Valuation and Appraisal

Pricing property correctly is central to a salesperson's value. This chapter covers the three approaches to value, the economic principles behind them, highest and best use, the forms of depreciation, and how market value differs from assessed value under California's Proposition 13. Learn when each approach applies and the difference between a licensee's market analysis and a certified appraisal.

The rule: the three approaches to value

An appraiser uses three approaches, then reconciles them (weighs, not averages).

• Sales comparison (market data) approach — compares the subject to recent sales of similar properties, adjusting the comparables (never the subject). Add value to a comparable that lacks a feature the subject has; subtract for a feature the comparable has that the subject lacks. Most reliable for single-family homes and land; rests on the principle of substitution.
• Cost approach — value = land value + (replacement/reproduction cost of improvements − accrued depreciation). Best for new construction and special-purpose properties (churches, schools) that rarely sell.
• Income approach — for investment property: Value = Net Operating Income ÷ Capitalization Rate. NOI is gross income less vacancy and operating expenses (not mortgage or depreciation). A lower cap rate → higher value. For small residential income property, the gross rent multiplier: Value = Gross Rent × GRM.

The adjustment logic of the sales comparison approach is precise, and getting the direction right is half the battle. You always adjust the comparable, never the subject, to make it resemble the subject. If the comparable is superior to the subject (it has an extra bathroom, a bigger lot, a better view), you subtract value from the comparable's sale price — because the subject would not command that premium. If the comparable is inferior (it lacks a garage the subject has), you add value to the comparable. A memory aid: CIA / CBS — "Comparable Inferior, Add; Comparable Better, Subtract." After adjusting several comparables to a common footing, the appraiser reconciles them, giving the most weight to the comparables that required the fewest and smallest adjustments, because they are the most similar to the subject.

Building the income approach correctly means constructing NOI from the top down. Start with potential gross income (rent if fully occupied), subtract a vacancy and collection loss allowance to get effective gross income, then subtract operating expenses — property taxes, insurance, management, maintenance, reserves for replacement — to reach net operating income. Critically, NOI does not subtract mortgage payments (debt service), income taxes, or depreciation, because those reflect the particular owner's financing and tax situation, not the property's inherent earning power. Only then do you capitalize: Value = NOI ÷ Cap Rate. Two properties with identical NOI can have very different values if the market applies different cap rates, and the cap rate itself rises with perceived risk. This is why a small error in classifying an expense, or in slipping the mortgage into the calculation, throws off the whole valuation.

The capitalization rate itself carries meaning worth understanding. A cap rate is the market's required rate of return on the property's income, so it moves with risk and with interest rates: riskier or higher-rate environments push cap rates up, which pushes values down for the same income. Because Value = NOI ÷ Cap Rate, the relationship is inverse — a favorite exam point. Appraisers derive cap rates from comparable sales (dividing each comparable's NOI by its sale price) and sometimes build them up from the cost of the mortgage and equity (the band-of-investment method). For a quick screen on small residential income property, the gross rent multiplier substitutes for a full income analysis, but because the GRM ignores expenses, it is only reliable when the compared properties have similar expense ratios. Knowing that a cap rate expresses risk-adjusted return — and that value and cap rate move in opposite directions — turns the income approach from a formula into an intuition.

The rule: the principles of value

• Substitution — a buyer pays no more than the cost of an equally desirable substitute (upper limit on value; foundation of sales comparison).
• Anticipation — value reflects the present worth of future benefits (foundation of the income approach).
• Supply and demand — scarcity and demand drive price.
• Conformity — value is maximized when a property conforms to its neighborhood.
• Progression — a modest property gains value among better ones.
• Regression — a superior property loses value among lesser ones.
• Contribution — an improvement adds value only to the extent it raises overall market value, not what it cost.
• Change — all property moves through phases of growth, stability, decline, and revitalization; nothing about value is permanent.
• Increasing and diminishing returns — added investment increases value up to a point, after which further spending returns less than it costs.
• Competition — excess profit attracts competition, which tends to reduce that profit over time.

These principles are not abstract trivia; each one answers a specific kind of question. Substitution caps value and explains why an appraiser hunts for the cheapest adequate alternative. Anticipation explains why an investor pays for a building's future rent stream, not its past. Contribution explains why a $50,000 pool might add only $20,000 of value — the market, not the cost, sets the increment, and over-improving a property (the principle of regression at work in a modest neighborhood) can waste money. Progression and regression together explain why the smart buy is often the worst house on the best street (progression lifts it) and the risky buy is the best house on a modest street (regression drags it down). When a question describes a value effect, name the principle that produces it, and the answer usually follows.

The rule: highest and best use

A property is valued at its highest and best use — the use that is legally permissible, physically possible, financially feasible, and maximally productive. This may differ from the current use: an old house on land now zoned commercial may be worth more as a redevelopment site. Assemblage is combining adjoining parcels; the resulting value increment is plottage.

The rule: the three kinds of depreciation

In appraisal, depreciation is any loss in value of the improvements from any cause.

• Physical deterioration — wear, tear, age, the elements; often curable.
• Functional obsolescence — outdated or poorly designed features within the property (poor floor plan, one bath in a big house).
• Economic (external) obsolescence — loss from factors outside the property (a nearby freeway, airport, or declining area); almost always incurable.

Distinguish them by source: physical wear, internal design, external forces.

Depreciation is also classified as curable or incurable, and the test is economic, not physical: a defect is curable if fixing it adds at least as much value as it costs, and incurable if the cost exceeds the value gained. A dated kitchen (functional) is usually curable; a fundamentally bad floor plan may be incurable; and external obsolescence (a freeway next door) is almost always incurable because the owner cannot fix what lies beyond the property line. Appraisers estimate depreciation by methods such as the economic age-life method — depreciation = (effective age ÷ total economic life) × cost of the improvements — where effective age reflects condition and updating rather than actual years. A well-maintained 20-year-old home may have an effective age of only 10; a neglected one may have an effective age greater than its actual age. This is why two houses built the same year can show very different depreciation.

Note that appraisal depreciation differs from tax depreciation. The accountant's depreciation (cost recovery) is a bookkeeping deduction spread over a fixed schedule for income-tax purposes and applies only to improvements on income or business property, never to the land or to a personal residence. Appraisal depreciation is a real-world loss in market value from the three causes above. The vocabulary overlaps, but the concepts are separate — a trap when a question mixes the appraisal and tax contexts.

The rule: market value vs. assessed value under Prop 13

Market value is the most probable price in a competitive, open market with a willing, informed buyer and seller and adequate exposure. Market price is what a property actually sold for; cost is what was paid to build or acquire — all three can differ.

Assessed value is set by the county assessor for taxation. Under Proposition 13 (Revenue and Taxation Code), a property is generally assessed at its acquisition value (purchase price), with the assessed value rising by no more than a capped percentage each year (historically 2%) while ownership does not change, and the base tax rate limited to 1% of assessed value plus voter-approved additions. On sale, the property is reassessed to current market value — which is why identical neighbors can pay very different taxes. Verify the current rate, cap, and reassessment-exclusion rules.

A comparative market analysis (CMA) is the salesperson's informal pricing tool — not a certified appraisal, which only a licensed/certified appraiser may issue.

Proposition 13 has practical consequences a salesperson should be able to explain. Because assessed value is generally frozen at the acquisition price and rises no more than the capped percentage per year, a long-time owner may pay far less in property tax than a new buyer of an identical home next door — and a buyer should be counseled that their taxes will be based on their purchase price after reassessment, not the seller's old bill. Certain transfers are excluded from reassessment (for example, some transfers between spouses, and — subject to current rules that have changed in recent years — some parent-child transfers and transfers of a base-year value for older or disabled homeowners), so verify the current exclusions before advising anyone. In addition to the 1% base rate, a tax bill can include voter-approved bonded indebtedness, Mello-Roos special taxes, and special assessments for local improvements. Owners who believe the assessor overvalued their property may file an assessment appeal.

Finally, keep the three "values" distinct in your own vocabulary, because clients confuse them constantly. Market value is an appraiser's opinion of the most probable price under normal conditions. Market price is the actual number a property sold for, which can be distorted by a rushed sale, a family transfer, or unusual financing. Assessed value is the assessor's figure for tax purposes under Proposition 13. A CMA estimates a likely selling range to help price a listing or evaluate an offer; it is a skilled opinion, but it is not an appraisal, and a licensee must never present it as one or charge for it as an appraisal.

A couple of assessment mechanics occasionally appear. When a property is sold or newly constructed, the assessor issues a supplemental assessment that captures the difference between the old base-year value and the new value, prorated for the remainder of the tax year — which is why a new buyer often receives a supplemental tax bill a few months after closing. An owner who believes the assessed value exceeds market value may file an assessment appeal with the county assessment appeals board within the filing window. And because Proposition 13 ties value to acquisition, a decline-in-value ("Prop 8") reassessment can temporarily lower the assessed value below the factored base year when the market falls, later restored as values recover. These details reinforce the core idea: assessed value follows acquisition and statute, not the day-to-day market.

Worked example — the income approach (cap rate)

An apartment building produces $120,000 of net operating income, and the market capitalization rate is 8%. What is its value?

• Value = NOI ÷ Cap Rate = 120,000 ÷ 0.08 = $1,500,000.
• Now suppose investors demand a higher 10% cap rate. Value = 120,000 ÷ 0.10 = $1,200,000.

Notice that a higher cap rate produces a lower value for the same income — a favorite exam point. Rearranged: Cap Rate = NOI ÷ Value, and NOI = Value × Cap Rate.

Worked example — the gross rent multiplier

A comparable rental sold for $540,000 and generated $45,000 of annual gross rent. A subject property produces $50,000 of annual gross rent. Estimate the subject's value.

• GRM from the comparable = Price ÷ Gross Rent = 540,000 ÷ 45,000 = 12.
• Subject value = Gross Rent × GRM = 50,000 × 12 = $600,000.

The GRM is a quick screen, not a precise appraisal; it uses gross income, ignoring expenses.