The three Approaches to value

There are three generally accepted methods for estimating real estate values. This information is not intended to teach these methods, nor is it intended to defend or recommend any one method over another. This information is to simply help you understand how estimates for property values are arrived at using the various methods.

The Cost Approach

The Cost Approach to value is the method generally used by Towns for ad valorem tax purposes. This method of property appraisal is the quickest to apply to mass appraisals, however it is also the least accurate method.Most lending institutions will not lend on an appraisal based on the Cost Approach due to its inaccuracy.

There are several cost analysis companies in the country. These companies keep track of costs of construction for various types of buildings throughout the country. One well known company is The Marshall & Swift Cost Service.

These Cost services provide information to help the appraiser estimate the value of the property by indicating how much it would cost to build a similar type of property. The basic underlying theory is if you can buy a building lot for, as an example, $30,000, and then build a 1,000 square foot ranch style home on it for $60,000, your total investment in the home would be $90,000. You would not pay $120,000 for a similar house and lot that already exist if you can construct one for less money.

In this method, the house is measured for square foot size. All of the various components are observed and recorded. The value of the land is calculated from sales of lots to arrive at a land value. The house is also observed for depreciation, or items that are worn out, or are wearing out. This information is then applied to the cost to construct the dwelling new. The depreciation is applied to the property to arrive at an estimate of the value of the property. You should be aware that when depreciating a home, the depreciation is generally subjective, and is in the eye of the beholder. What you may call a completely worn out roof, another observer may consider it to still have 6 more years of use left.

The Market Data Approach

This method is known as The Market Data Approach, and is also known as The Sales Comparison Approach. In this method, the property being appraised is compared to a similar style property. Costs are not as important in this method as in The Cost Approach. This approach measures the market's reaction to style, size, amenities, condition, and utility. The theory behind the Sales Comparison Approach is known as "Substitution". If you can buy a 3 bedroom, 2 bathroom home on 1 acre for $90,000, you would not pay $100,000 for a similar home, unless there were substantial differences. Some of these differences would be location, size, number of baths, garage, etc. For residential values, the Market Approach is generally the preferred method for banks lending on Residential Real Estate. This method indicates the markets reaction to a given property on the date of the appraisal. This is the value the Courts look for when deciding on a tax assessment & appeal matter. The Court wants to know how much is the property worth at present (in most towns it is as of April 1 of the year of grievance). This is the function of the Market Approach to value.

The Income Approach

The Income Approach to value is generally the most appropriate for income producing properties, such as apartment complexes, etc. This method analyzes the income stream for the property. Once the Net Income is determined, (the income after all expenses are paid, and all reserves are accounted for), the value can be determined by applying the market's indicated Capitalization Rate to the property. Some of the considerations made by investors are how much they can buy a "safe" investment for (such as U.S. Government Bonds), the risk of the property, the income return, whether current rents seem to be moving up or down, the vacancy rates in the area, etc.

Generally, appraisals for tax purposes do not consider the income stream and expenses when appraising an income producing property. They usually concentrate on the Cost Approach, estimating the cost to construct the property. Quite often, income and cost are far apart. For instance, a 5 year old income property built when rents were high will have a much lower current value if rents have slipped by 20%, even though it may still cost the same or more to build at present.