Appraisers and other property valuation professionals use three methods to build a value for a piece of property. The sales comparable or market approach looks at what comparable properties sell for, the cost approach looks at what it would cost to build the property, and the income approach considers the value of the income stream that a property generates or could generate. Each method has different uses and different classes of property for which it is most appropriate.
Comparable Sales Approach
In the comparable sales approach, a value is created by looking at what similar properties in a similar market have sold for. For example, if three similar three-bedroom homes sold in the same neighborhood in a range of $180,000 to $190,000, it's reasonable to assume that a comparable property would also sell in that range. The appraiser chooses a specific value by adjusting each comp for the unique characteristics of the property that he is analyzing.
The cost approach values properties on the basis of what it would cost to build them today. The valuation starts by estimating the cost for labor and materials to either build a comparable replacement building or to completely reproduce the building, depending on the scope of the analysis. Next, the appraiser subtracts out an estimate of the building's loss of value due to depreciation since the building being analyzed is probably not in the same condition as a newly constructed property.
The income approach values properties based on the income that they produce. Typically, the analysis starts with calculating a net operating income for the property that takes its rent and its operating expenses into account. Next, the person conducting the analysis chooses a capitalization rate, which is an income multiplier. The cap rate is usually derived from comparable sales data. The price gets calculated by dividing the NOI by the cap rate. For example, if a property has a $50,000 NOI and comparable buildings trade at a 7 percent cap rate, it would be worth $714,285. The price comes from dividing the property's $50,000 income by 0.07, which is the market cap rate. If the market cap rate was 8 percent, the property would be worth $625,000 (50000 / 0.08).
Choosing an Approach
Each approach has different uses. The income approach typically gets used for commercial and income producing properties like four-plexes. Most cost approach analyses are done with newly constructed properties because there is less depreciation to calculate. Unique properties for which it is hard to find comparable properties, like specialized vacation properties or oil refineries, are also good candidates for the cost approach. The sale comparable approach is typically used for properties like single family residences where many comparable sales from which to choose exist.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.