Notes

There are three main approaches to property value estimation: sales comparison approach, cost-depreciation approach, and income capitalization approach. These approaches are not mutually exclusive, and an appraiser may use all three in conjunction with one another to estimate property value. However, an appraiser may focus on an approach that is most relevant to the type of property being assessed.

The sales comparison approach is most applicable to residential property and vacant lots where comparables can be found. The sales comparison approach to appraisal utilizes two value principles: contribution and substitution. The value principle of substitution states that a person will only pay as much for a property as he or she would be willing to pay to acquire a comparable property. The principle of contribution states that an improvement to a home is only worth as much as it adds to the property's market value and does not relate to the improvement's actual cost.

In addition to the adjustments made for differences in property amenities, adjustments are also made to account for changes in market conditions since date of sale, differences in financing terms and conditions of sale. Adjustments are made to achieve the greatest similarity possible between comparable properties and the subject property.

Use these phrases to help decide whether to add or subtract value from the comparable property:
More is Less: If the comparable has something MORE than subject, then LESS means subtract value from the comparable.

Less is More: If the comparable has something LESS than the subject, than MORE means add value to the comparable.

Additional adjustments should include the following:
Financing Terms: In order to determine if the sale price reflects special financing terms, an appraiser must investigate the financing associated with each sale.

Conditions of Sale: An appraiser must verify the conditions of sale to check whether the buyer or seller was under unusual pressure to buy or sell, or if there was a personal relationship between the parties.

Market Conditions: Market conditions fluctuate over any given period of time; as a result, an appraiser must determine whether the price paid for a comparable property (sold during another period of time) would increase or decrease if sold on the current market.

Square Footage: If a comparable is larger in square feet than the subject property, a downward adjustment must be made. If a comparable is smaller than the subject property, an upward adjustment must be made.

Landscaping: If a comparable property has better landscaping than the subject property, a downward adjustment is made.

After comparable properties have been assessed and appropriate adjustments have been made to the comparable property purchase price, an appraiser determines the adjusted sale price for each comparable property. If the comparables are more or less equally suitable for assessing the value of the subject property, the appraiser may average the adjusted sale prices. If one property is more suitable than another, the appraiser may place more emphasis on that comparable property's adjusted sale price. Reconciliation is the process of weighting the adjusted sale prices of comparable properties to reach a final value estimate for the subject property.

The cost-depreciation approach is most applicable to special purpose structures or new construction where there are no comparables. The cost-depreciation approach estimates the value of a property by separating land value and the value of all present improvements.

To approximate the value of the improvements, the appraiser estimates the cost of replacement of a structure with new materials at current market prices. The appraiser then subtracts any depreciation on the actual improvements to calculate the current value of the improvements. The appraiser adds this amount to the estimated site value, usually found through the sales comparison approach.

The cost-depreciation approach to appraisal requires several steps. It is important to note that this approach uses the sales comparison approach to establish the value of land. An appraiser must calculate the value of the building and the value of the land independently. Review the following steps:

1. Estimate the reproduction or replacement cost of the improvements. Reproduction cost is the amount of money that would be necessary to build an exact replica of the original structure (normally used exclusively for historically significant properties). Replacement cost is the amount of money that would be necessary to replace a structure with the same use and function as the subject property using new materials. Cost manuals that contain information regarding construction may help in assessing the cost of these materials.
There are three methods that are commonly used in estimating building reproduction or replacement costs:
Quantity Survey Method: All labor, building supplies, products, and builder's profit are inventoried. The cost for each item is multiplied by the number of items required for building. Additionally, the hours for each type of labor is estimated, and then multiplied by the cost per hour. These costs, plus overhead and indirect costs, are then added to reach an aggregate cost for reproduction or replacement.
Unit-in-place Method: The cost of materials, plus the cost of labor for construction of the materials, is calculated for each part of the new structure, such as the foundation or roof. The unit cost for a part is multiplied by the number of units in the entire structure. For example, the unit cost for a roof tile is multiplied by the number of tiles in the entire roof. These costs are added to builder's profit to reach the cost for reproduction or replacement.
Comparative Square-foot or Cubic-foot Method: The replacement costs of a similar property are used to estimate the replacement costs of the subject property. The comparative property must be similar in size; adjustments are made for quality, shape, and amenities. This method is most commonly used by appraisers because it is relatively fast and easy. However, the employment of this method is usually limited to small structures, such as single family dwelling units.

2. Estimate the amount of depreciation in dollars on the existing building, excluding the land. Deprecation is a loss in value due to any cause or any condition that adversely affects the value of an improvement. There are three main causes of depreciation:
Physical deterioration: The normal wear and tear caused by use, lack of maintenance, and exposure to weather. If the correction of a defect results in as much added value as the cost to correct, such defect is curable. If the cost of correcting a defect is greater than the added value, the defect is incurable.
Functional Obsolescence: Any structural component that is obsolete or inadequate in operation, such as old plumbing or outdated fixtures. Functional obsolescence also includes over-improvements, and should be identified as curable or incurable.
External Obsolescence: A loss of value due to external factors such as population decreases, legislative action or the deterioration of a neighborhood. Because these causes for depreciation are beyond the control of the property owner, they are identified as incurable.

Steps in the Cost-Depreciation Approach
One approach to estimating depreciation is the straight-line method. This method implies that for each year of economic life of the structure, an equal amount of structural value is lost. Economic life is the estimated period over which a property may be profitably utilized. Depreciation may be calculated for each year of a property's economic life and then added to total the accumulated depreciation.

Another approach to estimating depreciation is the age-life method. This method is based on a ratio of a property's effective age to its economic life. Effective age is the age determined by the current structural condition and utility. For example, a five-year-old home that is used during the summer months, and therefore does not have a significant amount of wear and tear, may have an effective age of only two years. To calculate accrued depreciation using the age-life method, divide effective age by total economic life and multiply it by replacement cost to equal the estimated total accrued depreciation

3. Establish the value of the site with assumptions that the land is vacant and will be put to the assessed highest and best use.

4. Calculate the property's estimated value by adding the estimated value of the site to the depreciated cost of structural improvements.


The income capitalization approach calculates property value in relation to the profit that an owner expects to bring in over the course of his or her investment. This approach is most applicable to income producing properties. Value then equals the worth of future income during a property's economic life or the profit a property will generate before it diminishes due to obsolescence or deterioration.

There are various types of income to be used in this approach. Review the following terms:
Potential Gross Income: A property's maximum profit opportunity, provided that there are no vacancies or collection losses.

Effective Gross Income: Potential gross income minus vacancy and collection losses, adding any income from other sources (such as amenities). Collection expenses include non-payment, late payment, etc.

Net Operating Income: Effective gross income minus all relevant operating expenses. Operating expenses are grouped into three categories: fixed expenses (property taxes, insurance), variable expenses (utilities, maintenance or management), and reserve for replacements (amount of money set aside for replacing building components, such as heating and cooling equipment).

The estimated net operating income may be further divided by the property's current value or sale price to reach the overall capitalization rate. A capitalization rate, also called rate of return, is an investor's annual percentage yield based off a property's income. Once the capitalization rate and net operating income are determined, the present value of income-producing properties may be calculated

Complete the following exercise using the income capitalization approach to appraisal.

Investment Property X yields a net annual rental income of $50,000. The investors expect a 20% return on their various investments. The investors wish to sell Investment Property X.

What should their asking price be (what is the market value of Investment Property X)?
Answer
$50,000 (Rental Income) / 20% (Return on Investments) = $250,000 (Market Value)

Gross Rent Multiplier
A gross rent multiplier (GRM) is determined by dividing comparable sales by the actual or estimated monthly rentals. GRM is the ratio between a property's gross monthly rent and its selling price. The GRM is only applicable to monthly rent income whereas gross income multipliers (GIM) can include non-rental income. The ratios derived from both approaches determine market value. The GIM and the GRM must be assessed for the local areas where the transaction occurs, and comparable properties should be similar to the subject property in terms of collection losses and vacancies.

Using the GRM or GIM to determine market value requires the following three steps:

1. Approximate the gross rental income for the subject property.

2. Using transactions of like properties, calculate a GRM or GIM. Review the following equation:
Sale Price / Gross Rent/Income = GRM/GIM
Average the multipliers to reach a market area multiplier.

3. Market value = gross rent of the subject property multiplied by GRM for the market area.