Ch6. Appraisal Practice Calculations — Income, Sales Comparison & Cost Approaches

The Three Approaches to Value

Sales Comparison Approach:
Sales Comparison Method (land & buildings)
Rent Comparison Method (rental rates)

Cost Approach:
Replacement/Reproduction Cost Method (buildings)
Summation Method (rental rates)

Income Approach:
Direct Capitalization / DCF (income-producing property)
Income Analysis Method (rental rates)

Reconciliation:
USPAP requires consideration of all applicable approaches
and a reasoned reconciliation to a final value opinion

Income Approach — Direct Capitalization

Direct Capitalization:
V = NOI / R
NOI = Net Operating Income
R   = Capitalization Rate

NOI Calculation:
  Potential Gross Income (PGI)
- Vacancy & Collection Loss
= Effective Gross Income (EGI)
- Operating Expenses
= Net Operating Income (NOI)

Capitalization Rate Development:
  Market Extraction (from comparable sales: NOI ÷ sale price)
  Band-of-Investment (mortgage & equity components)
  Built-Up Rate (safe rate + risk + management + illiquidity)

DCF Method:
  Sum present values of periodic cash flows
  Plus reversion (resale proceeds at end of holding period)

Sales Comparison Approach

Indicated Value = Sale Price × Conditions-of-Sale Adj.
                            × Market Conditions Adj.
                            × Location Adj.
                            × Physical Characteristics Adj.

Conditions-of-Sale (Transaction):
  Adjust for non-arm's-length sales (foreclosures,
  related-party transactions, etc.)

Market Conditions (Time):
  Adjust from contract date to effective date of appraisal

Location:
  Differences between subject and comparable neighborhoods

Physical Characteristics:
  Site size, access, frontage, topography, utilities, etc.

Selection Criteria:
  Prioritize recent sales within the same neighborhood/market area
  Exclude non-market transactions

Cost Approach

Replacement Cost New (RCN):
  Cost to construct a building of equal utility at today's prices

Depreciation:
  Physical Deterioration (age/condition)
  Functional Obsolescence (outmoded features or design deficiencies)
  External (Economic) Obsolescence (off-site factors)

Age-Life Method:
  Effective Age / Total Economic Life = % Depreciation
  Remaining Economic Life = Total Economic Life − Effective Age

Depreciated Cost (Indicated Value):
  RCN − Accrued Depreciation + Land Value

Key Concept Cards

NOI = EGI − Operating Expenses ★★★★★ : PGI → less vacancy/collection loss → EGI → less operating expenses → NOI. Memory hook: NOI = EGI minus OpEx

V = NOI / R ★★★★★ : The fundamental direct-capitalization formula. Memory hook: Value = Net Income ÷ Cap Rate

Sales Comparison adjustments: Conditions → Time → Location → Physical ★★★★☆ : Apply the four adjustment types in this sequence. Memory hook: C-T-L-P

Practice Questions

Q. What happens to value when the cap rate increases?

V = NOI / R. A higher cap rate (R) means a larger denominator → lower value (V). Higher-risk properties command higher cap rates. Core urban assets might trade at 4–5% cap rates; secondary-market income properties at 7–9%. The cap rate is analogous to an investor’s required rate of return.

Q. Why must conditions-of-sale adjustments be applied before other adjustments?

Non-arm’s-length transactions (foreclosures, REO sales, related-party deals) may produce prices that deviate significantly from market value. The conditions-of-sale adjustment normalizes the sale to an arm’s-length equivalent before time, location, and physical adjustments are applied. Applying other adjustments to a distorted base price compounds error — so normalization comes first.