Three Approaches to Real Estate Value
June 23rd, 2009
Categories:Home Buyer Education
Appraisers use three methods to determine the value of a property. Depending on the property, each approach will be more relevant or less relevant to the value of the property. Appraisers will often use a process called Reconciliation which takes into consideration how well each approach applies to the property being appraised.
Here are the three approaches to value:
- Sales Comparison Approach
- Cost Approach
- Income Approach
Method 1: Sales Comparison Approach
This is also known as the market data approach and is similar but far more detailed than a competitive market analysis (CMA). In this approach the appraiser looks at all the comparable homes that have recently sold and analyzes the differences between the sold homes and the property being appraised. Each difference is then factored in to determining the market value of the home.
These are the elements used to adjust the value of the home:
- Property Rights
- did one home sell with more rights to the property? - Financing Concessions
- did the home sell in a manner that allowed for concessions or contributions by one of the parties? For example, did the seller pay for the buyer’s down payment? - Market Conditions
- Interest rates, supply and demand and other economic indicators are analyzed - Conditions of Sale
- what motivated the buyer to buyer or the seller to sell? Short Sale, Foreclosure?
The sales comparison approach is often considered the best approach for appraising homes.
Method 2: Cost Approach
The cost approach is based on the principle of substitution, or essentially the property is worth what it would cost to reproduce it. There are five steps involved with the cost approach:
- Estimate the value of the land
- Estimate the current cost of constructing buildings and improvements
- Estimate the amount of accrued depreciation – remember land never depreciates, on the building on the land does
- Deduct the accrued depreciation
- Add the estimated land value
Step 2 Expanded:
There are two ways of looking at the construction cost of a building.
- Reproduction
- This is the cost involved in today’s market to build an exact duplicate of the building, including any flaws or unique construction materials. - Replacement Cost New
- This is the cost required to construct a similar building, using today’s materials and standards. This is more frequently used as it is the more practical and less costly of the two approaches
Step 3 Expanded:
The depreciation of a property can be looked at in three different ways, physical deterioration, functional obsolescence and external obsolescence.
- Physical Deterioration
- these are items that can be fixed or repaired, but because they are broken they effect the depreciation value of the property - Functional Obsolescence
- in the case where a home has unique and outdated functional features, there can be a negative effect on the home’s value. An example would be a five bedroom home with one bathroom. These are items that are typically too costly to remedy. - External Obsolescence
- this refers to the environmental, social and economic factors surrounding the building. For example, after purchasing the home, a power plant was build next door. These are items that can not be fixed.
Method 3: Income Approach
The income approach looks at the value based on the amount of income it can generate. This is more commonly used on commercial or rental properties.
Reconciliation
Reconciliation is the art of analyzing and effectively weighing the findings from each approach to determine the value of the property. Reconciliation is not just an average of all three values.
For example, a large home with ten bedrooms on a half acre of land is appraised. The home has a significant characteristic as a single family home in the neighborhood and is appraised accordingly. However, the ten rooms in the home are often rented out. Because there is an income factor to the home, the income approach also generate a value of the home. Reconciliation would rely heavier on the Sales Comparison approach because it is a home, and would factor in the income approach to a smaller degree, because the home is not technically a commercial rental property, but it does generate an income.
Related posts:
- Real Estate Market Update
- 5 Best Questions Asked When Buying a New Home
- Yes on 100 – Protect Our Homes
- The 9 Principals of Value
- Encumbrancing with Liens and Easements