Appraisers can value real estate based on one of three different approaches: the Income Approach, Cost Approach and the Sales Comparison Approach.
The Income Approach is designed for income producing or rental properties. The value is based on the potential income and expenses of the property and its ability to provide a return to the owner.
The Cost Approach is used mostly on newer houses and it is based on how much it would cost to rebuild the house and all of the improvements (well, septic, excavating, driveway, etc.). Physical (age, wear and tear) as well as functional and external depreciation are subtracted from the cost of the construction then the land or site value is added to arrive at an opinion of value based on the replacement cost of the entire property.
The Sales Comparison Approach is the most often used approach and is based on using similar properties to the subject that have sold recently and are adjusted for the differences between the subject property and the comparable sales. This approach uses current market sales to show the property’s market value while adjusting the sales for such items as lot size, quality of construction, condition, room count, living area, finished basement area, garage area, etc.
The subject property is a two story house with a 1 car garage and has 2 bedrooms and 1 bathroom. The house next door just sold for $100,000 and has a 2 car garage, 2 bedrooms and 2 bathrooms and is similar to the subject in most other ways. A house a few doors down recently sold for $90,000 and was a similar two story house with no garage and had 2 bedrooms and 1 bathroom and was of similar size and other features. The first sale is superior at $100,000 since it has an additional garage space and bathroom. The second sale was inferior since it did not have a garage. The Appraiser would then conclude that the value of the subject would probably be more than $90,000 and less than $100,000, maybe between $93,000 and $95,000.
Active listings and pending sales can also be used to help reflect current market activity since often similar sales can be 3, 4, 6 and 8+ months old sometimes. This approach is often given the most weight in the appraisal since given the quality and quantity of sales data for most properties. Also, it is important to use similar sales and compare like properties like using two story sales against a two story house and ranch or one story houses against a one story house. Likewise, an appraiser should use industrial plant sales when appraising an industrial plant instead of using shopping plaza or office buildings sales when appraising an industrial or manufacturing plant.
As discussed elsewhere, unique properties sometimes don’t have truly comparable sales or a slow market could severely limit the number of comparable sales. The quality and the quantity of the sales data are extremely important in providing a reasonable or accurate opinion of market value.