There are three traditional approaches typically available to develop indications of real property value: the cost, sales comparison, and income capitalization approaches.
Cost Approach
The cost approach is a summation approach. The approach develops separate values of the vacant site, site improvements, and the improvements. The value of the improvements developed by arriving at an opinion of cost new and then deducting accrued depreciation, which is the loss in value from physical, functional, and external factors.
For many existing properties, the cost approach is not considered applicable since typical market participants do not rely upon the approach in arriving at value indications for properties of this age. The cost approach is typically most applicable for new or nearly new properties.
Sales Comparison Approach
The principle of substitution constitutes the basis for the sales comparison approach. This principle states that a well-informed buyer would not pay more for a property than it would cost to acquire a comparable substitute property. Alternatively, the price for which an item will most likely sell is closely related to the prices for which similar items in the same market are selling. The principle of contribution is the basis for making adjustments to comparable sales to reflect differences between the subject and the sale properties.
The sales comparison approach analyzes pertinent comparable market data in order to make comparisons with the subject. To establish comparability, property characteristics which typical purchasers for the property type would find significant are identified.
In active markets, this approach simulates the process by which informed buyers and sellers proceed in deciding upon a price. When reasonable, market-supported adjustments for differences between the subject and comparable sales are appropriately applied and when historical comparable data is interpreted in the current market, this approach is valid in most circumstances.
Comparable data may consist of consummated sales, properties under contract for sale, listings, and offers. Analysis of the comparable sales is based on the elements of comparison. These include: interest conveyed, motivation, financing or sales concessions, date of sale, location, physical characteristics.
Income Capitalization Approach
The income capitalization approach converts the anticipated flow of future benefits (income) to a present value indication through capitalizing a single year’s income and by discounting a series of cash flows.
The approach relies on the principle of anticipation. This principle is based on the premise that an investor would base a purchase decision for a property on the capitalized value of the expected income benefits to be derived from the ownership of the property.
Appraisers typically consider two types of methodologies when employing the income capitalization approach. Depending on the characteristics of the property or income stream, either direct capitalization (single year’s income converted into value) or yield capitalization (typically discounted cash flow analysis) may be utilized. One method may be more applicable than the other in specific cases.
Final Reconciliation
The appraisal process concludes with final reconciliation where the values derived from the approaches based on their respective strengths and weaknesses logically result in one or more final opinions of value. Different properties and assignment types require different means of analysis and lend themselves to one approach over the others.