Steps in the approach
Broker’s comparative market analysis
The sales comparison approach, also known as the market data approach, is used for almost all properties. It also serves as the basis for a broker’s opinion of value. It is based on the principle of substitution– that a buyer will pay no more for the subject property than would be sufficient to purchase a comparable property– and contribution– that specific characteristics add value to a property.
The sales comparison approach is widely used because it takes into account the subject property’s specific amenities in relation to competing properties. In addition, because of the currency of its data, the approach incorporates present market realities.
The sales comparison approach is limited in that every property is unique. As a result, it is difficult to find good comparables, especially for special-purpose properties. In addition, the market must be active; otherwise, sale prices lack currency and reliability.
Steps in the approach
The sales comparison approach consists of comparing sale prices of recently sold properties that are comparable with the subject, and making dollar adjustments to the price of each comparable to account for competitive differences with the subject. After identifying the adjusted value of each comparable, the appraiser weights the reliability of each comparable and the factors underlying how the adjustments were made. The weighting yields a final value range based on the most reliable factors in the analysis.
To qualify as a comparable, a property must:
- resemble the subject in size, shape, design, utility and location
- have sold recently, generally within six months of the appraisal
- have sold in an arm’s-length transaction
An appraiser considers three to six comparables, and usually includes at least three in the appraisal report.
Appraisers have specific guidelines within the foregoing criteria for selecting comparables, many of which are set by secondary market organizations such as FNMA. For example, to qualify as a comparable for a mortgage loan appraisal, a property might have to be located within one mile of the subject. Or perhaps the size of the comparable must be within a certain percentage of improved area in relation to the subject.
The time-of-sale criterion is important because transactions that occurred too far in the past will not reflect appreciation or recent changes in market conditions.
An arm’s length sale involves objective, disinterested parties who are presumed to have negotiated a market price for the property. If the sale of a house occurred between a father and a daughter, for example, one might assume that the transaction did not reflect market value.
Principal sources of data for generating the sales comparison are tax records, title records, and the local multiple listing service.
The appraiser adjusts the sale prices of the comparables to account for competitive differences with the subject property. Note that the sale prices of the comparables are known, while the value and price of the subject are not. Therefore, adjustments can be made only to the comparables’ prices, not to the subject’s. Adjustments are made to the comparables in the form of a value deduction or a value addition.
Adding or deducting value. If the comparable is better than the subject in some characteristic, an amount is deducted from the sale price of the comparable. This neutralizes the comparable’s competitive advantage in an adjustment category.
For example, a comparable has a swimming pool and the subject does not. To equalize the difference, the appraiser deducts an amount, say $6,000, from the sale price of the comparable. Note that the adjustment reflects the contribution of the swimming pool to market value. The adjustment amount is not the cost of the pool or its depreciated value.
If the comparable is inferior to the subject in some characteristic, an amount is added to the price of the comparable. This adjustment equalizes the subject’s competitive advantage in this area.
Adjustment criteria. The principal factors for comparison and adjustment are time of sale, location, physical characteristics, and transaction characteristics.
- time of sale
An adjustment may be made if market conditions, market prices, or financing availability have changed significantly since the date of the comparable’s sale. Most often, this adjustment is to account for appreciation.
An adjustment may be made if there are differences between the comparable’s location and the subject’s, including neighborhood desirability and appearance, zoning restrictions, and general price levels.
- physical characteristics
Adjustments may be made for marketable differences between the comparable’s and subject’s lot size, square feet of livable area (or other appropriate measure for the property type), number of rooms, layout, age, condition, construction type and quality, landscaping, and special amenities.
- 4 transaction characteristics
An adjustment may be made for such differences as mortgage loan terms, mortgage assumability, and owner financing.
Adding and subtracting the appropriate adjustments to the sale price of each comparable results in an adjusted price for the comparables that indicates the value of the subject. The last step in the approach is to perform a weighted analysis of the indicated values of each comparable. The appraiser, in other words, must identify which comparable values are more indicative of the subject and which are less indicative.
An appraiser primarily relies on experience and judgment to weight comparables. There is no formula for selecting a value from within the range of all comparables analyzed. However, there are three quantitative guidelines: the total number of adjustments; the amount of a single adjustment; and the net value change of all adjustments.
As a rule, the fewer the total number of adjustments, the smaller the adjustment amounts, and the less the total adjustment amount, the more reliable the comparable.
Number of adjustments. In terms of total adjustments, the comparable with the fewest adjustments tends to be most similar to the subject, hence the best indicator of value. If a comparable requires excessive adjustments, it is increasingly less reliable as an indicator of value. The underlying rationale is that there is a margin of error involved in making any adjustment. Whenever a number of adjustments must be made, the margin of error compounds. By the time six or seven adjustments are made, the margin becomes significant, and the reliability of the final value estimate is greatly reduced.
Single adjustment amounts. The dollar amount of an adjustment represents the variance between the subject and the comparable for a given item. If a large adjustment is called for, the comparable becomes less of an indicator of value. The smaller the adjustment, the better the comparable is as an indicator of value. If an appraisal is performed for mortgage qualification, the appraiser may be restricted from making adjustments in excess of a certain amount, for example, anything in excess of 10-15% of the sale price of the comparable. If such an adjustment would be necessary, the property is no longer considered comparable.
Total net adjustment amount. The third reliability factor in weighting comparables is the total net value change of all adjustments added together. If a comparable’s total adjustments alter the indicated value only slightly, the comparable is a good indicator of value. If total adjustments create a large dollar amount between the sale price and the adjusted value, the comparable is a poorer indicator of value. Fannie Mae, for instance, will not accept the use of a comparable where total net adjustments are in excess of 15% of the sale price.
For example, an appraiser is considering a property that sold for $100,000 as a comparable. After all adjustments are made, the indicated value of the comparable is $121,000, a 21% difference in the comparable’s sale price. This property, if allowed at all, would be a weak indicator of value.
Broker’s comparative market analysis
A broker or associate who is attempting to establish a listing price or range of prices for a property uses a scaled-down version of the appraiser’s sales comparison approach called a comparative market analysis, or CMA (also called a competitive market analysis). While the CMA serves a useful purpose in setting general price ranges, brokers and agents need to exercise caution in presenting a CMA as an appraisal, which it is not. Two important distinctions between the two are objectivity and comprehensiveness.
First, the broker is not unbiased: he or she is motivated by the desire to obtain a listing, which can lead one to distort the estimated price. Secondly, the broker’s CMA is not comprehensive: the broker does not usually consider the full range of data about market conditions and comparable sales that the appraiser must consider and document. Therefore, the broker’s opinion will be less reliable than the appraiser’s.
The following exhibit illustrates the sales comparison approach. An appraiser is estimating market value for a certain house. Four comparables are adjusted to find an indicated value for the subject. The grid which follows the property and market data shows the appraiser’s adjustments for the differences between the four comparables and the subject.
For comparable A, the appraiser has made additions to the lot value, design, number of bedrooms and baths, and for gross living area. This accounts for the comparable’s deficiencies in these areas relative to the subject. A total of five adjustments amount to $45,000, or 4.5% of the purchase price.
For comparable B, the appraiser has deducted values for age, site, design, construction quality, condition, bedrooms, baths, and living area. This accounts for the comparable’s superior qualities relative to the subject. The only addition is
the lot size, since the subject’s is larger. A total of nine adjustments amount to $144,000, or 12% of the sale price.
For comparable C, the appraiser has added value for the age and deducted value for the lot size. The two adjustments offset one another for a net adjustment of zero.
For comparable D, one deduction has been made for the comparable’s superior location. This is offset by six additions reflecting the various areas where the comparable is inferior to the subject. A total of seven adjustments amount to $35,000, or 3.2% of the sale price.
In view of all adjusted comparables, the appraiser developed a final indication of value of $1,120,000 for the subject. Underlying this conclusion is the fact that Comparable C, since it only has two minor adjustments which offset each other, it is by far the best indicator of value. Comparable D might be the second best indicator, since the net adjustments are very close to the sale price. Comparable A might be the third best indicator, since it has the second fewest number of total adjustments. Comparable B is the least reliable indicator, since there are numerous adjustments, three of which are of a significant amount. In addition, Comparable B is questionable altogether as a comparable, since total adjustments alter the sale price by12%.