L

Real Property Appraisal – Core Vocabulary

Sales Comparison Approach (aka Market Data or Market Comparison)

  • Core Idea
    • Determine subject (base) property value by comparing it to recently-sold similar properties (“comparables” or “comps”).
    • Comps should be in the same market area and have typically sold within the last six months (never more than nine).
  • Strengths & Weaknesses
    • Most useful & accurate for typical residential properties because it reflects actual market behavior.
    • Main limitation: requires an active market with recent sales; poorly suited for special-purpose, unique, or rarely-sold properties (e.g., churches, schools).
  • Minimum Data Requirement
    • Secondary-market lenders usually demand at least three comparables, but an appraiser may use more to form an objective opinion of value.
  • Adjustment Basics (Making comps "look" like the subject)
    • Matched-pair analysis: isolate one differing feature between paired sales to measure its market contribution.
    • Rules of thumb:
    • Subject never changes.
    • If a comparable is inferior → ADD value to its price.
    • If a comparable is superior → SUBTRACT value from its price.
    • Repeat for every significant feature, then reconcile the adjusted prices; never simply average them—weight the most similar comps more heavily.
  • Sequence of Adjustments (order matters because some are percentage-based)
    1. Property Rights Conveyed (fee simple vs. partial interests)
    2. Financing Terms (e.g., seller financing, rate buy-downs)
    3. Market Conditions (date-of-sale adjustments, appreciating/declining market)
    4. Location (neighborhood, site position)
    5. Physical Characteristics (size, quality, amenities)
  • Ethical/Practical Implications
    • Ensures fairness by basing value on arm’s-length transactions.
    • Risk: manipulating adjustments can bias the appraisal—professional standards require transparent, supportable figures.

Cost Approach

  • Ideal Uses
    • Special-purpose properties (hospitals, houses of worship) lacking reliable comps and not producing income.
    • Estimating insurable value.
    • Cross-checking/supporting other approaches.
  • Fundamental Formula \text{Value} = \big(\text{Replacement or Reproduction Cost NEW}\big)
    • \big(\text{Accrued Depreciation}\big) + \big(\text{Site (land) Value}\big)
  • Replacement vs. Reproduction
    • Replacement: build a modern functional equivalent (same utility).
    • Reproduction: build an exact replica (historic restorations, special materials).
  • Depreciation Concepts
    • Only improvements depreciate; land never does.
    • Curable vs. Incurable: Can the cost of remedy be justified by the value gained?
    • Types:
    • Physical Deterioration (wear & tear; usually curable).
    • Functional Obsolescence (poor design/layout; sometimes curable).
    • External/Economic Obsolescence (outside influences like nearby factory; typically incurable & most severe).
  • Age-Life (Straight-Line) Depreciation Method
    • Formula: \dfrac{\text{Effective Age}}{\text{Economic Life}} = \text{Age-Life Ratio}
    • Accrued Depreciation = \text{Cost New} \times \text{Age-Life Ratio}
    • Example (Jim’s appraisal):
    • EA = 25 yrs, EL = 100 yrs → Ratio = 0.25.
    • RC = \$200{,}000.
    • Accrued Depreciation = 200,000 \times 0.25 = \$50,000.
    • Depreciated Improvement Value = 200,000 - 50,000 = \$150,000.
  • Land & Site Valuation
    • Land is valued separately (usually via the sales comparison approach) because it does not depreciate.
    • Site value includes off-site & on-site improvements (utilities, grading) needed to make land build-ready.
    • Final Opinion of Value = Depreciated Improvement Value + Site Value.

Income Approach

  • Relevance
    • Applied when property produces, or could produce, a rental income stream (multifamily, retail, office, some SFR investments).
    • Relies on historical data → considered objective.
  • Two Primary Methods
    1. Gross Rent Multiplier (GRM) – simpler, for 1–4 unit residential rentals.
    • Step 1 (derive multiplier):
      \text{GRM} = \dfrac{\text{Sale Price}}{\text{Gross Monthly (or Annual) Rent}}
    • Step 2 (subject value):
      \text{Value} = \text{Gross Rent} \times \text{GRM}
    • Gross Income Multiplier (GIM) expands to annual gross income from all sources.
    • Caveat: confirm whether monthly or annual figures are used.
    1. Capitalization Rate (Cap-Rate) / IRV Method – standard for commercial & investment property.
    • Net Operating Income (NOI) = Potential Gross Income − Vacancy/Collection Losses − Operating Expenses.
      • Operating Expenses include:
        • Fixed (taxes, insurance)
        • Variable (utilities, maintenance)
        • Reserves for Replacement (future capital items)
      • NOT included: depreciation or debt service.
    • IRV Formula (Direct Capitalization):
      I = R \times V \quad \text{or} \quad V = \dfrac{I}{R} \quad \text{or} \quad R = \dfrac{I}{V}
      where:
      • I = NOI (annual)
      • R = Capitalization Rate (market-derived return requirement)
      • V = Value (what an investor will pay today for the future income stream)
  • Practical Implications
    • Allows investors/lenders to compare returns across properties & markets.
    • Sensitive to small errors in NOI or cap-rate—requires meticulous data verification.

Key Terms & Concepts

  • Amenity: Any feature raising desirability (e.g., pool, view, nearby park).
  • Arm’s-Length Transaction: Buyer & seller act in self-interest under normal conditions; ensures sale price reflects market value.
  • Comparables (Comps): Recently sold similar properties used for benchmarking.
  • Cost Manuals: Databases providing localized construction cost estimates.
  • Debt Service: Scheduled principal & interest payments on a loan.
  • Economic Life (Useful Life): Period a structure contributes value > operating cost.
  • Effective Age: Apparent age based on condition, not chronological age.
  • Effective Gross Income (EGI): Potential Gross Income – Vacancy/Collection Losses.
  • Fixed/Variable Expenses & Reserves: Categories of operating costs (see Income Approach).
  • Functional / External Obsolescence: Design flaws vs. external negatives lowering value.
  • Gross Income Multiplier (GIM) vs. GRM: Annual gross income vs. rent-only measure.
  • Improvements: Man-made additions to land (buildings, substantial fixtures).
  • Matched-Pair Analysis: Technique to isolate value contribution of a single feature.
  • Market Rent vs. Contract Rent: What property could rent for today vs. rent stipulated in existing lease.
  • Net Operating Income (NOI): Income remaining after operating expenses but before debt & depreciation.
  • Potential Gross Income (PGI): Ideal income with 100 % occupancy & perfect collections.
  • Reconciliation: Final step weighing results of each approach to produce one value opinion.
  • Replacement vs. Reproduction: Functional equivalent vs. exact copy of a structure.
  • Site Valuation: Land value + site improvements (ready-to-build condition).
  • Subject Property: The property being appraised.
  • Variable Expense: Expense tied to occupancy (utilities, janitorial).

Connections to Prior/Future Topics & Real-World Relevance

  • Sales comparison relies on principles of substitution (buyers won’t pay more than a similar alternative) and supply & demand—core economic foundations introduced earlier in the course.
  • Cost approach links to construction economics, insurance underwriting, and historic-preservation decision-making.
  • Income approach dovetails with investment analysis, finance (time value of money), and portfolio diversification.
  • Ethical standards (USPAP) mandate transparency in data sources, adjustment logic, and reconciliation, protecting public trust in valuation.
  • Appraisals influence lending decisions, taxation, investment feasibility, and eminent-domain compensation—demonstrating broad societal impact.