The Market and Cost Approaches to Value
Hi my name is Brandon McHarkey. I am a retired expat who decided to slum it out here in the Philippines after I have fallen in love with this country (and a woman in fact). Now I do charity work and blog about several topics to save my mind from Alzheimer’s, and to share the wisdom I have with the world. Something I take as a solid financial investment here in the Philippines is in real estate. From what I’ve learned through a decade of investing in condominiums here is that it is safe, inflation-proof, and is reliable for solid gains. In this blog I discuss more about real estate, specifically how to appraise the value of a piece of real estate.
After reading this blog, you should be familiar with the following points:
- The meaning of market value.
- Organization of appraisal reports.
- Advantages and disadvantages of the market approach to value.
- The analysis of real estate sales for appraisal purposes.
- The calculation at gross income multipliers and their use
- Methods of estimating costs for appraisal purposes.
- Methods of estimating depreciation.
For some appraisal problems, the market and cost approaches provide the most accurate means of estimating market value. The market approach, which is based on an analysis of recently sold properties, serves as strong evidence of value in the appraisal of vacant land and single family dwellings. Both types of property are frequently bought and sold in the open market, giving a valid indication of market value. First, the special meaning attached to the “market approach” should be noted. Simply stated, the term refers to the process of analyzing sales of similar recently sold properties in order to derive an indication of the most probable sales price.” The approach is also referred to as the market data approach or the sales comparison approach. If you were to appraise a new brick veneer three-bedroom dwelling under this approach, you would search for recently constructed three-bedroom dwellings in the same neighborhood that were sold within the last 12 months or so the more recent the sale, the more accurate is the market indication. Likewise, the greater the similarity between the dwellings sold and the dwelling appraised, the more accurate is the market indication.
In contrast, the cost approach is a method of estimating market value by adding the cur-rent land value to the depreciated building cost. To estimate value under this method, the land must be valued separately, usually by sales comparisons. The building value is estimated from costs of recently completed buildings of like de-sign and construction. An allowance for depreciation is deducted from the cost estimate to account for deferred building maintenance and obsolete building features. A separate discussion of the market and cost approaches shows how these two methods differ in their logic.
Before discussing additional details, it is helpful to review the concept of market value and describe the format of appraisal reports. With this introduction, the blogs describes and evaluates each approach to value.
The unmodified term value means the power of-one good to command other goods in exchange. Price is value expressed in money. To have value a commodity must be relatively scarce not a free good, such as air and it must have utility. Utility is the quality of a good that creates satisfaction or minimizes dissatisfaction. Hence, real property, assuming utility, is valuable because of its scarcity in relation to effective demand. In one sense, the value of real estate is a function of its utility and its relative supply.
Market Value Defined
The term market value has gained a very special meaning for appraisal purposes. A clearer understanding of market value may be gained by reviewing several commonly accepted definitions. For example, one of the more popular definitions states:
Market value is the highest price in terms of money which a property will bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.
Some authorities prefer a shorter definition: Market value is the price at which a willing seller would sell and a willing buyer would buy neither being under pressure. Market value contemplates (1) value in ex-change to persons generally, as distinguished from value in use to a particular person, (2) the marketability of property as a final test of its value, and (3) the value of the highest legal use to which the property may be adapted. Several assumptions are implied in the term market value:
1. Many buyers and sellers, such that the decision to buy or sell on the part of a single buyer or seller does not affect the price. 2. Buyers and sellers who have a reasonable knowledge of the market.
3. A standardized product.
4. Freedom of buyers and sellers to enter and leave the market.
It is fairly clear that the market value definition forces the appraiser to think in terms of constructive value. That is, the appraiser must construct” a hypothetical value as if the idealized conditions of pure competition prevailed.