Real Estate Property Valuation

Three Approaches to Value

Cost Approach

The cost approach involves making an estimate of the depreciated cost of reproducing or replacing the building and site improvements. Reproduction cost refers to the cost, at a given point in time, of reproducing a replica property; replacement cost refers to the cost of reproducing improvements of equal utility. From this "cost new," any depreciation for loss in value caused by physical deterioration and functional or economic obsolescence is deducted. To this depreciated cost is added the estimated land value, resulting in an indication of value derived by the cost approach.

The cost approach is significant because it is the one approach that can be applied to all types of construction. It is a starting point for appraisers and therefore a very effective yardstick in any equalization program for ad valorem taxes. Its widest application is in the appraisal of property where the lack of adequate market and income data preclude the reasonable application of the other traditional approaches.

Income Approach

The income approach is the most often used approach in the appraisal of commercial or industrial property. Its strength is the ability to measure a property's value based on the property's ability to generate and maintain a stream of income for the owner. To be effective, this method requires the appraiser to gather basic information, analyze income yields in terms of their relative quality and durability, and relate that information to the changing economic environment of the area being studied.

This approach lends itself best to commercial or industrial property because prospective buyers are primarily interested in the potential net return and tax shelter the property will provide. The price they are justified in paying is a measure of the prospects of net return from their investment.

Market Data Approach

The residential appraiser analyzes the selling prices of comparable properties and considers the same factors the buyer considers: location, size, quality, design, age, condition, desirability, and usefulness. When using the market data approach, the appraiser compiles sales figures and compares a property with similar properties that have recently sold, selecting only those which are truly comparable. This ability to select comparable sales is significant because it produces estimates of value that directly reflect the attitude of the market.

Approaches to Property Classes

The prime objective of mass appraisals for tax purposes is to equalize property values regardless of property class. The value of one residential property must be equalized with every other residential property, as well as with each agricultural, commercial, and industrial property within the political jurisdiction. The common basis for equalization is market value: the price which an informed and intelligent person, fully aware of competing properties and not compelled to act, is justified in paying for a particular property. The appraiser must coordinate the valuation approaches to reflect the prospective buyer's motives for each property type.

Residential Property

A prospective buyer of residential property is primarily interested in the property's capacity as a place to live. Location, size, quality, design, age, condition, desirability, and usefulness are the primary factors considered. The residential appraiser relies upon the market data approach, analyzing the selling prices of comparable properties and evaluating the relative degree of appeal of one property to another.

Agricultural Property

The buyer of agricultural property is primarily interested in the productive capabilities of the land. For local tax equalization, the appraiser relies heavily on prices paid for comparable farmland and uses the market data approach. The land is divided into classes according to type and use — tillable, pasture, woodland, and wasteland — with consideration of soil types and fertility. Rural dwellings are valued like any other residence; other farm buildings are valued for the utility they add to the land's productivity. The appraiser also considers location relative to market, accessibility, topography, field shape and size, fences, drainage, and water supply.

Commercial Property

The commercial buyer is primarily interested in the potential net return and tax shelter. The appraiser explores the rental market and relies heavily on the income approach to determine the net economic rent the property can yield and the investment required to achieve a return investors would expect. Because commercial property is not bought and sold as frequently as residential, the sales market cannot be established as readily.

Industrial Property

The industrial buyer is interested in the overall utility value of the property, with individual consideration given to the land and each improvement. Industrial buildings are generally designed for a special purpose and maintain value as long as that purpose remains a vital operation. The appraiser relies heavily on the cost approach — determining replacement cost new and the subsequent loss of value from physical, functional, and economic factors — because limited comparable sales and investments make the market data and income approaches difficult to apply.