When it comes to determining property values, there are several different property valuation methods that can be used. Two of the most common are the sales comparison approach and the cost approach. Both are commonly used by real estate appraisers, and both have their pros and cons. In this article, we'll take a closer look at both methods and what real estate investors need to know about each.
What is the sales comparison approach?
The sales comparison approach uses analysis of similar properties that have recently sold (also known as comps or comparables) in order to determine the true market value of a particular property.
First, the person doing the analysis will select recent sales that are as similar as possible to the subject property. They need to be physically close (the same neighborhood is ideal), but they don't need to be exactly the same in terms of square footage, lot size, bedrooms, and age. They just need to be in the same ballpark. Typically, appraisers will find three to five comparable sales to use in their analysis.
Then, they will make adjustments to each of the comps in order to account for slight differences. For example, if the subject property is 2,200 square feet and one of the comps is 2,300 square feet, the appraiser will likely adjust its sale price downward. If the subject property has a two-car garage and one of the comps has a one-car garage, the sales price of the comparable property will likely be adjusted upward.
Finally, they'll use the adjusted valuation of all of the comparable sales evaluated to determine the approximate market value of the subject property.
The sales comparison valuation method is often used by appraisers, as well as by real estate investors to evaluate potential investment properties, in order to determine the actual market value of real estate.
What is the cost approach to valuation?
The cost approach to real estate valuation is based on the concept that the maximum a buyer should be willing to pay for a home is equal to what it would cost to build it. To determine valuation using the cost approach, an appraiser calculates the construction cost of a home, makes adjustments to account for any accrued depreciation, and adds the land value.
For example, a new property (no depreciation) that would cost $200,000 to replicate and sits on a $100,000 piece of land would be valued at $300,000 using the cost approach.
Sales comparison approach pros and cons
The obvious benefit to the sales comparison approach is that it takes into account the conditions of the current real estate market. It analyzes how much comparable homes are actually selling for and makes adjustments to determine the market value of your property.
On the other hand, the sales comparison approach might not be the best approach in certain situations. For example, if your real estate market is slow or few houses comparable to yours have sold recently, you might find your appraiser relying on outdated information or sales that aren't the best comparisons. Also, in a particularly hot housing market where values are rising rapidly, it's certainly possible that the market value when comparable sales closed doesn't accurately reflect the true property value of your home, even if they're only a few months old.
Cost approach pros and cons
The cost approach can be a highly effective way to determine the market value of a new home. Since it primarily relies on construction costs, as do new home prices, the approach translates well to appraisals of new construction and recently completed homes.
On the other hand, the cost approach can be far less accurate when it comes to evaluating older homes in a real estate appraisal. Simply put, the construction costs of a home and its value in the current real estate market can be two very different things.
The Millionacres bottom line
Both of these valuation approaches can be useful in certain situations. In practice, the sales comparison approach is relied on more often when trying to determine the value of real estate for the purposes of obtaining mortgage financing or when deciding how much is a reasonable amount to offer for a house.
On the other hand, the cost approach can be a useful tool in new home valuation, as well as for the purposes of obtaining a homeowners insurance policy. After all, in a worst-case scenario, the insurer would have to pay to replace the home.