Three Approaches to Value
There are three methods of appraising or establishing the full cash value of property:
- : The cost of reproducing or replacing a property plus land value minus accrued depreciation.
- : The value indicated by recent sales of comparable properties in the market, with adjustments for age, condition, and other characteristics.
- : The investment value represented by the net earning power of a property based on the capitalization of the income stream.
There are situations where only one or two approaches may be applicable. For instance, an owner-occupied residential
property is not likely to produce rental income that could be capitalized into an estimate of value through use of
the income approach. Therefore, the sales comparison or cost approaches might be more appropriate. Vacant land has
no cost of improvements, so the cost approach would not be an appropriate method for that situation.
Specialized properties such as mortuaries, hospitals, or zoos do not typically change hands enough to generate
comparative sales, so the cost or the income approach might be more appropriate in those cases.
Replacement Cost Approach
Basic steps to this approach are:
- Estimate the Replacement Cost New of the improvements (RCN).
- Estimate the loss in value from depreciation.
- Deduct the total amount of depreciation to arrive at the Replacement Cost New Less Depreciation (RCNLD).
- Estimate the value of the land as if vacant.
- Add the land value estimate to the depreciated cost value to arrive at the total property value.
Replacement Cost New is defined as the cost and overhead that would be incurred in constructing an improvement having
the same utility as the original, without necessarily reproducing exactly the same characteristics of the property,
but using today's materials, labor, and building techniques. In other words, replacement cost represents the cost to
create an equally desirable substitute property.
In Arizona for cost estimation, the unit-in-place method is used. The unit-in-place method is less detailed than the
quantity survey method, but still reasonably accurate and complete. This is the method used in the Construction Cost
Manual prescribed by the Arizona Department of Revenue, for many building components. These allow the appraiser to
make adjustments for individual components for various types of structures.
This method combines direct and indirect costs into a single cost for a building component (the unit-in-place) which
is then multiplied by the area of the portion of the building being valued to arrive at a total cost for that component.
The depreciation rates in Arizona's Department of Revenue Construction Cost Manual reflect only the physical factors
affecting the value of structures. These tables were developed from market analysis. The rates assume that normal
maintenance has been performed. The rate of physical depreciation is calculated based on the age of the structure and
the quality of the construction. When the overall quality of an improvement is low, normal physical deterioration is
more rapid than for fair or good construction.
Normal physical deterioration is calculated according to actual age. Other factors are computed as they arise in
individual structures. If a structure has a serious physical defect, the appraiser will first estimate the RCN, and
then compute the cost to cure the physical defect (if curable) and then deduct that amount from the to arrive at
In ad valorem appraisal, deferred maintenance is not normally included in a valuation consideration. This would have
the effect of punishing property owners who kept a property in good condition and rewarding those who let properties
rundown. Special obsolescence factors may be noted and taken into consideration, but the aim is to achieve equity, so
that owners of similar properties bear an equal share of the tax burden, regardless of whether they perform regular
In situations where modernization has occurred during the life of a structure, the appraiser must estimate the of
each type of structure and compute the effective age and/or the weighted age.
The effective age is calculated by taking the percentage of the remodeling or modernization in relation to the whole.
Market/Sales Comparison Approach
The Market Approach is based on comparison of the subject property to similar properties, which have sold in the same
market. Similarities and differences must be noted in detail—date of sale, location of property, physical characteristics,
and conditions of the sale are a few examples. For investment properties, potential income should also be documented.
The conditions of the sale are extremely important when considering whether a property is comparable to the subject or
not. If the parties are related, or special financing was obtained, or the seller was forced to sell by some condition of
their life (a move, divorce, etc.) then the sale might have to be eliminated as invalid. Remember the definition of
"market value": "the most probable price, in terms of cash, in a competitive and open market, assuming a willing and
knowledgeable buyer and seller, allowing sufficient time for the sale, and assuming that the transaction is not affected
by undue pressures." Some factors like size or shape or location may have to be accommodated by adjusting the value of the
comparable up or down to reflect the difference between that property and the subject.
The comparable is always adjusted, never the subject property.
The market approach indicates a range of possible values, rather than a precise figure, especially if few sales are
available or many adjustments have to be made. In Arizona, the market approach is the most widely used for residential
property valuation. It is ideal for types of property that are regularly sold. Furthermore, it may be the only valid
approach for valuing properties that are very old or where reliable cost or income data is unavailable.
The Income Approach is used to value commercial or industrial properties, or properties, which are bought and sold by
investors primarily because of their income producing potential. This approach to value depends on reliable and detailed
information on the income and the costs of doing business for a particular business or enterprise. This is referred to as
the "income stream" of the property. The Income Approach defines value as "the present worth of future benefits of owning
a property." These are composed of the annual income for an estimated number of years (called the economic life of the
property) plus a capital amount representing land value or land value plus some remaining worth of the improvements. This
approach emphasizes investment components rather than physical components of a property.
The steps in the income approach are:
- Estimate Potential Gross Income (PGI).
- Deduct vacancy and collection losses.
- Add miscellaneous income to derive Effective Gross Income (EGI).
- Deduct operating expenses to derive Net Operating Income (NOI).
- Select appropriate capitalization rate and method.
- Develop an estimated value.