Valuation Approaches and Methods: Comparison, Income, and Cost
Valuation Approaches and Methods tests mechanics: can you build an adjustment grid, capitalize a net operating income, or roll forward a cost approach without contaminating the inputs? The exam favors computational items where one wrong line item changes the answer, plus conceptual items on which approach applies and how results are reconciled.
Sales comparison approach
Sequence the elements of comparison correctly. Transactional adjustments come first: real property rights conveyed, financing terms, conditions of sale, expenditures made immediately after purchase, and market conditions. Property adjustments follow: location, physical characteristics, economic characteristics, legal and use characteristics, and non-realty components. Derive adjustments from paired data, and show the direction of each adjustment (superior comparables adjust downward).
Income approach
Potential gross income minus vacancy and collection loss equals effective gross income; subtract operating expenses to reach net operating income. Debt service, depreciation, income taxes, and capital expenditures are not operating expenses. Direct capitalization: value equals NOI divided by a market-derived overall capitalization rate, which may be built with a band of investment (loan-to-value ratio times mortgage constant plus equity ratio times equity dividend rate). Use gross income multipliers only for gross-income-consistent property, and DCF when income is irregular.
Cost approach
Replacement cost estimates current construction; reproduction cost replicates the subject. Subtract physical deterioration (deferred maintenance plus short- and long-lived components), functional obsolescence (deficiency or superadequacy), and external obsolescence (always incurable). Add land value last, not first.
Worked example
A 24-unit apartment building rents for $1,200 per unit per month. Potential gross income is 24 x $1,200 x 12 = $345,600. Vacancy and collection at 5% is $17,280, giving effective gross income of $328,320. Operating expenses at 35% of EGI are $114,912, so NOI is $213,408. At a 6.50% overall rate drawn from comparable sales, value is $213,408 / 0.065 = $3,283,200.
Traps
- Capitalizing potential gross income or deducting debt service from NOI.
- Pairing a net-leased NOI with a rate derived from gross-leased comparables.
- Double-counting land, or deducting entrepreneurial profit twice in the cost approach.
- Averaging approach indications instead of reconciling them on the basis of reliability.