Real Estate Appraisal: Chapter 9 Sales Comparison Approach to Value

Key Concepts:

Terms in this set (40)

The concept of a real estate market is central to the sales comparison approach.

A real estate market is a distinct group of buyers and sellers whose actions are influenced in similar ways by similar forces of supply and demand.

Prices paid for properties within a given market should indicate the value of other similar properties in that market, but usually don't indicate the value of properties in a different market.

Ex. Prices paid for home in a community with a strong economic base and high wage levels are likely to be much higher than prices paid for similar homes in a depressed community.

In applying the sales comparison approach, the appraiser must be keenly aware of the subject property's market.

The geographic boundaries of a market may be large or small, depending on the type of property.

Markets for residential property tend to be smaller, encompassing neighborhoods or districts, while markets for large commercial properties may be national or even international.

Markets are sometimes defined by physical boundaries, but the critical factor in defining a market for appraisal purposes is similarity in the forces (economic, social, governmental, and physical/environmental) that influence value.

If these forces are rapidly changing, it becomes much more difficult to identify comparable sales, and the sales comparison approach becomes much less reliable.

Ex. In a period of rapid inflation, the pool of buyers who can afford to purchase a particular size of house may change almost daily, and sales of similar properties that closed a month ago may no longer be representative of the present market.
When comparing different properties, it is important for the price of each property to be stated in the same unit of comparison.

It would make no sense to compare one property's price per square foot of living area to another property's price per front foot of water frontage.

The third step in the sales comparison approach is selecting units of comparison.

That unit may be an acre, a front foot, or a square foot.

Ex. The price of vacant land is often stated as a price per acre, per square foot, or per front foot.

In residential appraisals, the price per square foot of living area and the price for the entire property are commonly used units of comparison.

The appraiser must choose the unit or units of comparison that are most appropriate for the particular property being appraised.

More than one unit may be appropriate, and the appraiser will make a comparison for each of the applicable units.

If comparing several different units of comparison leads to a consistent indicator of value, that indicator of value will be more reliable.

If a wide range of values results from using different units of comparison, the appraiser will want to investigate the cause of discrepancy.

Ex. An analysis of comparable properties results in an indicated value for the subject property of $304,000, and an indicated value per square foot (derived separately) of $91.32. The size of the subject property is 2,000 square feet, so its indicated value based on value per square foot is $182,640 ($91.32 x 2,000). The values indicated by using different units of comparison are inconsistent, so the appraiser must investigate further to determine the reasons for the discrepancy, and make appropriate adjustments.
Conditions of sale are the circumstances under which a real estate transaction took place.

Normal conditions of sale include a buyer and a seller who are typically motivated--whose motivations in entering into their transaction are essentially the same as those of most other buyers and sellers in the real estate market.

A sale can generally be considered to have taken place under normal conditions if:

1. it was an arm's length transaction (between unrelated parties)
2. neither party was subject to undue stimulus (unusual pressure to act)
3. both parties acted prudently and knowledgeably, and in their own best interest
4. the property was exposed on the open market for a reasonable length of time

If one or more of these conditions were absent, the parties weren't typically motivated.

The price paid for the property isn't necessarily a reliable indication of its market value.

A seller who has been transferred to another city may accept a low offer to make a quick sale, or a developer may pay an above-market price for a property that is necessary to complete a certain project.

If the buyer was a relative, friend, or business associate, the seller may have accepted a lower price than she would have been willing to accept from a stranger in an arm's length transaction.

Ex. The appraiser finds a comparable that is very similar to the subject property and located only two blocks away. The comparable sold for $620,000 three months ago. Because the buyer was the seller's nephew, it wasn't an arm's length transaction, and the appraiser must assume that the motivation of the parties was not typical. The price paid may be significantly less than the property's true market value..

The appraiser must investigate the circumstances surrounding each comparable sale to make sure it took place under normal conditions.

If it didn't, that usually means it shouldn't be used as a comparable.

Because the buyer and the seller were acting under the influence of forces that don't affect the market in general, the price paid is not a reliable indicator of market value.

It's typically very difficult to quantify exactly how much those unusual forces affected the price.

Occasionally a sale that didn't take place under normal conditions can be used as a comparable if the appraiser makes an appropriate adjustment to the price.

Adjustments for conditions of sale are rare and should be made with great care; the appraiser must conduct careful research to find data that support the adjustment.

If sufficient supporting data are not available, the appraiser should not use the transaction as a comparable sale.

When appraising a property that is owned by a financial institution because of a mortgage default (referred to as an REO, for "real estate owned"), the appraiser should use only other REOs as comparables.

REOs are usually vacant, which means that there's an increased risk of vandalism and other physical deterioration.

Further, there are often delays in the closing process, caused by institutional bureaucracy.

Lengthy delays can jeopardize the buyer's financing and will certainly mean a later possession date.

If an appraiser who is evaluating an REO is forced to use a non-REO as a comparable, she will usually have to make a downward price adjustment to the comparable property.
The price paid for a comparable property reflects the state of the market as of the date the property was sold, but the forces that affect value are subject to constant change.

If market conditions have changed between the date of the comparable sale and the effective date of the appraisal, an adjustment must be made to account for this fact.

The closer a comparable sale is to the effective date of the appraisal, the more reliable it will be as a value indicator.

Comparables that sold within 6-months of the appraisal date don't necessarily require any adjustment for market conditions, unless significant change has occurred in the market since the date of the comparable sale.

If the real estate market has been unusually inactive, the appraiser may have to use sales older than 6-months as comparables.

In this case, adjustments must be made for inflation or other economic trends that have affected market price since the date of sale.

Ex. The appraiser is unable to locate three comparable properties that have sold in the past 6-months, so he chooses a comparable that sold 10-months ago. Since then, property values have increased about 3% due to inflation. To account for the effect of inflation, the appraiser adds 3% to the comparable's sales price.

Comparables older than one year are usually not considered, even in the absence of any obvious change in market conditions.

Ex. Suppose an appraisal has an effective date of December 1. If the appraiser locates a comparable that sold back in July, he could use that comparable without adjustment, unless the market was unusually volatile between July and December. If he locates a comparable that sold in April, he would need to adjust the comparable's price to account for any inflation since then. If he locates a comparable that sold in November of the previous year, he would not be able to use that comparable at all.
(Matched Pairs Analysis)
(Paired Data Set Analysis)

A technique for measuring the effect on value that is caused by differences in a single element of comparison.

The effect on value is estimated by comparing the prices of properties that differ in only one element of comparison.

Also called matched pairs analysis.

In paired data analysis (also known as matched pairs analysis, or paired data set analysis), an appraiser uses data from a matched pair of properties to assign a value to an element of comparison.

The appraiser first locates properties that are identical (or very similar) to each other in all aspects except one.

Note that these are not the properties the appraiser has selected as comparables; they don't need to be similar to the subject property, just similar to each other.

By selecting two properties with only one significant difference, the appraiser isolates the effect this one characteristic has on value.

This allows the appraiser to assign a value to the characteristic when it's used as an element of comparison.

So when a comparable differs from the subject property as to this characteristic, the appraiser can use the value of the characteristic to adjust the price of the comparable property.

Paired data analysis is best illustrated by a market data grid listing several elements of comparison for five different properties.

1. Identify pairs of properties that vary in only one characteristic.

Ex. Properties #1 & #4 are identical except for how big the garage is. Since the price paid for property #4 is $6,000 higher than the price of property #1, an appraiser would conclude that the market value of the extra garage space was $6,000.

Ex. Properties #2 & #5 are identical except for 100 sq.ft more in #2. Since the price paid for property #2 is $8,000 higher than the price of property #5, an appraiser would conclude that the market value places $80 per square foot on the additional living space.

The appraiser in this example has now identified adjustment values for four elements of comparison:

1. Garage size
2. Living area
3. Lot size
4. Basement

These values can hen be used to make adjustments to the sales prices of comparables to account for differences between the subject property and the comparables.

Although the concept behind paired data analysis is fairly simple, the real world is more complex.

Rarely will an appraiser be able to identify two properties that are identical in all characteristics except one.

It's often necessary necessary to make price adjustments for other differences first, in order to isolate the effect of the particular difference the appraiser is trying to measure.

Another issue that comes into play when using paired data analysis is the effect of one characteristic on value can often depend on another characteristic.

The amount of the adjustment to account for the difference in the size of the improvements may well depend on the age of the improvements: 100 sq. ft. of living space may add more value (in terms of dollar amount) to a 10-year-old home than it does to an 18-year-old home.

Appraisers must analyze and compare hundreds of sales transactions to gain an understanding of the effects on value caused by different elements of comparison.

Paired data analysis is a useful tool in this process, but more sophisticated statistical analysis is often necessary as well.

For each measured difference in an element of comparison, the appraiser must make adjustment to account for the resulting difference in value.

Adjustment are made to the prices of the comparables.

If a comparable is superior to the subject in some respect, its price is adjusted downward.

If the comparable is inferior to the subject, its price is adjusted upward.

The appraiser makes a series of these adjustments for each significant difference between the subject property and the comparable.

In this way, she arrives at an estimate of what the comparable would have sold for if it has been identical to the subject property.

Adjustments are never made directly to the value of the subject property.

This is because the subject property's value is unknown, so there is no starting point from which to make adjustments.

Because the appraiser is comparing several properties against the subject property, it would be easy to make mistakes such as adjusting twice for the same factor.

Most of an appraiser's adjustments are made to account for differences in physical characteristics between the comparables and the subject property.

Although the appraiser uses comparables that are as similar to the subject property as possible, at least some physical differences will usually exist.
A technique for estimating whether a difference in a single element of comparison has a positive, negative, or neutral impact on value.

Similar to paired data analysis.

In relative comparison analysis, the appraiser considers the relative quality of the comparables and the subject property, without assigning a numerical value to the differences make a comparable superior to the subject property.

Based on the prices of the comparables, the appraiser can develop an opinion of the subject property's value.

The subject property should be worth less than comparables that are superior, and it should be worth more than comparables that are inferior.

Relative comparison analysis provides a range of possible values for the subject property.

The prices of the superior comparables define the upper end of the range, and the price of the inferior comparables define the lower end.

The appraiser can be reasonably confident that the subject property's value falls within the range, without deciding on a precise value figure.

The process of determining a probable range of values is know as bracketing.

The adjusted sales prices of comparables that require mostly downward adjustment and the comparables that require mostly upward adjustment are "brackets" that mark each end of the range of likely values for the subject property.

If the comparables chosen are all superior or all inferior, only the upper or lower limit of the range can be identified.

To narrow down the range of values for the subject property, the appraiser may need to look for additional comparables.

In addition to measuring the comparables against the subject property, the comparables can also be compared to each other.

The appraiser can rank the comparables based on a particular characteristic and analyze where the subject property would fall in this ranking.

The can help the appraiser identify trends in value related to specific elements elements of comparison.

Ex. An appraiser might rank comparables according to square footage to see where the subject property fits in.

The ranking and prices of the comparables help the appraiser understand how the subject property's square footage affect its value.
In converting a percentage to a dollar figure, great care must be taken to understand exactly what the percentage is referring to.

Saying that Property A is worth 10% more than Property B is not the same thing as saying that Property B is worth 10% less than Property A.

In the first case, the 10% is referring t the value of Property B: Property A is worth 110% (100% + 10%) of the value of Property B.

In the second case, the 10% is referring to the value of Property A: Property B is worth 90% (100% - 10%) of the value of Property A.

If Property A is worth $100,000, the value of Property B in the first case would be $100,000 ÷ 1.1 = $90,909.

In the second case, Property B's value would be $100,000 x 0.9 = $90,000.

To determine whether a percentage applies to the value of the subject property or the value of the comparable, simply state the relationship between the values of the two properties.

The statement should be in this form, with X representing the percentage amount: "Property A is worth X% more (or less) than Property B."

If your statement of the relationship has the subject property first (Property A is the subject property), the percentage applies to the value of the comparable (Property B).

The adjustment calculation is simple, since it is always the comparable's value (not the subject's value) this is adjusted:

1. Multiply the value of the comparable by the percentage amount to get the amount of the adjustment.

2. Then add or subtract this amount from the comparable's value, depending on the relationship between the two properties.

If the statement of the relationship says the subject property is worth more than the comparable (the comparable is Property A), then the percentage applies to the value of the subject (Property B).

If the percentage applies to the value of the subject, the calculation is more difficult, since the value of the subject is not known.

A 4-step process is required.:

1. If the comparable is worth more than the subject, add the percentage to 1 (100%); if the comparable is worth less than the subject, subtract the percentage from 1(100%).

2. Divide the percentage by the number calculated in Step 1.

3. Multiply the value of the comparable by the number calculated in Step 2 to get the amount of the adjustment.

4. Adjust the comparable's value by the adjustment amount calculated in Step 3. Add the amount to the comparable's value if the comparable is worth less than the subject property. Subtract it if the comparable is worth more than the subject property.

Ex. You've located a comparable that is nearly identical to the subject property. The comparable sold for $300,000 two weeks ago, but it's located in a different neighborhood. The comparable's neighborhood is considered a better location and its homes are generally worth about 10% more than properties in the subject property's neighborhood.

First write out the statement of the relationship between the subject property and the comparable: "The comparable is worth 10% more than the subject property." The subject property is Property B, so the percentage applies to the subject property's value.

Step 1. Add the percentage (10% or 0.1) to 1.
0.1 + 1=1.1.

Step 2. Divide the percentage by the result of Step 1.
0.1 ÷ 1.1 =0.091 or 9.1% (rounded).

Step 3. Multiply the value of the comparable by the percentage from Step 2 to find the amount of the adjustment.
$300,000 x 9.1% = $27,300.

Step 4. Since the comparable is worth more than the subject property, adjust the comparable's value downward by the adjustment amount from Step 3.
$300,000 - $27,300 = $272,700. This is the adjusted value of the comparable.
When making adjustments for a number of different elements of comparison, the sequence in which the adjustments are made doesn't affect the outcome of the calculations, unless one or more of the adjustments is a percentage.

Ex. A comparable requires two adjustments: a 5% upward adjustment for changing market conditions, and a $10,000 downward adjustment because the comparable has an extra bathroom. The price of the comparable is $500,000.
If the appraiser makes the 5% adjustment first, then the first calculation is 5% of $500,000 = $25,000.
The two adjustment amount are then applied to the comparable's price to get an adjusted value of $515,000 ($500,000 + $25,000 - $10,000).
If the appraiser made the $10,000 adjustment first, the first calculation would be: $500,000 - $10,000 = $490,000.
Then the percentage adjustment would be: 5% of $490,000 = $24,500. That would mean that the adjusted value of the comparable is %514,500 ($500,000 - $10,000 + $24,500).
Thus, in this situation, the order in which the adjustments are applied makes a $500 difference in the adjusted value.

There are no hard and fast rules for the sequence of adjustments in a sales comparison analysis.

It's up to the appraiser to determine the most appropriate sequence based on the appraiser's analysis of the market.

In percentage cases the adjustment should be made in the following sequence:

1. Real property rights conveyed
2. Financing terms
3. Conditions of sale
4. Market conditions

These adjustments should be made first, and then adjustments concerning the comparable property (location, physical characteristics, etc.).

Ex. One comparable has unusual financing terms that require the appraiser to make a percentage adjustment. The comparable's price needs to be adjusted based on physical differences in the property: the comparable has a fireplace and the subject property doesn't.
In this situation, the appraiser would make the adjustment for the financing first, before adjusting the value of the comparable to account for the fireplace.
The final step in the sales comparison approach to value is reconciliation, in which the appraiser reviews all of the data and analysis and forms an opinion about the subject property's value.

The appraiser will always analyze at least three different comparable properties, with each analysis providing a value indicator for the subject property.

Even if the appraiser has chosen good comparables, it is unlikely that they will all indicate exactly the same value for the subject property.

The adjusted sales price typically present a range of values, and the appraiser must use her judgement and experience to select some value within this range.

The appraiser may need to reconcile values based on paired data analysis with conclusions drawn from relative comparison analysis.

Choosing an appropriate value for the subject property is not a mechanical process.

An appraiser should never average the values indicated by the comparables to estimate the subject property's value.

Instead, in reconciling the values, the appraiser considers their relative reliability and gives more weight to the more reliable value indicators.

According to the principle of substitution, a comparable that is more similar to the subject property should be a more reliable indicator of value.

This is because a more similar comparable competes more directly with the subject property than less similar comparables.

Other factors that may affect a value indicator's reliability might include a neighborhood's stability or a market's size: a changing neighborhood indicates unstable values, while an extremely small market can translate into less reliable indicators.

In paired data analysis, a good indicator of reliability is the extent of adjustment that is required for each comparable.

Comparables requiring less adjustment are generally more reliable than those that require larger adjustments. These comparables will therefore e given more weight when the figures are reconciled.

Ex. The adjusted sales prices of four comparable properties indicate the following range of values for the subject property.

1. $302,300
2. $297,700
3. $305,100
4. $303,700

Comparable #1 is the most similar to the subject property and requires the fewest adjustment.

The appraiser gives the most weight to this comparable, concluding that the indicated value of the subject is $302,000.