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The Three Approaches to Value
The appraiser considers three approaches to develop indications of value. These are: 9 Cost approach; 9 Sales comparison (market) approach; and 9 Income approach.
All three approaches are used to arrive at an indication of value. The three indications of value are then reconciled into one final conclusion of market value.
The appraiser must:
Understand the basics involved in each approach; Have the ability to recognize pertinent data; and The skill to select the proper method and apply it to the specific problem involved.
County valuation systems use a combination of the cost and sales comparison approaches to arrive at RMV. This combined process is called the market-related cost approach and is primarily used when valuing residential property.
The Valuation Process
The valuation process is a step-by-step approach that leads the appraiser to a defendable and supportable value conclusion. The valuation process involves: Identification of the property to be appraised; Data collection; General data, Social, Economic, Governmental, and Environmental. Specific data, Sales verification, and Property characteristics. Data analysis, and highest and best use conclusion; Estimating value by the three approaches; Reconciliation of the three approaches to value; Final estimate of value.
All elements of the appraisal process are involved in any appraisal that estimates market value.
Cost Approach to Value
The cost approach can be used to appraise all types of improved property. It is the most reliable approach for valuing unique properties. The cost approach provides a value indication that is the sum of the estimated land value, plus the depreciated cost of the building and other improvements.
The total cost of constructing a new building today frequently sets the upper limit of value, assuming the building is the highest and best use for the land. The cost approach produces a reliable indication of market value when a sound building replacement or reproduction cost estimate is coupled with appropriate accrued depreciation estimates.
The principle of substitution is the basis for the cost approach to value. A person will pay no more for a building than the cost of constructing an equally desirable substitute, assuming no unusual delay. Equally desirable substitute means the substitute need not be an exact duplicate, but contains similar utility and amenities as the existing structure. This provides the rationale for developing the replacement cost of the subject building rather than the reproduction cost.
Replacement cost is the cost of constructing, using current construction methods and materials, a substitute structure equal to the existing structure in quality and utility. Replacement cost is generally used for mass appraisal purposes. It provides expediency and a reliable indication of the cost for most structures. The replacement cost method is the cornerstone of residential mass appraisal.
The replacement cost includes, but is not limited to, direct and indirect costs and entrepreneurial profit.
Reproduction cost is the cost of constructing, as closely as possible, an exact replica of the existing structure.
Direct costs are expenditures for labor, utilities, equipment, the materials used to construct the improvement, and the contractor’s profit and overhead.
Indirect costs are expenditures for items other than labor and materials such as financing, interest on construction loans, taxes and insurance during construction, marketing, sales and lease-up costs, plans, and specifications.
Entrepreneurial profit is a market-derived figure that represents the amount an entrepreneur expects to receive in compensation for his or her risk and expertise associated with development. This is the difference between the total cost of development of the property and its market value after completion.
Methods of Cost Estimating
Cost estimating uses three methods: Comparative (unit of area or volume); Quantity survey; Unit-in-place.
Of the three, the comparative or unit of area method, which uses the square foot area as a base, is the most efficient method for the mass appraisal system. The other two methods of estimating are used primarily to produce an estimate of the reproduction cost of a building.
In analyzing physical deterioration, the appraiser must distinguish among the following:
Deferred maintenance. These are curable items in need of immediate repair and can be either short- or long-lived. Short-lived items. These are items that can be replaced later. Short-lived items include roofing, paint, floor covering, water heater, etc. Long-lived items. These are items expected to last for the remaining economic life of the building. Long-lived items include framing, wiring, plumbing, etc.
Curable Physical Deterioration Physical deterioration is measured by the cost to cure the problem. Physical deterioration is curable if the cost to repair or replace the item is equal to or less than the value added to the property by its replacement. This may include items such as a leaky roof, a broken window, or any item needing repair or replacement as of the appraisal date.
Incurable Physical Deterioration Physical deterioration is incurable if the cost to repair or replace the item is greater than the value added by the repair or replacement. Incurable physical deterioration includes all basic structural or long-lived items, as well as short-lived items that are still serviceable.
Functional Obsolescence This is the loss in value due to superadequacy or deficiency within the property.
Superadequacy describes a component or system that exceeds market requirements and adds less value than the cost of the component. Examples of superadequacy include: Over-sized heating system; Excess plumbing features; Over-sized structural supports (rafters, studs); and Any other items in excess of reasonable requirements.
Deficiency or inadequacy describes a component or system that is substandard or lacking. Examples include: Components smaller than normally expected; Poor design (lack of closet space, ceilings too high or too low, poor room arrangement); and An architectural style that is not compatible with other buildings in the area.
Some functional obsolescence may be found in older structures as construction methods, materials, and market preferences change. Obsolescence can result from poor planning or design.
As in physical deterioration, functional obsolescence is either curable or incurable, depending on whether the cost to cure is economically justified as of the appraisal date.
Curable Functional Obsolescence Functional obsolescence is considered curable when the increase in value gained by correcting the problem exceeds the cost to cure it.
Curable functional obsolescence, usually a deficiency, is measured by the excess cost to cure. To determine the excess cost to cure, compare the difference in cost between adding the item to an existing structure or installing the item as part of a new structure, as of the appraisal date.
The excess cost to cure usually reflects the additional labor costs for installing the item in an existing structure. The difference is the loss in value.
Example: A residential dwelling has only one bath in a market where two baths are expected. If the cost of building a second bath in the original structure would have been $8,000 and the cost of adding the bath in new construction would be $5,000, the excess cost to cure is $3,000. ($8,000 – $5,000 = $3,000).
Incurable Functional Obsolescence Functional obsolescence is considered incurable when it is possible and reasonable to cure an item but there is no economic advantage in doing so. Incurable functional obsolescence is a condition that decreases the utility of the property and is not economically feasible to cure as of the appraisal date. For this reason, most superadequacies are considered incurable.
Incurable functional obsolescence is seen in poor room arrangement or a design feature that cannot be corrected without excessive cost. Estimate the loss in value from these causes by the loss in rent or by comparing to a sold property that suffers from similar conditions.
External Obsolescence This is a loss in value resulting from conditions outside the property. There are many causes of external obsolescence such as: Deterioration of a neighborhood due to social changes; Oversupply of housing; Changing traffic patterns; High unemployment; Proximity of dwelling to sewage treatment plant; and Any other condition outside the property that causes a loss in value.
External obsolescence can be temporary or permanent but is always considered incurable.
External obsolescence is measured by capitalizing the rental loss or comparing the subject to sales of comparable properties without the obsolescence.
External obsolescence can be allocated between land and improvements by using a land-to building ratio derived through market area analysis.
Some units most commonly encountered are:
Square footage; Front footage; Number of apartment/motel units; Number of bedrooms/baths; Number of acres; and Customer capacity.
Analyze and adjust sold properties to ensure the unit value derived from the sale truly reflects land and/or buildings only.
Income multipliers and capitalization rates are not adjusted in the sales comparison analysis since rents and sale prices tend to move in relative tandem. The appraiser should, however, analyze the variances in income among the sale properties.
Elements of comparison are the characteristics of properties and transactions that cause the prices of real estate to vary. Elements of comparison include:
Location; Date of sale; Design, age, and quality of construction; Improvement size; Amenities (special-purpose rooms, swimming pools, garages, and parking); Condition (maintenance, remodeling, and additions); Land size; Site amenities (view, waterfront, golf course, etc.); Personal property items (furnishings, equipment, and inventory); and Business considerations (operating expenses, income, lease provisions, management, government restrictions, business licenses, and intangibles).
Sales Comparison
After you determine that the sales are valid, compare the sold properties to the subject property. Comparisons can be made on a total property basis (one total property to another) or by any unit(s) common to the type of property involved. Differences in elements of comparison are reflected in the adjustment process.
Select sufficient comparable sales to determine the subject’s market value. Sold properties that require excessive adjustments may yield an unreliable value.
Follow these five steps in the comparison process:
- Research and select sales of comparable properties.
- Document and confirm sales data.
- Select relevant units of comparison.
- Compare sale properties to the subject and make appropriate adjustments.
- Reconcile value indications and estimate value of subject property.
Always adjust the comparable sales to make them equivalent to the subject property. If the comparable is superior to the subject, apply a minus adjustment to the comparable. If the comparable property is inferior to the subject, apply a plus adjustment to the comparable property.
Sales Comparison Grid
Sales comparison grids are useful tools for analyzing the differences between the subject property and comparable properties.
Analyze the sales comparison adjustments to select the best indication of value for the subject. This analysis includes a review of each comparable property and the amount of adjustment needed to make the sale property comparable to the subject property. Comparable properties needing the least adjustments are the most like the subject property and are usually given the most weight in the value selection.
The Uniform Residential Appraisal Report (URAR) format illustrates plus (added) and minus (subtracted) adjustments. This type of grid may be altered to fit any type of property.
Gross Income Multipliers
Many people associate a gross income multiplier (GIM) and a gross rent multiplier (GRM) with the market approach to value. The use of GIMs is also part of the income approach to value because it is a capitalization technique.
Income Approach
Income-producing properties are appraised using all three approaches to value. However, since income property is usually bought and sold on its ability to generate and maintain an income stream, it is typical to place more weight on the income approach.
One basic principle in estimating the value of income property is the anticipation of future benefits. The income approach, also called income capitalization, converts future benefits of property ownership into an indication of present worth (market value). Present worth, which is the result of capitalizing net income, is the amount a prudent investor would be willing to pay now for the right to receive the future income stream.
Steps in the Income Approach to Value
The steps used to value property by the income approach are:
Estimate potential gross income. Deduct vacancy and collection loss. Add miscellaneous income to arrive at effective gross income (EGI). Estimate expenses before discount, recapture, and taxes. Deduct expenses from EGI to determine the net operating income (NOI). Select the proper capitalization rate. Determine the appropriate capitalization procedure to be used. Capitalize the net income into an indication of present value.
The calculation for the capitalization process is:
Potential Gross Income/Rent
- Vacancy and Collection Loss
- Miscellaneous Income Effective Gross Income
Effective Gross Income
- Operating Expenses Reserves for Replacement Net Operating Income (before discount, recapture, and taxes)
Step 3—Add Miscellaneous Income
Miscellaneous income may come from several sources such as parking, vending machines, and laundry services.
EGI is the amount remaining after allowances for vacancy and collection loss are subtracted from potential gross rent and miscellaneous income is added.
Step 4—Estimate Expenses Before Discount, Recapture, and Taxes
NOI is estimated by subtracting operating expenses and reserves for replacement from EGI. Determine operating expenses and replacement reserves by reviewing the historical expenses for the property, usually for three or more years, and by estimating the expenses that the typical buyer will expect the property to incur in the future. NOI is useful for comparing one property to another.
It is important to consider lease terms when estimating expenses. Leases are usually referred to as net or gross , although many are not completely one or the other. With a net lease, the tenant pays all taxes and operating expenses. The owner is not involved with property operations. The terms triple-net lease and net-net-net lease are synonymous with the pure net lease.
In a gross lease, the landlord pays all taxes and operating expenses. Operating expenses are the costs necessary to maintain the property so it can continue to produce rental income. Traditionally, a distinction has been made between fixed and variable operating expenses. Now, they are generally grouped together under the single heading of operating expenses.
The income and expense information you receive from a property owner is usually in a format prepared for purposes other than property taxation. Typically, it leaves out some appropriate expenses for estimating property value, such as reserves for replacement.
The information is likely to include some expenses that are not appropriate for appraisal purposes. Some expenses reported by the property owner are dealt with in other ways by the appraiser. To avoid duplication, exclude them from the operating statement.
Following are frequently reported expenses to exclude for appraisal purposes.
Property taxes are a legitimate property expense, however, for ad valorem tax purposes, property taxes should not be included as an operating expense. Property tax impact as an expense is accounted for by adding an effective tax rate to the capitalization rate.
Depreciation is considered in the income approach by the recapture component of the capitalization rate.
Income taxes are not allowed in the income approach because the tax is based on the personal income of the individual and not on the income produced by the property.
Debt service is the amount of payment made toward principal and interest on the loan for the purchase of the property. It is an expense of the buyer, not of the real estate. Properties owned free and clear won’t have debt service.
Capital improvements are long-lasting additions to the property that usually increase income, total value, or economic life but are not considered operating expenses. These may be items such as building additions or property renovations.
Operating expenses typically include: Insurance; Management; Salaries; Utilities; Supplies and materials; Repairs and maintenance; and Reserves for replacement.
Reserves for replacement are funds for replacing short-lived items that will not last for the remaining economic life of a building. Replacing these items usually requires spending large lump sums. A portion of the expected replacement cost can be set aside each year to stabilize expenses. An appraiser provides for the reserves for replacement even if an owner has not done so. Stabilizing income and expenses is necessary for a proper economic indication of the property. Three or more years of the property’s stabilized income and expenses are standard for analysis. It is important to review the net income statement carefully to ensure the result reflects the property’s potential income. Check the repairs and maintenance line items to make sure they do not duplicate reserves for replacement. Appeal disputes can occur due to misunderstanding of proper appraisal methodology.
Reserves for replacement items include: Roof and floor covering; HVAC system; Water heaters; Painting and decorating; and Kitchen appliances.
Calculate the annual monetary charges for any specific item by: Estimating the economic life of the item; Estimating the replacement cost new (RCN); and Dividing the RCN by the economic life.
To express the cost as a percentage, replace the RCN figure with 100 percent. Display either figure as:
RCN ÷ Economic Life = $ per Year
100 ÷ Economic Life = Percentage per Year
Step 5—Deduct Expenses from Effective Gross Income to Determine Net
Operating Income
After estimating all operating expenses and appropriate reserves for replacements, reconstruct the income and expense statement. Subtract adjusted expenses from the EGI to derive NOI.
time value of money, nonliquidity, and other factors associated with investment. A prudent investor looks to the future income stream, as well as potential resale, to provide this return.
Discount Rate is the required rate of return on investment necessary to attract investors. The discount rate contains an interest rate , which is a required rate of return on debt capital, and a yield rate, a required rate of return on equity.
The discount rate takes into account four aspects of investment: safety, risk, liquidity, and management cost.
- Safe rate—the rate available for long-term deposits and other low-risk investments.
- Risk rate—an adjustment for a property’s perceived level of risk.
- Non-liquidity rate—a rate based on how readily assets can be converted to cash.
- Investment management rate—an adjustment for the level of investment management skill required.
The rates for risk, non-liquidity, and investment management are added to the safe rate to make up the discount rate.
The discount rate of properties purchased with a high expectation of value appreciation will sometimes be lower than the safe rate. Since investors expect to make a significant amount of money from resale of the property, it isn’t necessary for the annual rent to be the source of all profit. Because a capitalization rate is nothing more than net annual rent expressed as a percentage of the total property value, a lower income level implies a lower capitalization rate.
Conversely, a property expected to lose value over the term of ownership requires a higher level of annual income to deliver the desired level of profit to the investor. It is assumed the discount rate required by property investors includes provisions for any expected appreciation. Therefore, the interest rate applicable to any particular type of property will frequently be lower than commercial bank investment rates.
Recapture Rate provides for the recovery of capital on an annual basis, also called the rate of return of investment. Land, treated as non-depreciating, is not included in recapture rates. The return of investment in a property can be accomplished in one of two ways or a combination of both. One is a return of the investment through payment from the income stream. The other is a return of the investment (all or part) at the end of the term of ownership by resale of the property.
Effective Tax Rate is an allowance for property taxes included in the capitalization rate for ad valorem appraisal purposes when the typical lease is a gross lease. If the typical lease for the property is a net lease, the tenant pays the taxes so they are not a consideration. To use property taxes as an expense item assumes the value of the property is known, and thereby discredits the entire approach.
The rate used for taxes in the capitalization rate is expressed in decimal form. In Oregon, taxes are not directly related to RMV, therefore you must calculate an effective tax rate. Do not confuse the effective tax rate with the actual tax rate used to calculate taxes. To calculate an effective tax rate, divide the tax rate for the taxing district where the property is located by 1,000, then multiply that figure by the changed property ratio (CPR) for the subject’s property class.
Example: To calculate a tax rate of $15 per $1,000 of assessed value:
15 ÷ 1,000 = .015 ⋅ .80 (CPR) = .012 effective tax rate
The CPR may vary by property class; thus the effective tax rate will also vary. When assessed value and RMV are equal, the tax rate and effective tax rate will be the same.
Step 7—Capitalization: Determining the Appropriate Procedure
Once you have estimated annual NOI before discount, recapture, and taxes, you can use several methods and techniques to capitalize that income into an estimate of market value.
Proper rate selection is necessary to correctly estimate value. Small variations in the capitalization rate will result in substantial differences in value estimates. For example:
$39,035 (NOI) ÷ 0.10 (capitalization rate) = $390, $39,035 (NOI) ÷ 0.11 (capitalization rate) = $354,
One percentage point in the cap rate changed the value $35,486, or 10 percent.
Direct Capitalization Method
In this method, net income is capitalized into an indication of market value using an overall rate developed from the market with no prediction being made for the behavior of income or for the period of recapture. An overall rate is the annual NOI divided by the sale price. Capitalization of the income stream is accomplished by dividing the estimated income by the appropriate rate.
You can also calculate it by multiplying the income by an income factor. In the following example of direct capitalization using an overall rate, the income-expense ratios, remaining economic lives, and land-to-building ratios of the sale are comparable to those of the subject property. The sale property is located in the same taxing district as the subject and has the same effective tax rate. Note: If it were not located in the same taxing district, adjustments can be made so the comparison is valid.
Selection of Capitalization Technique
There are three techniques for processing income into an indication of value:
- Building residual;
- Land residual; and
- Property residual.
To calculate a residual technique, satisfy the income requirements for the known portions of the property, then capitalize the remaining income into a value estimate for the unknown portion. Which technique you use will depend on the information available and the conditions existing on the property.
Building Residual Technique
Use the building residual technique if you have sufficient information to develop an estimate of land value and the building is older, making cost and depreciation estimates difficult to support. To use the building residual technique, you must know:
Net income; Land value; Proper discount rate; Proper recapture rate; and Effective tax rate.
comparables are reflected in the rents of each property. If the sales used to extract a GIM from the market are valid and the properties are comparable, the resulting factor should produce a reliable indicator of value for the subject. Using a GIM to arrive at an estimate of value is one form of direct capitalization.
When the GIM is used to capitalize income, the relationship between I (income) and V (value) is
expressed as F , (factor or multiplier). A factor is the reciprocal of a rate, or F = I ÷ R. Using this
basic formula, the GIM can be derived thus: Value = Income ÷ Rate, or V = I ÷ R
After extracting a GIM from the market, the gross income of the subject for a single period is multiplied by a factor to produce an estimate of value. The multiplying factor is called a gross rent multiplier (GRM) if the period is one month. It's called a GIM if the period is one year. Generally, monthly rents are used for single-family residences and annual incomes are used for other income-producing properties.
To properly develop a GIM study, use all available comparable sales. Properties from which a GIM is developed, and properties to which a GIM is applied, must be similar in effective age, quality of construction, and use. For example, it would not be appropriate to apply a GIM to a 20-unit property that was developed from sales of 4–to 6–unit properties.
When developing a GIM, give careful consideration to: Gross income-to-expense ratio— The gross income-to-value relationship may be different for similar properties depending on the expenses involved in producing the income. The gross income for an office building where rent includes heat, lights, water, and janitorial service will be substantially greater than the gross income from an identical building where these services are not furnished. If you develop a GIM from a sale in which these services are furnished and apply it to the income of a building that does not include the same services, you will not get an accurate indication of value.
Land-to-building ratio— A large land-to-building ratio may indicate that a sale property includes excess land. Such a sale may produce a higher than normal GIM.
Remaining economic life— A sale of a building with a short remaining economic life may produce a low GIM. Applying the low GIM to a building that has a longer life will indicate a value below market.
The following example of how to develop a gross income multiplier from a sold property includes an unusual amount of services. Typical service furnished for retail stores in the area is water only.
Retail store sales price: $150, Rentable area: 10,000 sq. ft. Gross income: $ 22,500 ($2.25/sq. ft.) Services furnished: Heat, lights, water, janitorial Comparable space rents for: $ 2/sq. ft. with water only Adjusted gross income: $ 20, $150,000 ⎟ $20,000 = 7.5 GIM
Convert gross income into an indication of value using the GIM developed in the previous example: Gross income attributable to subject $ 21, Indicated GIM 7. Value indication (7.5 ⋅ $21,450) $161,000 (rounded)
