The Three Approaches to Value

Three routes to the same destination

Appraisers have three recognized methods for estimating value: the sales comparison approach, the cost approach, and the income capitalization approach. Each looks at the property through a different lens, and each is strongest for a different kind of property. A single appraisal may use more than one of them, then reconcile the results into one final opinion of value.

Sales comparison approach

The sales comparison approach compares the subject property to recently sold comparable properties and makes dollar adjustments to each comparable's sale price to account for differences (location, size, condition, amenities, date of sale). Adjustments are made to the comparable, never to the subject. After adjusting, the appraiser weights the comparables by reliability and settles on a value range. This approach dominates for houses, condominiums, and other properties that sell frequently, because there are plenty of comparable sales to work from.

Cost approach

The cost approach estimates value as land value plus the depreciated cost of the improvements. The appraiser values the land as if vacant, estimates the current cost to build the improvements, subtracts accrued depreciation, and adds the two figures together. It is most reliable for new construction, special purpose buildings (churches, schools, public buildings), and properties that rarely sell, where comparable sales are scarce.

Income capitalization approach

The income capitalization approach values a property by its ability to earn. The appraiser estimates net operating income and divides it by a market derived capitalization rate: Value = NOI divided by Cap Rate. It is the primary approach for income producing property such as apartment buildings, office buildings, and retail centers, where the buyer is really purchasing a stream of income.

Reconciliation

Reconciliation (sometimes called correlation) is the process of weighing the results of the approaches used and arriving at a single value opinion. The appraiser does not simply average the numbers. Instead, the appraiser judges which approach best fits the property type, the quality of the data, and the purpose of the appraisal, then gives the most weight to the most credible result.

Property type	Best approach
Single family home	Sales comparison
New or special purpose building	Cost
Apartment or office building	Income capitalization

A concrete example

A bank orders an appraisal of a six unit apartment building. The appraiser runs the income approach by dividing its net operating income by a market cap rate, uses the sales comparison approach on other recent apartment building sales, and checks the cost approach against what it would take to build the building new. All three produce a range. Because the property's value is driven by its rent, the appraiser weights the income approach most heavily and reconciles to a final number near it.

Exam angle

The exam most often asks you to match an approach to its definition or to a property type. Remember the three core formulas and what each approach starts from: sales comparison adjusts comparable sale prices, cost adds land to depreciated improvements, and income divides NOI by the cap rate. Watch for a distractor that describes the cost approach but calls it the sales comparison approach, or that tells you to adjust the subject instead of the comparables.