Understanding the Three Approaches to Real Estate Valuation

In real estate appraisals, appraisers are tasked with providing an independent and unbiased opinion of the market value of a property. To do so, they analyze data from three primary sources: comparable sales, cost to replace (or reproduce), and income. These sources are often referred to as “The Three Approaches to Value.”

Sales Comparison Approach

The Sales Comparison Approach is the method most people are familiar with. In this approach, appraisers research and analyze the sales of similar properties, known as comparables or "comps," to determine the value of the subject property. When possible, appraisers try to find comparables that buyers would view as suitable substitutes for the subject property.

The key question that guides the process is, “If the subject property weren’t on the market, what would the most likely buyer choose instead?” Once comparables are identified, the appraiser takes into account various factors that buyers and sellers consider when assessing a property. For single-family homes, this could include factors like the number of bedrooms and bathrooms, the size of the land, quality of construction, and features like ocean views.

To ensure fairness in the comparison, appraisers make adjustments based on differences between the subject property and the comps. For example, if a comparable property has more bedrooms than the subject, the appraiser will adjust the price downward. Similarly, if a comparable has fewer features, such as only one garage instead of two, the appraiser may adjust the value upward.

Cost Approach

The Cost Approach is based on the idea that a rational buyer would not typically pay more for a property than it would cost to build it new. While this method is less commonly used for general property valuation, it is often useful when valuing new construction or properties that rarely sell and do not generate much income, like schools, parks, or churches.

The cost approach involves three steps:

1. Estimating the cost to reproduce or replace the existing improvements.

2. Deducting depreciation, which includes physical deterioration from age, as well as functional and external obsolescence (changes in market tastes or location).

3. Adding the value of the land beneath the property, which is typically valued using the Sales Comparison Approach.

After accounting for depreciation and adding land value, the result is the property’s value under the Cost Approach.

Income Capitalization Approach

The Income Capitalization Approach is often summarized as the present value of future benefits. It’s typically used for income-generating properties, such as commercial real estate. This approach estimates the present value of future income from the property, along with its eventual resale value.

There are two primary types of capitalization in this approach: Direct Capitalization and Yield Capitalization.

• Direct Capitalization involves considering one year of income and converting it into a property value. This is often referred to as using a “Cap Rate.”

• Yield Capitalization is more complex, as it takes into account multiple years of income and the eventual resale of the property. It uses a “discount rate” to convert future cash flows into present value. This method is typically used for properties with uneven future cash flows, such as when a large tenant is expected to vacate the property in the near future.

Conclusion

Each of the three approaches to value has its own strengths and is suited to different types of properties and circumstances. Sales Comparison is often the most reliable for properties with numerous similar sales, while the Cost Approach is useful for new or unique properties, and the Income Capitalization Approach is ideal for income-producing real estate.

Understanding these approaches can help both buyers and sellers gain a clearer view of a property’s market value. If you are looking to understand the value of a property, it’s essential to work with an experienced professional who can navigate these different approaches to provide a well-rounded valuation.

If you're interested in learning more, feel free to reach out to John Bianchimano  at https://www.phillyandsuburbscre.com/propertyvaluation.