Let’s Be Honest

As I type this, there are many unknowns in the world around us – some of them a bit more urgent than assessing the current value of your home or the value of real estate you may wish to purchase. That said, life goes on in the midst of the chaos and despite whatever fears we’re currently facing. We have to assume that at some point we’ll be trying to get back to “business as usual,” although it won’t be “as usual” at all because some things will probably have changed.

The trick is knowing which ones.

So yes, I’d like to talk about different appraisal approaches used for estimating value when it comes to real estate. It’s one of several common methods used to value real estate, and while the dollar amounts and dynamics of the market may change (they always do, even in the best of circumstances), the general methodology and processes will almost certainly remain the same. That means at some point, you’re probably going to consider selling your home or other real estate you own, or consider purchasing a home or other real estate. Maybe both.

When you do, whatever the surrounding circumstances, it will be helpful to have a working understanding of how realtors and others value real estate in such situations. That’s what we’re going to look at here.

The “Sales Comparison Approach” To Real Estate Valuation

While there are THREE different primary approaches to estimating value when it comes to buying or selling homes or other real estates, they all include FOUR factors in different proportions.

What Factors Are Most Important When Estimating Value For Real Estate?

Demand

Supply

Useful

Transferability

What Are the Three Most Common Appraisal Approaches for Real Estate?

As I hinted at above, none of these methods are perfect or exclusive. They’re each efforts to determine the hard value of something in order to compute tax obligations, leverage equity, or choose a starting point for buying or selling. In the end, of course, like anything, real estate is worth whatever someone’s willing to pay for it. We can critique Nickleback or Iggy Azalea from technical, professional, or artistic standpoints all day long; in the end, if they sell a million albums, they’re successful musicians. The rest is just different ways to argue about it.

The Cost Approach

This method attempts to value real estate by adding the cost of the land on which the property is located to the estimated costs of replacing the house or other structures on it. It then factors in depreciation based on the age of the existing structures. The Cost Approach often attempts to base its estimations on a cost-per-square-foot calculation drawn from similar properties in the area. I mention this because this sort of estimation as a way to value real estate will come up again in a moment.

The Income Approach

This method is more common when considering the purchase of a commercial real estate, like office spaces or rental homes. It starts with an estimation of the income potential of the property, minus the cost of maintaining it over time. The trick, of course, is to accurately predict that income and those costs. Even if you have hard figures from which to begin, so many factors change over time – often unpredictably.

The Sales Comparison Approach

For most of us, this is the most familiar of the various appraisal approaches. It’s also what we’re going to talk about next.

If you’ve ever gone through the process of selling your home through a realtor, you probably remember this one, even if you didn’t know what it was called. You’re not sure how to price your home – what sort of asking price you should initially set. If you’re too high, you worry people won’t even look or make an offer. Too low, and you feel like you’re losing money unnecessarily. Your realtor shows up with printouts of several other listings in your area – some current, most from the past three-to-six months. He or she talks you through them, including where they are, how many square feet, any features they have, and what they sold for or what they’re asking. This is used as a starting point for setting your initial asking price.

The same thing happens in reverse when you’re looking to buy, although perhaps less overtly. Your realtor starts with a list of what sorts of things are important to you in terms of size, location, features, and price points, then focuses on showing you homes that meet many or all of these hopes. It would be unusual for you to visit and seriously consider a half-dozen homes with absolutely nothing in common with one another. It’s difficult to compare homes that simply aren’t, well… comparable.

Factors in the Sales Comparison Approach

If you’re comparing vehicles, you might be able to find three or four which virtually identical and all within a reasonable distance from you. At that point, it’s just a matter of comparing price and deciding if it’s really worth it to you to pay an extra $500 because you like the one in blue or drive another 20 minutes to get the one with the nicer interior fabric. It’s a little trickier with homes or commercial real estate.

Your realtor or other interested professional will probably start by looking at similar places within your ZIP code, ideally within your actual neighborhood. (Maybe they’ll get lucky and there’s one on your street!) They want several “comparables” (or “comps”) – properties largely like the one you’re wanting to buy or sell – which have been sold in the previous year. Just like with location (the closer, the better), the more recent the sale, the more useful the “comparable” to value real estate similar to it.

Of course, they’re rarely exactly the same. The value of the property in question is then adjusted up or down based on a number of factors and how similar – or different – they are from yours. A few of the most common include…

Location, Location, Location

My wife and I love to go walking when the weather permits. We live in an area with numerous small rivers everywhere, which means we have to pay attention to where we turn or it might be several miles before we can find another way back across this or that stretch of water. We’ve noticed something about pretty much every part of town through which one of our rivers flows.

When homes right along the river are up for sale, they cost much, MUCH more than similar homes even right across the street, and certainly more than in our neighborhood. Wherever you live, you’ve no doubt figured out long ago that residential or commercial properties – or even renting an apartment – cost far more close to downtown, or popular shopping areas, or with easy access to the highway (but not ALONG the highway). Fairly or not, no one wants to live near certain types of industries, and certainly not too close to the local dump, airport, or prison.

You may even encounter the term “walk score.” This is a system that puts a number value to the “walkability” of any given address based on what you can get to from there without needing a vehicle. The easier it is to walk to the grocery store, local restaurants, your kids’ school, etc., the higher a property’s “walk score.” Obviously this is the sort of thing which applies in some cities far better than in others.

When finding comparables to better value real estate, it’s important to find options close to the property in question. If that’s’ not possible, then in very similar areas.

Age and Condition

When using comparables to help value real estate with the sales comparison approach, you want to use properties of roughly the same age and in the same general condition as the property you’re trying to value. Most of the homes in my area are at least 50 years old. Some are very well-preserved and have clearly been maintained with great care. A few hurt to even look at. But most are in the same basic “mostly decent, not particularly fancy” condition.

A large, lavish house with sagging floors and in desperate need of storm windows simply can’t compare to a similar home with modernized amenities and floors replaced in the last decade. An office property that has all the right characteristics on paper but which looks like the setting for a cheap horror movie once you see it in person simply won’t have the same value real estate a mile away with good paint, clean walls, and nothing haunting it.

Square Footage, Numbers of Rooms, and Other Features

Using the sales comparison approach to value real estate assumes you’ll be able to find at least a few places with the same number of rooms – particularly bedrooms and bathrooms – the same number of floors, etc., as the property whose value you’re estimating. Let’s look at an example.

Let’s say you’re wanting to sell your 3-bedroom, 2-bath home. It comes with a detached garage and a small apartment over it, and you’ve recently remodeled the deck out back. It was built in 1997 and you’ve kept it in pretty good shape, other than the landscaping. (You’re just not that great with outdoor stuff and don’t use the yard that much anyway.) You’re not sure how much to ask.

Your realtor is going to start by pulling up info on any 3-bedroom, 2-bath homes in the area which may have sold recently – especially those matching the features of yours fairly closely. She finds one only a few miles away, in a very similar neighborhood, which sold a month ago for $193,000. There you go, problem solved, right?

Well, not quite. The house she’s looking at is actually a 3-bedroom, 2.5 bath home. It’s a little bigger than yours, and that’s not even including the half-finished basement which was apparently used as a game room and which you don’t have. That means your asking price will have to be adjusted down a bit.

On the other hand, you have that garage which is fairly new and the apartment above it, not to mention the deck. Plus, you’re in a different school district and while you don’t want to be a snob, your local elementary school is way better than the one any kids from this other home would attend. That means your asking price can go up a bit.

The ability to do this more or less accurately is something that only comes with time and experience.

Converting to Price-Per-Square-Foot

Once you have several comparables not TOO dissimilar from the property you’re valuing, the price of each is divided by its square footage to arrive at a “price-per-square foot.” These are then averaged together to come up with a final “price-per-square-foot” and multiply it by the actual square footage of the property you’re trying to sell or which you’re considering buying. The result is arguably about as close as humanly possible to a useful measurement to value real estate using the specific information available in your area right this moment.

The more adjustments necessary to value real estate based on comparables, the less reliable the resulting figures. That’s just a reality of the method. Nevertheless, I personally still prefer this approach because it’s the most closely based on what in my mind is the final determination of value – what would other people who have the resources to purchase this particular property actually be willing to pay for it?

In other words, at the risk of oversimplifying, the sales comparison approach is the one which most closely matches the idea that “it’s only worth what you can get for it.”

Conclusion

Let’s recap, shall we?

There are four more-or-less universal factors used to value real estate: Demand, Supply (or Scarcity), Usefulness (or Utility), and Transferability.

There are three primary approaches commonly used to value real estate, each of which consider these four factors in different ways. The “Cost Approach” adds the cost of the land to the costs of replacing the building, minus depreciation. It utilizes “comparables” and average price-per-square-foot to assist in these calculations. The “Income Approach” focuses more on the money which can be made by using the property, usually in the form of charging rental to residential or commercial tenants. To value real estate under the “Income Approach” requires accurate estimates of the costs involved in maintaining the property as well as the potential income going forward.

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Finally, of course, is the “The Sales Comparison Approach.” This one leans heavily on comparables (or “comps”) to determine the cost-per-square-foot value of whatever residential or commercial property you’re wishing to sell or looking to buy. For this, or any of the methods, we believe in the power of being personally informed as well as the value of hiring a professional before making any major buying or selling decisions.

Stay safe, stay hopeful, and let us know if we can be of any assistance along the way.

How to Use the Sales Comparison Approach to Value Real Estate?