Approaches to Valuation

Market Data Approach

The best way to value residential property or vacant land is with the market data approach, which is looking at comparable properties. The market data approach is based on the principle of substitution which says that our property is only worth what we can get another one for just like it. When a licensee goes out to list a seller's home for sale, the seller would typically ask for an estimate of value. The licensee will look at comparable homes in the neighborhood that have already sold that are similar to the seller's property. No properties are alike, so we need to make adjustments to the comparable properties to basically see how they compare to the seller’s subject property. Then we can estimate the value. Appraisers never average comparable values together to come up with an estimate of value for the subject property. The appraiser, just like a licensee, will make adjustments to the comparable properties, pick the comparable that is the most similar to the subject property, then come up with an estimate of value. Finally, as licensed real estate agents, when a seller asks for an estimate of value, we typically do what is called a competitive market analysis or CMA. This is where a licensee will show the seller what properties have sold in the neighborhood that is similar to the seller's property, what properties are currently for sale, which is the competition, and what properties have not sold, which will be the expired listings. By looking at the sold properties, the properties currently for sale, and the expired listing properties, a licensee can give a seller an estimate of the range of value for the seller's property.

Cost Approach

The cost approach is another approach that we can use in estimating the value of a property. The cost approach is used on special purpose properties, such as churches, schools, or hospitals. It's also used for new properties as well. There are three steps involved in the cost approach. In step one, we have to estimate the current replacement cost of the property. In step two, we then subtract for depreciation based on the age of the property. And step three, we finally add the current land value because land never depreciates, simply due to the passage of time. In step one, with the replacement cost, we typically use the square footage. The length times the width will give us square footage and we always use outside dimensions for square footage. Then we can take a square footage amount times the cost per square foot to estimate what it costs to rebuild their property as if it were brand new.  Once we get the replacement costs as if the property were brand new, step two is then to subtract for depreciation because the property we're looking at is not brand new. It might be 15 years old. There are three things that cause depreciation. The first one is called physical deterioration, which is basically things like peeling paint and sagging floors that would cause the property to suffer in value. Number two is called functional obsolescence. Functional obsolescence means we have problems inside the property lines and the property doesn't function the way modern properties do, meaning it’s outdated. It might have window unit air conditioners, things like that, which would make it functionally obsolete. The third thing that causes a depreciation is economic or external obsolescence, which are problems outside their property lines, such as having a house next door to a sewage treatment plant or having air pollution that invades the property. Those are problems outside the property lines. Finally, step three is to add in the current land value, so the replacement cost minus depreciation plus the current land value would give us an estimate of the value.

Income Approach

The income or capitalization approach is best used on income-producing properties, such as apartment complexes and shopping centers. The way we use the income approach is as follows. We start off by estimating the potential gross income of the property, then subtract out a vacancy rate, and subtract out the operating expenses. What is left over is called the net operating income. Once we arrive at the net operating income, we then divide the net operating income by a capitalization rate, which is basically a rate of return on the investment.  That would give us an estimate of the value of the income-producing property. So once again, net operating income divided by a capitalization rate would give us an estimate of value for the income-producing property.

Appraisal Process

The key things to remember regarding the appraisal process would be our three different approaches to value. The market data approach is best used in residential and vacant land. The cost approach is best used on special purpose properties like churches, schools, hospitals, or new properties.  Finally, the income or capitalization approach is best used on income-producing properties, such as apartment complexes or shopping centers.

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