New Jersey Real Estate Salesperson · Valuation and Market Analysis
Approaches to Value
On this page 6 sections
In 30 seconds
Appraisers reach value three ways: comparing recent sales, pricing land plus the cost to rebuild minus depreciation, or capitalizing the income a property earns. The most tested rule is that adjustments are made to the comparable, never the subject: subtract when the comparable is better, add when it is worse.
Why this matters
The exam tests which approach fits which property and whether you adjust the comparable or the subject, and licensees who reverse the direction produce upside-down price opinions.
The college version
In normal terms
- Sales comparison suits homes and land; the cost approach suits new or special-purpose buildings; income capitalization suits rental and commercial property.
- In sales comparison the subject is the fixed point; each comparable is adjusted toward it, superior features subtracted and inferior features added.
Concepts in this outline
- Sales comparison approach — value from recent sales of similar properties, adjusted for differences; primary for homes and land.
- Comparable selection — choose recent, nearby, arm's-length sales that most resemble the subject.
- Adjustment process — add or subtract amounts from each comparable's price for differences from the subject.
- Subject-versus-comparable adjustment rule — adjust the comparable, never the subject; if the comparable is better, subtract; if worse, add.
- Market conditions adjustments — correct for price changes between the comparable's sale date and the effective date.
- Physical characteristics — differences in size, age, condition, and features that require adjustment.
- Location — adjustment for a comparable in a better or worse neighborhood or lot position than the subject.
- Financing terms — adjustment for unusual financing that pushed a comparable's price off cash-equivalent.
- Cost approach — land value plus cost to build new, minus accrued depreciation; best for new or special-purpose buildings.
- Land value — the site's value as if vacant at its highest and best use.
- Replacement cost new — cost today to build a structure of equal utility with modern materials and methods.
- Reproduction cost new — cost today to build an exact duplicate, outdated materials included.
- Depreciation — any loss in value from physical, functional, or external causes (see Topic 03).
- Accrued depreciation — total loss in value from all causes to the effective date, subtracted from cost new (see Topic 03).
- Income capitalization approach — value derived from the income a property produces; used for rental and commercial property.
- Potential gross income — total annual income if fully rented at market rent with no losses.
- Effective gross income — potential gross income minus vacancy and collection losses, plus other income.
- Operating expenses — costs of running the property, such as taxes, insurance, and maintenance; mortgage payments excluded.
- Net operating income — effective gross income minus operating expenses; income available before debt service.
- Capitalization rate — the return investors expect, taken from comparable sales; a higher rate means lower value.
- Gross rent multiplier — small-rental shortcut: sale price divided by gross rent, then applied to the subject's rent.
- Capitalization formula: V = I / R — value equals net operating income divided by the capitalization rate.
- V is value — the estimated value of the income-producing property.
- I is net operating income — annual effective gross income minus operating expenses, before loan payments.
- R is capitalization rate — the market-derived rate of return, written as a decimal when dividing.
Eli explains
The same idea, in plain words
Explain it like I’m 10
There are three roads to value, and an appraiser picks the one that fits the property.
The sales comparison approach asks what similar properties recently sold for. Because no two houses match, the appraiser adjusts each comparable to look like the subject, which never changes. If the comparable has something better, such as a garage the subject lacks, you subtract that garage's worth from its price. If the comparable is worse, you add.
The cost approach asks what it would take to buy the land and build the structure today, then subtracts depreciation (see Topic 03). It fits new or unusual buildings with few comparable sales.
The income capitalization approach treats a property as a money machine. Start with potential gross income, subtract vacancy and collection loss to get effective gross income, subtract operating expenses to get net operating income, then divide by the capitalization rate the market expects. For small rentals, a gross rent multiplier from nearby sales offers a shortcut.
Worked example
Luis appraises a small Morristown building with offices upstairs and a shop below. Full-occupancy rent would be 80,000 dollars a year, but similar buildings run about ten percent vacant, so effective gross income is 72,000 dollars. Taxes, insurance, maintenance, and management total 22,000 dollars, leaving net operating income of 50,000 dollars. Comparable Morristown sales show buyers accepting an eight percent return, so Luis divides 50,000 by 0.08 and arrives at a value of 625,000 dollars. One comparable sold with generous seller financing, so he adjusts its price downward first.
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