Appraisal Methods: Direct Comparison Method

In the literature, you may come across three sub-types in the income approach. These are:

Gross Rent Multiplier

Direct Capitalization

Discounted cash-flow

In this blog post, the market comparison method is explained in some detail. The other methods will be discussed in future blog posts.

In a free market economy, market value is the basis of any transaction. The market comparison method's operating assumption says that market participants will pay a similar price for a similar product in a similar market condition. Another way of saying this is that the market value of a property is approximately equal to the prices recently paid for similar properties. Similarity is the key component in this approach. Physical, financial, legal, location, and timing characteristics of two real estate properties determine the degree of similarity between the subject property and the comparable properties. The more similar comparables we have, the more accurate our valuation output will be. This approach has three steps:

• Identifying the similarities
• Adjustment for value
• Determining the most probable sale price

We all know we should not compare apples and oranges. Unlike stocks, in the real estate world, no two products are exactly the same. This means in our valuation process we should first identify the features that would material affect the valuation of a real estate product. Some similarities are fairly obvious, such as similarity in the type of the product (i.e. SUV as a type of car). In the real estate world, for example, the comparables for an apartment subject property should be apartments and not detached homes. What else? Similarity in market timing. The place and time of the offering play a significant role in determining the similarity as well. We all have heard the expression that timing is everything. The same property in a hot market could be worth significantly more than it is worth in a downturn. In commercial real estate, the interest rate policies, the change in migration policies, new tax laws, pandemic, or any other shock to the system can cool down a hot real estate market in a matter of a few days. The reverse is also true. New government incentives, increase in wages, or quantitative easing policies of the central banks could shoot up prices overnight. So, the first major factor is market timing. Sold or withdrawn listings in a different market environment should not be included in the list of comparables.

Real estate is all about location, location, location. We've all heard this one too. The house on top of the hill with a view cannot be the comparable property for a subject property in the middle of downtown with no view. Sometimes walking a couple of blocks could significantly change the character, view, and safety of the property. The street number in the same street with two physically identical houses could mean two drastically different pricings. So in pricing the subject property, products in qualitatively different neighborhoods should not make it to the list of comparables. It is best to get the comparables as close to the subject property and within the same neighborhood.

Other features of a real estate property such as the lot size, livable area, number of bedrooms, views, property title, etc. are all relevant in the pricing process of the subject property. Lot sizes being the same, typically, bigger frontage lots are more desirable than skinny lots. In other words, the lot frontage is more important than the lot depth. The built-quality, fit and finish, and maintainability should also be factored in when comparing properties.

To determine the price of a property under this method, we first collect similar comparables. Generally speaking, the more comparables the better. However, depending on the type of the product and the market timing, we may have only a few comparables. The best comparables to a subject property are the ones with the least number of dissimilar features. The second step is to establish what are the features that have price significance. In the Market Comparison Approach, we should list all the comparable properties and the relevant features in a rating grid or table. The following table is a simplified comparison table to valuate a detached dwelling: