Ch. 1 - Valuation Principles and Procedures of the Sales Comparison Approach

In residential properties, the anticipated future benefits are amenities. They may include:

The security of having a roof over your head The prestige of owning a nice home in a good neighborhood The anticipation of being able to put your feet up on your deck or cuddle up in front of the fireplace The benefits of owning versus renting The privacy entailed in owning a home of your own

Step 2: Verify the information

We need to verify information in order to assure its accuracy. STANDARD 1 of USPAP states, in part, "An appraiser must...........correctly complete research and analyses necessary to produce a credible appraisal". STANDARD 2 says: "In reporting the results of a real property appraisal, an appraiser must communicate each analysis, opinion, and conclusion in a manner that is not misleading". Proper analysis of data is important but we need to make sure that our starting point is factual and true. It is crucial to verify this information to gain an understanding of the motivation behind each transaction. We need to ascertain if the elements of the transaction were atypical in any aspect. If so, we may need to adjust the price of the transaction or in some cases discard it entirely from our analysis. A transaction should, if at all possible, be verified with a party who has firsthand knowledge of the transaction. Perhaps, the buyer or seller, or a broker or agent involved in the transaction.

The Sales Comparison Approach is defined as:

"The process of deriving a value indication for the subject property by comparing market information for similar properties with the property being appraised, identifying appropriate units of comparison, and making qualitative comparisons with or quantitative adjustments to the sale prices (or unit prices, as appropriate) of the comparable properties based on relevant, market-derived elements of comparison. The sales comparison approach may be used to value improved properties, vacant land, or land being considered as though vacant when an adequate supply of comparable sales is available."

When choosing comparables, the appraiser looks for properties that are as similar as possible to the subject in all aspects. This includes analyzing diverse factors such as:

Sales or financing concessions Market conditions when sale occurred Location Property rights appraised Site characteristics Physical characteristics of structures Quality Functional attributes Amenities Motivations of sellers and buyers

Step 3 Continued

The reason to convert data to units of comparison is to facilitate the process and make it more meaningful and easier to understand. One benefit is that once we choose meaningful units of comparison it eliminates the necessity to make an adjustment for differences in size. In appraising one-unit properties, generally we can find comparable sales that are similar enough overall so that we can make adjustments for relatively minor differences between the properties and then make one to one comparisons of the adjusted prices. When appraising vacant land for example, it may seem difficult to consider a land sale of $90,000 to another one that sold for $210,000. On the face of it, they may not appear comparable or competitive in the marketplace. However, after breaking the two sales down as to what they sold for per acre, they may be very similar in price. One may have sold for $35,000 per acre and the other one at $40,000 per acre. The same thought process applies when appraising multi-unit properties. A three-unit property may sell for $120,000 and a four-unit property may sell $160,000. They both sold for $40,000 per unit.

The Sales Comparison Approach is defined in the IVS Glossary as:

"A comparative approach to value that considers the sales of similar or substitute properties and related market data and establishes a value estimate by processes involving comparison. In general, a property being valued (a subject property) is compared with sales of similar properties that have been transacted in the open market. Listings and offerings may also be considered. A general way of estimating a value indication for personal property or an ownership interest in personal property, using one or more methods that compare the subject to similar properties or to ownership interests in similar properties. This approach to the valuation of personal property is dependent upon the Valuer's market knowledge and experience as well as recorded data on comparable items."

Even before Step 1, the COMPETENCY RULE of the Uniform Standards of Professional Appraisal Practice (page 11 of USPAP 2018-2019) requires that you determine if you're qualified to do the job at hand. It says

"Prior to accepting an assignment or entering into an agreement to perform any assignment, an appraiser must properly identify the problem to be addressed and have the knowledge and experience to complete the assignment competently." "The appraiser must determine, prior to accepting an assignment, that he or she can perform the assignment competently. Competency requires: 1. the ability to properly identify the problem to be addressed; and 2. the knowledge and experience to complete the assignment competently; and 3. recognition of, and compliance with, laws and regulations that apply to the appraiser or to the assignment." Do you have the knowledge and experience to provide a competent appraisal? If not, you must disclose this fact to your client. Often you can accept the job if you are affiliated with someone who does have the requisite knowledge. Or you might hire someone to help you with the necessary skills. Sometimes you will be deep into an appraisal before you find out that it's beyond your abilities. At that point, you must tell your client. Together, you can work out whether you should (a) stop working on the project so it can be assigned to someone else, or (b) bring in an expert to help. If the assignment cannot be completed competently, you must decline or withdraw from the assignment. Now that you've determined that you're the person for the job, you can go to work. Here's an overview of what you will do in each step of the appraisal process.

Step 5: Reconcile the value indications

Because the market is not perfect and we are not usually able to collect all the pertinent data, the indications of value from various sources will generally vary. If we use various indicators of value the results will probably not be exactly the same but hopefully will form a consistent pattern. The same occurs when using multiple comparable sales to obtain indications of value for the subject property. It usually only happens in textbooks or classroom examples that the adjusted values of the comparable sales all come out to be the same amount. Therefore, we have to embark on a reconciliation, in which we examine the strengths and weaknesses of our data and come to a reasoned conclusion as to the indicated value for the subject property. Of course, a final reconciliation is required, too, if one or more other approaches to value are utilized. Then we have to reconcile the validity of the Sales Comparison Approach with the conclusions of the other approach or approaches.

Step 3: Select relevant units of comparison

First, we gather and verify sales data. Before we begin our analysis, we need to select relevant units of comparison. These will vary according to the type of property that we are appraising. Property Type Typical Units of Comparison One unit residential Total property price Price per SF of GLA 2-4 unit residential Price per SF of GBA Price per unit Price per room Price per bedroom Offices Price per SF of GBA Price per SF of Gross Leasable Area Price per SF of Net Leasable Area Vacant land Price per SF Price per acre Price per Front Foot Price per Buildable Unit Price per Animal Unit

Applicability of the Sales Comparison Approach

Generally, the only limitation is that you need to have a sufficient number of reliable sales. There are many situations when the Sales Comparison Approach may NOT be the best way to find an indicated value. Examples would be unusual or special-use properties like historic homes, one-of-a-kind designs, homes that are unusually large or small, or other factors that make comparison difficult. Even when you don't have great data, the Sales Comparison Approach may be employed to provide a range of value to justify values obtained from using another approach. It can serve to double-check the value opinions from the Income Capitalization Approach or the Cost Approach.

The Sales Comparison Formula

Here is the basic formula for the Sales Comparison Approach: Sale Price of Comparable +/- Adjustments to Price = Indicated Value of Subject Notice that the process starts with the comparable, not the subject! We NEVER adjust the subject property. We make adjustments to a comparable sale to show what the comparable would have sold for if it were just like the subject. You start with the sales price of the comparable. Then you add or subtract for differences between the comparable and the subject (like an extra bathroom, nice deck, new roof, swimming pool, etc.). The resulting figure will give you the indicated value of your subject.

Step 4: Identify differences and make adjustments

If we had a perfect comparable, no adjustments would be necessary. Presume a property exactly identical to the subject property just sold for $235,000. It wouldn't take a genius to conclude that the value of the subject was, by comparison, $235,000. Unfortunately, this is rarely the situation encountered in the real world. It is even less likely if we're appraising commercial or industrial property. First, we have to identify pertinent, significant differences between the subject property and each comparable sale. We do not make an adjustment for every single, observable difference. We only make adjustments for differences that are significant enough to be recognized by a typical purchaser and strong enough of an influence to result in a modification in his or her buying decision. Secondly, we have to analyze the available data to mathematically predict the dollar amount, or percentage amount, that will be ascribed to each different attribute. We will get into details of this process later on in the course. For convenience of analysis, appraisers generally array details of the subject property and the comparable sales on a data grid. This is a feature in most appraisal forms.

In income-producing properties, the anticipated benefits are primarily financial in nature. They may include:

Income from rentals Build-up of equity Tax benefits Future resale at a profit

Step 1: Research the market

Our first step is to research the market in which the subject is competing for indications of value. Our primary search is for sales of comparable properties that are as similar as possible to the subject property in all aspects, including size, age, condition, quality, lot size, functional utility and amenities. We may also be able to gather information on other indications of value, which might include: Listings Offers to purchase Refusals Options to purchase Contracts on properties that have yet to close Obviously, data from transactions that have closed are the most pertinent. However, we can gain additional insight into the workings of the local market by examining listings and offers to purchase. Listings will tend to give us an upper limit of value. Properties that are in contract but have not closed may also produce valuable information; particularly in a market that is undergoing a rapid upward or downward change. There may not yet have been closed transactions that would reflect the new price levels.

In applying the Sales Comparison Approach, the appraiser should employ a systematic approach:

Research the market Verify the information Select relevant units of comparison Identify differences and make adjustments Reconcile the value indications

Sales Approach History

The "Sales Comparison Approach" is the most commonly used approach for appraising residential property. It originally was called the "Market Approach" or the "Market Data Approach." Then, people realized that all three approaches rely on market data. For a brief time it was referred to as the "Direct Sales Comparison Approach" which was then shortened to simply "Sales Comparison Approach."

Principle of Anticipation

The Principle of Anticipation is defined as "The perception that value is created by the expectation of benefits to be derived in the future." The Principle of Anticipation holds that value is future-oriented. It is a corollary of the principle of change in that it recognizes that change is inevitable. It recognizes the role of change in creating and amending real property values and assumes that typical buyers and sellers are capable of recognizing and quantifying the anticipated changes in the marketplace.

Principle of Balance

The Principle of Balance is defined as: "The principle that real property value is created and sustained when contrasting, opposing, or interacting elements are in a state of equilibrium." This principle embodies the concepts of some of the previous principles such as contribution, supply and demand, anticipation, and competition. It has to do with fine tuning the combined effects of some of these value-creating forces. This can apply to relationships among components of a property, such as the relationship between land and improvements. Once this proper balance is achieved, maximum value is attained. If there is an overbalance, then the principle of increasing and decreasing returns can come into play. In this case, additional expenditures will not produce a commensurate return.

Principle of Change

The Principle of Change is defined as "The result of the cause and effect relationship among the forces that influence real property value." Change is constant. Real property values are dynamic and subject to constant and immediate change. It doesn't mean that values change every day but that they are capable of dramatic and instant change. As the definition states, this is the result of a cause and effect relationship, or tug-of-war, among the various forces that interact to influence real property values. These are external market factors that may be categorized as Social, Economic, Governmental, and Environmental. In some cases, these changes are subtle and hard to recognize. But it's all part of our due diligence to properly analyze all factors to determine their value. The big, drastic changes are easy to recognize (such as a factory closing) but may be hard to quantify in the short term. Perhaps it occurred so recently that we cannot find market evidence of buyer's and seller's reactions to this happening yet.

Principle of Competition

The Principle of Competition is defined as "Between purchasers or tenants, the interactive efforts of two or more potential purchasers or tenants to make a sale or secure a lease. Between sellers or landlords, the interactive efforts of two or more potential sellers or landlords to complete a sale or lease. Among competitive properties, the level of productivity and amenities or benefits characteristic of each property considering the advantageous or disadvantageous position of the property relative to the competitors." The principle of competition is an offshoot of the principle of supply and demand. It studies the relationships between participants in the marketplace, such as buyers and sellers or landlords and tenants. It certainly has applicability in all phases of real property. Typical buyers and sellers of residential real property should be aware of the competition out there when they are making an offer or setting a listing price. The same goes for commercial or industrial properties. One should not act in a vacuum, but consider the competition. That is the only way to make an informed decision.

Principle of Conformity

The Principle of Conformity is defined as "The appraisal principle that real property value is created and sustained when the characteristics of a property conform to the demands of its market." This principle is closely aligned with the principle of balance. It postulates the premise that properties fare better when they coincide with the expectations of the market. When properties are unusual or atypical they may suffer a loss. There are more buyers for properties that exhibit characteristics that are commonly in demand. A contemporary house located in an historic New England village may have few takers. Whereas, an historical reproduction of a Victorian house may be out of place in Miami Beach and become a hard sell. Be aware, however, that the demands of the market can and do change over time. They also will vary considerably by area, price range, etc. It will require diligent research by the appraiser to be able to judge pertinent factors accurately.

Principle of Contribution

The Principle of Contribution is defined as "1. The amount a component of a property adds to the total value of the property. Contribution may or may not be equivalent to the cost to add the component. 2. The concept that the value of a particular component is measured in terms of the amount it adds to the value of the whole property or as the amount that its absence would detract from the value of the whole". The principle of contribution is used when determining how much to adjust for differences between various components of a property. How much does a fireplace contribute to the overall value of the property? How much does the lack of a swimming pool penalize a property's value in an area where almost everyone has a swimming pool? It is important to note, that the value of a particular component of a property is not measured by its cost. A swimming pool might cost $40,000 to install but the market might only ascribe a contributory value of $10,000; or even zero. This will depend on many factors such as the location of the property, the climate, the price range of properties in the neighborhood and perhaps the age of properties in the neighborhood.

Principle of Externalities

The Principle of Externalities is defined as: "1. The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value. 2. In appraisal, off-site conditions that affect a property's value. Exposure to street noise or proximity to a blighted property may exemplify negative externalities, whereas proximity to attractive and well-maintained properties or easy access to mass transit may exemplify positive externalities." This means that good things or bad things can happen to your property according to what is located around it. This isn't confined to good or bad houses nearby, but could describe the influence of myriad external factors such as exposure to hazards, convenience to work or shopping, adequacy and cost of government services, proximity of recreation, quality of schools, etc.

Principle of Substitution

The Principle of Substitution is defined as "The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. This is the primary principle upon which the cost and sales comparison approaches are based." Of the three appraisal approaches, the Sales Comparison Approach relies most heavily on the principle of substitution. The principle is used to price practically everything. If Foodland sells a can of beans for $.50 and Safeway sells the same can for $.75, consumers will go to Foodland. In appraising, the principle basically says "I won't pay more than $200,000 for your house, because I can buy another one just as good for $200,000." That is the gist of the Sales Comparison Approach. The concept is important for residential appraisal, because although all homes are different, they are also more or less replaceable. So the value of a home tends to be set by the cost of an equally desirable substitute. The concept assumes two important things: (1) that there will be no long delay in acquiring a substitute, and (2) that a buyer will accept a substitute. Maybe you've heard the saying, "You can sell any house at any price if you wait long enough for the right buyer." It just isn't true. Houses that are priced much too high can (and usually do) remain unsold. That's why it's important to consider how long a house has been on the market when using the Sales Comparison Approach. Similarly, sometimes you'll find that substitute properties lack important features of the subject, making them less desirable to buyers; or vice versa. So appraisers note all significant characteristics of both their subject and comparables when using the Sales Comparison Approach. Another way of determining substitution value is to look at the cost of new construction. What would a new house of similar value cost to build - assuming that it could be built in a reasonable amount of time? In this case the refrain is "I won't pay more than $200,000 for your home, because I can build another one just like it for $200,000." That is the basis for the principle of substitution in the Cost Approach. You can also use the principle of substitution to value income properties. Here, one would say "I won't pay more than $200,000 for your income property because I can buy another one with similar income returns and financial benefits for $200,000."

Principle of Supply and Demand

The Principle of Supply and Demand is defined as "In economic theory, the principle that states that the price of a commodity, good, or service varies directly, but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately, with supply. In a real estate appraisal context, the principle of supply and demand states that the price of real property varies directly, but not necessarily proportionately, with demand and inversely, but not necessarily proportionately, with supply." That is somewhat lengthy definition that says if something is in short supply it generally will command a higher price, and vice versa. The principle of supply and demand makes the world go 'round. It is the most basic of the underlying economic principles. It works in all areas. If cars are scarce, dealers can charge more. If there is an oversupply of cars, the dealers need to cut prices to be competitive. I don't care if we are talking about stocks, real estate, apples, or donuts. Supply and demand are crucial elements in pricing and in the ultimate values achieved. Price and demand move in an inverse relationship. In other words, if there is a large supply of a product or service the price we can charge will probably be reduced. This will be a direct effect of the competition for that product or service. Buyers will flock to lower prices. It is just human nature. Of course the opposite is true as well. If there is an undersupply of any given product or service, buyers will be competing for the limited supply and it will drive the prices upward. Classic economic theory says that supply and demand will tend to move towards a point of equilibrium. If there is an undersupply of anything, for example houses, new ones will be produced to try to fill the gap. If there is an oversupply of commodities, such as cars, production can be trimmed to decrease the supply and sales incentives can be applied to increase the demand. Unfortunately, with real estate, the supply side of the equation is relatively fixed and slow to change whereas the demand side of the equation can change quickly (the Principle of Change).

Theory

The Sales Comparison Approach is based on a relatively simple concept. To find the value of a property, you look at similar properties nearby that have sold recently. Of course, no two houses or pieces of property are exactly the same. So you make "adjustments" for differences, adding or subtracting value to the sales price of the "comparables," to figure out what the subject should be worth. The Sales Comparison Approach makes a lot of sense. It works the way people think. Buyers typically shop around before they make a purchase to be sure that they're getting a fair deal. They look at "comparables", on the market to see what is available, and current prices. The appraiser basically does the same thing in the Sales Comparison Approach, only looking primarily at actual sales rather than asking prices (although current listings are often considered as well).

Use of the Sales Comparison Approach

The Sales Comparison Approach is the most important and widely used approach for one- to four-unit residential properties. It is often the best approach to value when the subject property is not income-producing. It may also be used for commercial and industrial properties. However, income-producing properties are generally appraised with the Income Capitalization Approach; although the Sales Comparison Approach may also be used, if applicable. The Cost Approach may also be applied. Valuations derived from the Sales Comparison Approach are most credible when there are many similar properties nearby (such as in a subdivision), and the properties are bought and sold on a regular basis. The approach also does not work well in a very weak market, or when few transactions are available to provide comparable data.

Principles of Progression and Regression

The principles of progression and regression are the result of what happens when the principle of balance is violated. We intuitively understand what happens when we have the most expensive or the least expensive house in the neighborhood. The Principle of Progression is defined as "The concept that a lower-priced property will be worth more in a higher-priced neighborhood than it would in a neighborhood of comparable properties." This is the good situation. You should be happy if you own the cheapest home on the block. Your value will tend to be dragged upward towards the mean. People who can't afford more may be thrilled with the opportunity to buy into a better neighborhood and be willing to give you a premium. The Principle of Regression is defined as "In appraisal, the concept that a higher-priced property will be worth less in a lower-priced neighborhood than it would in a neighborhood of comparable properties." This is the flip side. You may lose value because of the presence of inferior properties around you. See the principle of externalities on the next page.

Data Requirements

The sale of one particular house might deviate from market trends because of special terms of sale, the buyer or seller's motivation, or numerous other reasons. But if you look at enough sales, you'll start to see patterns emerge. You can use these patterns to estimate value. It is true that one sale does not make a market. The more sales data you collect, the more supportable and defensible your appraisal will be. The traditional minimum number of comparable sales has been three. All standard appraisal report forms have room for a minimum of three comparable sales. The less reliable and comparable your sales are, the more sales you need to provide a degree of reliability in your value opinion. Sometimes, your subject property is just unusual and it is hard to find valid comparisons. There is safety in numbers. In some cases, your client will dictate the number of comparable sales they require. At any rate, three is a minimum number. You may have the luxury of lots of good data. Then you may want to provide 4, 5 or 6 comparables or even more. Simply add another page or two to your report.