year). This method is used to value stable tenants in shopping centers and office complexes.
Vacancy and collection losses exist when a property is not fully occupied or the tenants are not paying according to their leases. If the property has other income, such as vending machines, it should be added only after vacancy has been factored out.
Effective gross income (EGI) is the actual income that a property owner has available to pay bills. It is calculated by subtracting Vacancy and Collection losses from Potential Gross Income.
Operating expenses maintain properties and are classified in three categories:
1. Fixed expenses will be payable regardless of the occupancy rate. Taxes and insurance are considered fixed expenses.
2. Variable expenses will fluctuate depending on occupancy. Maintenance, management, and utilities are considered variable expenses.
3. Reserves for replacement is simply money set aside to pay for items that will break down later.
Operating expenses do not include the mortgage payment (debt service) or depreciation (for tax purposes).
Net Operating Income
The capitalization rate, also known as the cap rate or overall rate, is determined by comparing other similar properties that have sold (value) to their net income. The cap rate is considered to be either a required return or a return that is market driven.
Factors involved: Income (NOI), Rate, and Value. If you know two factors, you can find the third.
I I = Net Operating Income
R x V R = Capitalization Rate
V = Value (purchase price)
I = R x V
R = I
V = I
Example: What is the capitalization rate if Net Operating Income is $50,000 and the value is $400,000?
$400,000 = 12.5%
Gross Rent Multiplier
The GROSS RENT MULTIPLIER (GRM) is a simplified method in determining the value of smaller income-producing properties. It expresses the relationship between current market rent of a rental property and a multiplier which is market-driven that determines market value. Generally speaking, the GRM is a monthly calculation using a property’s monthly gross income. This approach is applied when the monthly rent is stable throughout the year.
In situations in which rents fluctuate throughout an annual rental period, the Gross Income Multiplier (GIM) is used. For example, a condominium on the beach may rent for one amount during the summer and another amount during the winter. To calculate use Annual Effective Gross income since we are looking for annual gross rent actually collected.
Factors involved: Value, Rent, and Multiplier. If you know two factors, you can find the third.
V V = Value (purchase price)
R X M R = Rent
M = Multiplier
V = R x M
R = V
M = V
Example: If the property’s value is $800,000 and the monthly rent is $5,000, what are the property’s Gross Rent Multiplier and Gross Income Multiplier?
Gross Rent Multiplier = 800,000 Gross Income Multiplier = 800,000
GRM = 160 GIM = 13.3
The underlying assumption in the Sales Comparison Approach is based upon the principle of substitution which states that a knowledgeable buyer will pay no more for a property than the cost of obtaining an equally desirable substitute property.
The Transaction Price is the price actually paid for a comparable property. The Normal Sales Price is the price of the comp after adjusting for conditions of sale and non-market financing. The market conditions adjusted normal sale price is the price after adjusting appreciation of depreciation (time). The final adjusted sale price is the actual price after making adjustments based on comps physical characteristics.
The final adjusted sale price is the price used to compare the various comps in establishing a range of values for the subject property.
The Cost-Depreciation Approach is appropriate for special purpose properties or other unusual properties and no comps are available.
Accrued depreciation includes physical deterioration (wear and tear), functional obsolescence (design problem), and external obsolescence (factors outside the subject property).
Gross Income Multiplier compares the relationship between a property’s value and the amount of gross income collected in a year.
Capitalization rate evaluates the relationship between a property’s net operating income and its value.
Vocabulary List: accrued depreciation, arm’s-length transaction, economic life, contract rent, curable, effective age, effective gross income, external obsolescence, fixed expense, fixture, functional obsolescence, incurable, market rent, net operating income, personal property, physical deterioration, potential gross income, replacement cost, reproduction cost, reserve for replacements, trade fixture, vacancy and collection loss, variable expense