Broker. Sales Comparison, Cost Depreciation and Income Approaches. Chapter 7. Copyright Gold Coast Schools 1

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1 Broker Chapter 7 Sales Comparison, Cost Depreciation and Income Approaches 1

2 Learning Objectives Describe the assumptions underlying the sales comparison approach Calculate the various adjustments necessary under the sales comparison approach Distinguish between fixtures and trade fixtures Construct a sales comparison adjustment grid using the proper sequence of adjustments 2

3 Learning Objectives Distinguish among normal sale price, market conditions-adjusted normal sale price, and final adjusted sale price List the steps in the cost-depreciation approach Distinguish between reproduction cost and replacement cost Describe the 3 methods for estimating cost Distinguish among the types of accrued depreciation 3

4 Learning Objectives Calculate an accrued depreciation adjustment using the lump-sum age-life method Define effective age and economic life Perform a GRM analysis Distinguish among potential gross income, effective gross income, and net operating income Distinguish among the 3 types of operating expenses 4

5 Learning Objectives Develop a reconstructed operating statement Calculate a market-derived capitalization rate Calculate value using the income approach formula 5

6 Sales Comparison Approach Basic premise Market value can be inferred from the sales of comparable properties Underlying assumptions Market price is valid evidence of market value Principal of substitution Methods of adjustment Comparable inferior add (CIA) Comparable better subtract (CBS) Most reliable approach for single-family homes 6

7 Sales Comparison Approach Elements of comparison Conditions of sale Financing terms Sales concessions Market conditions Personal property Location 7

8 Sales Comparison Approach Elements of comparison Financing terms Mortgage assumption Seller financing Contract for deed Wraparound loan 8

9 Sales Comparison Approach Conditions of sale All secondary sources of data must be confirmed thru a primary source Examples (undue stimuli) Pending foreclosure Loss of job Bankruptcy Non arm s-length transaction Adjustments are difficult, possibly impossible to make comp should not be used 9

10 Sales Comparison Approach Financing terms Institutional financing or market financing Nonmarket financing Mortgage assumption Seller financing Contract for deed 10

11 Sales Comparison Approach Sales Concessions Interest rate buydowns Seller-paid loan discount points & origination fees Seller-paid closing costs for buyer Refunds of buyers expenses Inclusion of non-realty items 11

12 Sales Comparison Approach Market conditions Time Successive sales analysis (formula) Resale price Minus initial sale price Equals difference in price Divided by initial sale price Equals percentage change Divided by # of months between sales Equals monthly rate of change Personal Property 12

13 Sales Comparison Approach Personal property Items not permanently attached to the real estate Fixture originally personal property, not permanently attached to real estate Trade fixture personal property attached to the real estate used in the tenant s business Remains personal property USPAP requires appraiser to identify items included in appraisal: Personal property Trade fixtures Intangible items 13

14 Sales Comparison Approach Location Proximity to schools, shopping & recreation Buffer from external diseconomies crime Government services police, fire protection Considerations outside the property External economies and diseconomies Property (physical) characteristics Size (square footage) Age and condition of improvements Construction quality Architectural style Age and amenities 14

15 Methods of Adjustment Normal sale price The price the comp would have sold for if the transaction would have been consistent with the market (conditions of sale, financing, sales concessions) Market conditions - adjusted normal sale price The price the comp would have sold for in today s market (inflation/deflation) Final adjusted sale price The price the comp would have sold for it were exactly like the subject property (location/physical condition) 15

16 Formula: Market Conditions Adjustment Resale Price Initial Price Initial Price = % of Chg Months btwn Sales = Monthly Rate of Chg A) $182,900-$167,000 $167,000= =.0034 B) $172,200-$158,500 $158,500= =.0033 C) $174,000-$160,000 $160,000= = = =.0036 Monthly Rate of Change =

17 Cost Approach Four Steps 1) Estimate the Current Reproduction (or Replacement) Cost 2) Estimate the Depreciation and Deduct it from the Cost 3) Estimate Value of Site and Nonstructural Site Improvements 4) Add the Value of the Site, Nonstructural Site Improvements to the Depreciated Cost new 17

18 Cost Approach Step One Estimate the Cost Three methods Quantity Survey - detailed inventory of everything required to reproduce a building (most detailed) Unit-In-Place - cost is calculated for each individual component Comparative Square-foot (Unit Comparison) Cost per square or cubic foot Benchmark properties - basis for comparison 18

19 Cost Approach Step Two Estimate the Depreciation and Subtract from the Cost Depreciation - The loss of value due to any cause Accrued Depreciation - The total loss in value from all types Land does not depreciate 19

20 Cost Approach Three types of depreciation Physical Deterioration - wear and tear Functional Obsolescence - does not meet current standards or an overimprovement External (Economic) Obsolescence - influence outside property boundaries Ways to accrue depreciation Breakdown method Market extraction method Lump-sum age-life method 20

21 Cost Approach Depreciation can be Curable The cost to correct is less than the added value Incurable The cost to correct is greater than the added value 21

22 Age-Life Depreciation Effective Age Economic Life X Reproduction (or replacement) cost new = Accrued Depreciation 22

23 Cost Approach Accrued depreciation using annual depreciation Economic Life - Estimated time in years that an improvement can be profitably useful Effective age - as it appears to be Cost new economic life = annual depreciation Yearly depreciation X effective age = accrued depreciation 23

24 Cost Approach Step Three - Estimate the Value of the Site and Site Improvements Value of the land Determined by Comparable Sales approach Land does not depreciate 24

25 Cost Approach Step Four Depreciated Cost (Step 2) + Value of the Site and Site Improvements (Step 3) = Value of Property 25

26 Income Approach Value - Present worth of Future income of the subject property 26

27 Gross Income Multiplier (GIM) or Gross Rent Multiplier (GRM) Gross Rent Multiplier (GRM) - Estimates value from monthly rental income only Sales price monthly rent = GRM Gross Income Multiplier (GIM) - Estimates value from all sources including rental income plus any other source Sales price annual rent - GIM 27

28 GIM/GRM Step 1 : Estimate Gross Rent (or Income) for Subject Property Step 2 : Calculate Average Multiplier (GRM or GIM) using several comps Sale price divided by gross rent (or income) of comparable properties and then average Step 3 : Estimate Value of Subject Property Average multiplier times monthly gross rent (or annual income) from subject property 28

29 Income Three types Potential Gross Income (PGI) - Annual income the property would produce if fully rented and there are no collection losses Effective Gross Income (EGI) - Income after vacancy and collection losses are subtracted and other income is added Net Operating Income (NOI) - Income remaining after subtracting all operating expenses 29

30 Operating Expenses Three categories Fixed Expenses (FE) - e.g. taxes and insurance Variable Expenses (VE) - e.g. utilities, maintenance Reserve for Replacements (R) - e.g. roof covering, air-conditioning Operating expenses do not include Depreciation Interest on loans Mortgage Payments (Debt Service) Income Taxes 30

31 Income Capitalization Approach Overall Capitalization Rate (OAR) - average rate of return received on similar properties I R x V 31

32 Income Capitalization Approach Math Concept Net Operating Income (the "I" in IRV) Potential Gross Income PGI (or GI) Vacancy and Collection loss allowance Other Income Effective Gross Income { Fixed Expense} - V&C + OI EGI (% or $) Operating Expenses { Variable Expense} { Reserves } - OE (or EXP) Net Operating Income NOI 32

33 Income Capitalization Approach Estimating Value IRV FORMULA" I R V Net Income divided by Rate = Value Net Income divided by Value = Rate Rate times Value = Net Income NOI R = V NOI V = R R x V = NOI Note: When the rate goes up, the value goes down (and vice-versa) (see math supplement) 33

34 Income-Capitalization Approach Reconstructed operating statement Appropriate items Vacancy and collection losses Reserves for replacement Management fee Inappropriate items Depreciation Personal expenses Federal income taxes Debt service 34