Real Estate Appraiser
01-21-2006, 04:24 PM
Three approaches to Real Estate Value
There are three usual approaches to determining the fair market value of a property, cost approach, sales comparison approach, and income approach. The appraiser will determine which of the approaches is applicable and develop an appraisal based upon information from each individual market area. Costs, income, and sales vary widely from area to area and particular importance is given to the specific location of the property.
Consideration is also given to the market for the property appraised. Properties that are typically purchased by investors (ie. skyscrapers) will give greater weighting to the Income Approach, while small retail or office properties (purchased by owner-users) will give greater weighting to the Sales Comparison Approach. Single Family Residences are most commonly valued with greatest weighting to the Sales Comparison Approach.
Cost approach
The Cost approach is sometimes called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. It is the land value, plus the cost to reconstruct any improvements, less the depreciation on those improvements. The value of the improvements is sometimes abbreviated to RCNLD—reproduction cost new less depreciation, or replacement cost new less deprecation. Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials.
In most instances, when the cost approach is involved, the overall methodology used is a hybrid of the cost and market data approaches. For instance, while the cost to construct a building can be determined by adding the labor and materials costs together, land values and depreciation must be derived from an analysis of the market data. This approach is typically most reliable when used on newer structures, but the method tends to become less reliable as properties grow older.
Observe that as the Cost Approach has non-market based components (costs), the approach may not be a good indicator of market value, even when new. This is most noticable on properties where the market demand is limited. Say for example a military base. The cost to produce the base is not indicative of its market value, even when new. In the US, the government is the only party that would be willing to "buy" this product. This immediate "loss" is a form of obsolescence.
Also observe that this includes "home improvements" that do not recover their costs in the market. A common example in California is the cost of a pool. In most houses, the cost to build a pool is far greater than the increase in market value to the house. This immediate "loss" is again, a form of obsolescence. Accurately determining obsolescence and depreciation (as the property ages) are usually the main problems within the Cost Approach to opine market value.
Sales comparison approach
The sales comparison approach looks at the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject. This approach is generally considered the most reliable, IF good comparable sales exist.
Income capitalization approach
The income capitalization approach, often simply called the income approach, is used to value commercial and investment properties. This appraoch capitalizes an income stream into a present value. This can be done using revenue multipliers or single-year capitalization rates of the net operating income. The Net operating income (NOI) is gross potential income (GPI), less vacancy (= Effective Gross Income) less operating expenses (but excluding debt service or depreciation charges applied by accountants).
Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers.
There are three usual approaches to determining the fair market value of a property, cost approach, sales comparison approach, and income approach. The appraiser will determine which of the approaches is applicable and develop an appraisal based upon information from each individual market area. Costs, income, and sales vary widely from area to area and particular importance is given to the specific location of the property.
Consideration is also given to the market for the property appraised. Properties that are typically purchased by investors (ie. skyscrapers) will give greater weighting to the Income Approach, while small retail or office properties (purchased by owner-users) will give greater weighting to the Sales Comparison Approach. Single Family Residences are most commonly valued with greatest weighting to the Sales Comparison Approach.
Cost approach
The Cost approach is sometimes called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. It is the land value, plus the cost to reconstruct any improvements, less the depreciation on those improvements. The value of the improvements is sometimes abbreviated to RCNLD—reproduction cost new less depreciation, or replacement cost new less deprecation. Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials.
In most instances, when the cost approach is involved, the overall methodology used is a hybrid of the cost and market data approaches. For instance, while the cost to construct a building can be determined by adding the labor and materials costs together, land values and depreciation must be derived from an analysis of the market data. This approach is typically most reliable when used on newer structures, but the method tends to become less reliable as properties grow older.
Observe that as the Cost Approach has non-market based components (costs), the approach may not be a good indicator of market value, even when new. This is most noticable on properties where the market demand is limited. Say for example a military base. The cost to produce the base is not indicative of its market value, even when new. In the US, the government is the only party that would be willing to "buy" this product. This immediate "loss" is a form of obsolescence.
Also observe that this includes "home improvements" that do not recover their costs in the market. A common example in California is the cost of a pool. In most houses, the cost to build a pool is far greater than the increase in market value to the house. This immediate "loss" is again, a form of obsolescence. Accurately determining obsolescence and depreciation (as the property ages) are usually the main problems within the Cost Approach to opine market value.
Sales comparison approach
The sales comparison approach looks at the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject. This approach is generally considered the most reliable, IF good comparable sales exist.
Income capitalization approach
The income capitalization approach, often simply called the income approach, is used to value commercial and investment properties. This appraoch capitalizes an income stream into a present value. This can be done using revenue multipliers or single-year capitalization rates of the net operating income. The Net operating income (NOI) is gross potential income (GPI), less vacancy (= Effective Gross Income) less operating expenses (but excluding debt service or depreciation charges applied by accountants).
Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers.