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; whereas replacement cost refers to the cost of reproducing improvements of equal utility. From this cost new is deducted any depreciation for loss in value caused by physical deterioration and functional or economic obsolescence. 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 on 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. The widest application of the cost approach 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. The strength of the income approach is its 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 have the ability to gather basic information, to analyze the income yields in terms of their relative quality and durability, and to relate all of the information gathered and analyzed to the changing economic environment of the area being studied. This approach lends itself best to the appraisal of commercial or industrial property because the prospective buyers of commercial property are primarily interested in the potential net return and tax shelter the property will provide them. The price at which they will be justified in paying for a property is a measure of the prospects of the net return from their investment in the property.
This approach has its basic application in the appraisals of properties universally bought and sold for their ability to generate and maintain a stream of income for their owners. The effectiveness of the income approach lies in the appraiser’s ability to relate to the changing economic environment and to analyze income yields in terms of their relative quality and durability.
Market Approach
The market data approach involves the compiling and comparison of sales information and relating it to the property being appraised. The appraiser must use sound judgment to make adjustments for dissimilarities between the property being appraised and the sale properties. For commercial and industrial properties, the market data approach works best for vacant land. It can be used for appraising improved properties only when the properties are truly comparable in construction and use.
The residential appraiser must analyze the selling prices of comparable properties and consider 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. The appraiser must take a large number of sales and select only those which are truly comparable with the property being appraised. Using a specially designed program, the appraiser can set parameters for comparison. The computer can search the sales file, seeking only those sales that truly match up with the subject property. This ability to select comparable sales from the sales file 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. For instance, the value of one residential property must be equalized with each residential property, as well as with each agricultural, commercial, and industrial property within the political jurisdiction. The property classes or types are residential, agricultural, commercial, and industrial.
The common basis for equalization is market value: the price which an informed and intelligent person, fully aware of the existence of competing properties and not being compelled to act, is justified in paying for a particular property. Therefore, the appraiser’s job is to estimate a reasonable price for the property. To make this estimation, the appraiser must coordinate the valuation approaches of the various property classes to reflect the prospective buyer’s motives for each property type. In other words, the motives that influence prospective buyers tend to differ depending upon the type of property involved, and the appraiser’s approach to value must differ accordingly.