Real estate appraisers use one of three methods: the sales comparison approach, the cost comparison approach, and the income approach. Sales comparison and cost comparison are the two most common methods. Below is an explanation of each, how they differ, and which types of home appraisals each one is most appropriate for.
What Is the Sales Comparison Approach?
The sales comparison approach is a home appraisal method that compares the subject property to other recently sold homes in the same area with similar features. We call these similar homes “comparable properties” or “property comps.”
This method accounts for a home’s features—such as its square footage, number of bedrooms, and number of bathrooms—and how they affect its overall value. In other words, the property’s worth is based on the sum of the value of all its features.
The sales comparison approach helps appraisers determine if the home is priced fairly and is comparable to the purchase prices in the current market.
Appraisers working with the sales comparison approach compare the subject property against other similar properties based on these factors:
- Location. The appraiser compares homes in the same neighborhood and considers proximity to parks, bodies of water, and highways, as well as pollution levels.
- Similar homes recently sold. These properties provide a baseline for determining the value of homes in the same neighborhood. Homes that have the same number of bedrooms and bathrooms and similar square footage could be used as comparable properties.
- Home’s condition and age. The property’s condition affects its valuation. For instance, if two houses in the same neighborhood are similar in every way, but one needs major repairs, the one that needs work will be worth much less.
- Average price per square foot. Once appropriate comparable properties are chosen, the appraiser divides each home’s sale price by its square footage, takes the average cost per square foot for all comps, and multiplies that number by the square footage of the appraised home.
What Is the Cost Comparison Approach?
Cost approach appraisals determine the value of a home based on the cost to build an equivalent home today. The cost comparison approach factors in how much the property’s land is worth and deducts any loss in value, known as its accrued depreciation.
The cost comparison approach is based on the belief that a buyer should not have to pay more for an existing home than what it would cost to build that same home today.
The two main types of cost approach appraisals are:
- Reproduction method. This considers what a replica of that property would cost to build today using the same materials.
- Replacement method. This assumes that the new structure serves the same function but is built with newer materials, current construction methods, and an updated design.
After the above estimated figures are gathered, the appraiser uses this formula with the cost comparison approach:
Cost – Depreciation + Land Worth = Total Property Value
How Do These Types of Home Appraisals Differ?
The sales comparison approach estimates a property’s value based on comparisons with similar properties recently sold in the same market. This method is ideal when the subject property and its comparable properties have the same features.
Sales comparisons are not an exact science. That’s because a property’s value can be somewhat subjective to people who want to buy a home. For instance, one buyer may perceive a house as having a higher value and be willing to submit a higher offer for it.
Other considerations—like the state of the economy, housing market, and job market—can also impact how long a home sits on the market and its sale price.
On the other hand, the cost approach method is not dependent on similar homes or the current market. Instead, this approach estimates value based on the value of the subject property’s building materials and other factors, including its land and the depreciated value of any improvements.
The cost approach can be less reliable than the sales comparison approach, however. This is because it assumes the availability of the same materials and enough vacant land to build an identical home. The value must be estimated, making the home appraisal less accurate.
Additionally, it’s not easy to measure physical depreciation on an older property. This is why the cost approach is more useful for appraising new construction or unique homes with few comparables.
What Is Each Type of Home Appraisal For?
How do appraisers use these two types of home appraisals? The vast majority of residential home appraisals are performed using the sales comparison approach. This method works best when homes in the same neighborhood have recently sold and have similar upgrades, square footage, and other features.
The accuracy of appraisals using the sales comparison approach is dependent on having comparable properties. There also could be bias when choosing those comps. Two homes are rarely precisely the same. So it follows that the differences between the subject property and its comparable properties can result in an inaccurate appraisal.
If the subject property has significant improvements, like green home upgrades, there may not be any comparable properties with that same feature. In that case, the cost comparison approach could be the better method.
The cost comparison approach also makes more sense for special-use properties that require an appraisal but are not marketed, such as libraries, schools, and churches.
The market value of new-construction homes depends on construction standards and completion. Therefore, a mortgage lender will require cost comparison approach home appraisals at different stages throughout construction before releasing funds to complete the next stage.
Insurance companies also use the cost comparison approach when underwriting homeowners’ policies and evaluating claims. That is because land value is separate from the property’s total value, and only improvements are insurable.
Questions?
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