Approaches to Valuation

Today we will talk about several different approaches to valuation. There are many factors in determining the best way to value a property. Some of the most common factors include whether the property is commercial or residential, whether the property is income-producing, and whether the property is a special purpose property like a church or hospital. In this article, we will cover the market data approach, the cost approach, and the income approach.

Market Data Approach

The best way to value residential property or vacant land is by using the market data approach, which is all about looking at comparable properties. The market data approach is based on the principle of substitution, which says that a property is only worth what one can get another property for just like it. Before a licensee lists a seller's home, the seller will typically ask for an estimate of value. The licensee will look at similar properties in the same neighborhood that have already sold. No two properties are exactly alike, so adjustments need to be made to the comparable properties in order to see how they compare to the seller’s property. At this point, an estimate of value can be given.  Appraisers never average comparable values together to come up with an estimate of value for the subject property. The appraiser will instead make adjustments to the comparable properties, pick the comparable that is the most similar to the subject property, then give an estimate of value. When a seller asks a licensed real estate agent for an estimate of value, the agent will typically put together a  competitive market analysis or CMA. This is where a licensee will show the seller similar properties in the neighborhood that have recently sold, , properties currently for sale, and expired listings. By looking at each of these factors,  a licensee can give a seller an estimated range of value for the seller's property.

Cost Approach

The cost approach is commonly used on special purpose properties, such as churches, schools, or hospitals. It can be used for new properties as well. There are three steps involved in the cost approach. The first step is to estimate the current replacement cost of the property. The second step is to subtract depreciation based on the age of the property. The third and final step is to add the current land value. Remember, land never depreciates simply due to the passage of time. Now let’s break down step one. In determining replacement cost, we typically use the square footage.  Always use outside dimensions when calculating square footage. We can then multiply the square footage by the cost per square foot to estimate the cost of rebuilding the property as if it were brand new. Once we have determined the replacement cost, step two is to subtract for depreciation because the property we're looking at is not brand new. There are three things that cause depreciation. The first one is called physical deterioration, which refers to things like peeling paint and sagging floors that would cause the property to suffer in value. The second is called functional obsolescence. Functional obsolescence means there are problems inside the property lines, causing the property not to function the way modern properties do, meaning it is outdated. The third thing that causes depreciation is called economic or external obsolescence, which refers to problems outside the property lines. An example of this would be a house located next door to a sewage treatment plant or having air pollution that invades the property. Each of these is a problem outside the property lines. After we have subtracted any depreciation, the third and final step is to add in the current land value. To recap, the replacement cost less depreciation plus the current land value gives us an estimate of value.

Income Approach

The income or capitalization approach is best used on income-producing properties, such as apartment complexes and shopping centers. The income approach involves estimating the potential gross income of the property, then subtracting out the vacancy rate and any operating expenses. The result is the net operating income. After arriving at the net operating income, the next step is to divide the net operating income by a capitalization rate, which is basically a rate of return on investment. This gives us an estimate of the value of the income-producing property.

The key thing to remember regarding the appraisal process is the three different approaches to value. The market data approach is best used for residential properties 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.