CH 9 - 3

This is a highly simplified example of the market approach, but it does show the basic concept of how the market approach attempts to adjust known comparable sales to reflect what the comparables should have sold for if the comparables had the characteristics of the subject property.

As consumers, people use an informal market approach when they shop for automobiles, furniture, clothes, and most other types of consumer purchases. When it comes to real estate, appraisers simply formalize the process by reducing the comparative facts to writing.

This process is called correlation (reconciliation). When reconciling, the appraiser gives full consideration to each approach; then, based on judgment and experience, the appraiser arrives at one final value or price.

Correlation or reconciliation is not the averaging of the three approaches! Averaging gives equal weight to each approach, which is wrong. For any given property, one of the approaches is better and should be given more weight.

To apply the market approach, an appraiser gathers data on current sales of properties that are similar to the property being appraised.

Ideally, the comparable properties should be in the same neighborhood; be similar in size, style, and quality; and contain similar internal characteristics as the subject property. Comparables should be recent sales.

Each comparable used must also be what is called a market sale. A market sale is a sale in which a property is sold using normal financing techniques and the buyer and the seller were fully informed and knowledgeable about the real estate market.

If either the buyer or the seller was under any duress or strain, such as divorce, death in the family, or financial reversals, the appraiser would discard the sale as not being a good comparable sale.

The appraiser takes sales prices of the comparable properties and adjusts these prices to reflect what the comparable properties would have sold for if they had the features or characteristics of the subject property.

It is important to remember that you always adjust the feature values of the comparable properties, never the subject property. The results of this process produce an indicated market value range for the property being appraised. Figure 9.6 is an example of an appraisal using the market approach.

The appraiser locates comparable homes, determines their gross multipliers, and selects the most appropriate multiplier.

Next, the appraiser determines the fair market rent of the subject home. Then the gross multiplier is multiplied by the fair market rent to arrive at an estimate of value.

Real estate loan payments and income tax depreciation deductions are not considered operating expenses because they are not costs incurred to run the building. Therefore, they are not deducted to arrive at net income.

Once annual operating expenses are calculated, they are subtracted from the effective gross income to arrive at the net operating income.

For the market approach to be valid, the sales used for comparison must reflect normal market conditions, not sales sold under abnormal circumstances.

Once the comparable properties are selected (three properties are usually the minimum; five are better), the appraiser makes adjustments for the differences between the comparable properties and the subject property being appraised.

After computing the effective gross income, the appraiser totals the annual operating expenses. Operating expenses are the costs of running and maintaining the property. Examples include the following:

Property taxes Supplies Insurance premiums Utilities Repairs Accounting and legal advice Maintenance Advertising Management fees Reserves for replacement

Because smaller residential properties have a higher expense ratio, gross multipliers are more frequently used on 1-4 residential units, while larger properties are values with a capitalization rate.

Reconciliation and Final Estimate of Value The process of bringing together the three indications of value derived through the market, cost, and income approaches is the final step in the appraisal process.

The capitalization rate reflects a return on the funds invested, as well as a return (recapture) of the investment. This is not unlike opening a savings account with $100. If at the end of the year you received $10 in interest, you would have a 10% return or 10% capitalization rate.

The determination of the appropriate capitalization rate is the most difficult aspect of the income approach to value. The techniques for the selection of a capitalization rate are complex and beyond the scope of this book.

For example, visualize the capitalization rate as being the rate that other like properties that are returning to their owners.

The final step in the income approach is to divide the capitalization rate into net operating income to arrive at an estimate of value.

net operating income divide by capitalization rate equals estimate of value

The income approach to value is appropriate for incomeproducing properties such as apartment buildings, commercial office buildings, and retail stores. Figure 9.5 is an example of an appraisal using the income approach

Net operating income is the income the property produces after the deduction of operating expenses, but before the payment of real estate loans.

The next step in the income approach is to select the appropriate capitalization rate. A capitalization rate can be defined as the rate necessary to attract an average investor to invest in the property being appraised.

Market Approach (Comparable Sales) The market approach to value is based on the principle of substitution.

The principle of substitution states that a buyer should not pay more for a home than the price it takes to acquire a comparable home. Therefore, the market approach is also known as the comparison sales approach to value.

After carefully selecting comparable sales, the appraiser determines that the gross monthly rentmultiplier should be 200. The fair market rent of the home is $1,500.

Therefore, gross monthly rent multiplier times monthly rent equals estimate of value. 200 times $1,500 equals $300,000 Estimate of value

An appraiser does this for many sales until a trend develops. When asked to conduct an appraisal on a home, the appraiser does a complete market approach (comparable sales) to arrive at an estimate of value.

To recheck the results of the market approach, the appraiser may also do a cost approach and an income approach. For a home, a full-blown income approach is not needed, so the gross rent multiplier approach is often used instead.

The market approach to value is not the main technique used when appraising income property, but it is an excellent approach to use when appraising homes, especially when the local home market is highly active with many comparable sales in the immediate neighborhood.

Use ofGrossMultipliers Appraisers have designed a method for quickly obtaining a rough estimate of value using what are called gross monthly rent multipliers aka GMRM, also known as gross rent multipliers aka GRM, if annual rents, instead of monthly rents, are used.

Value Range for Market Approach Example If the comparables in the market approach example (Figure 9.6) were near the location of the subject home and had the same lot size and overall condition of the subject home, the comparables A, B, and C would have sold for somewhere between $319,900 and $320,500; these figures reflect the indicated market value range.

Value Conclusions forMarket Approach Example Subject home in Figure 9.6 should sell for somewhere between $319,900 and $320,500. Final estimate is $320,000, as Comparable B is most comparable in the opinion of the appraiser.

A gross multiplier is a ratio between sales price and rental rates. The GMRM is found by dividing the sales price of a home by its monthly rent.

example: sales price is 300,000 divide by Monthly rental rate 2,000 equals 150 gross monthly rent multiplier

The gross rent multiplier is found by dividing the sales price of a home by its annual rent.

sales price 300,000 divide by annual rate 24,000 equals 12.5 gross rent multiplier

The final value estimate is not given in odd dollars and cents. The final estimate of value usually is rounded to the nearest $100, $500, or $1,000, depending on the value of the property.

the end