Sales Comparison Approach (Real Estate)
A valuation methodology that takes the value of recently sold properties with similar characteristics to value a real estate property
The value of neighboring properties, houses, or businesses is one of several variables that affect a property's total worth. Real estate brokers and agents employ methods like the sales comparison methodology to estimate a property's value.
You can more accurately estimate the value of houses and other assets if you understand how the technique functions. We will review the definition and methodology of the approach.
A sales comparison approach, also known as the market data approach, is a real estate appraisal method that evaluates a property based on other surrounding properties.
A real estate agent, broker, or appraiser will utilize a sales comparison strategy to compare the target home to others in the neighborhood that have recently sold and had comparable attributes. The goal is to estimate the target house's value.
The method gives real estate professionals a better idea of the worth of a home or property and assists in maintaining fair pricing within the local market.
Understanding the Sales Comparison Approach
The strategy entails identifying previously sold properties or active listings that are comparable to the property that is being appraised.
For an accurate comparison, or "comp," for the home in question, they should be comparable in terms of their location, amenities, age, and the number of rooms. Recent sales are more reliable because there was a committed buyer eager to make that payment.
The approach is applied to practically all properties.
It is based on two principles:
- Substitution: A buyer will not pay more for the subject property than would be necessary to buy a comparable property
- Contribution: Certain characteristics add value to a property. It also serves as the foundation for a broker's opinion of value.
The sales prices of comparable properties are used as proof of value in the sales comparison approach. The price at which a certain property sells is the price established by the interaction of supply and demand at the moment of sale.
The prices of sold homes, or comparables, must be adjusted because no two properties are precisely the same. The known prices are changed by adding or deducting the amount that a certain feature seems to increase or decrease the cost of a comparable property.
The law of supply and demand, as already explained, controls property values. To understand how the market value of various properties is changed, it is essential to identify the factors that affect supply and demand. Doing so will enable a more accurate valuation.
Factors that affect demand
- Consumer income
- The price of related goods - different neighborhoods
- The price of complementary goods - paint brushes, nails
- Consumer expectations of future price changes – increases in interest rates, the price of winter gas or heating oil
Factors that affect supply
- The price of the commodity
- The availability of land, labor, management, and capital
- Available technology
- Size of the housing stock available
- Construction costs and methodologies
Every property is unique. This fact limits the accuracy of the sales comparison approach. As a result, it is challenging to find suitable comparables, particularly for special purpose properties.
In addition, the market needs to be active for sales prices to be current and reliable. Check out more on how to find comparables for real estate here.
Sales Comparison Approach vs. Other Approaches
When valuing real estate, the three most common methodologies are: the income approach, cost approach, and sales comparison approach. An overview of the income and the cost approach is provided below, along with how they differ from the sales comparison technique.
1. Cost Approach
The cost approach accounts for depreciation due to age and condition when estimating value. This is based on the expected cost of materials and labor required to construct a structure of that size and quality in that location.
The cost to acquire the property plus the cost of the improvements less any accrued depreciation equals the value under the cost approach. Physical degradation, functional deterioration, or economic obsolescence are all examples of depreciation.
2. Income approach
The income approach calculates value based on the typical market income of a comparable property.
It calculates the value of the future benefits that come with real estate asset ownership in the present. The two variations of the income strategy are the net income approach and the gross income approach.
Net income is the amount that remains after deducting costs, vacancy and collection loss, and prospective gross income.
For an estimation of value, the net income is divided by a capitalization rate (the investor's desired rate of return).
Larger commercial establishments, including office buildings, retail stores, residences, hotels, and motels, are frequently used in the net income strategy. The gross income technique is frequently used on residential properties that generate income.
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How to Use the Sales Comparison Approach
It consists of comparing recently sold properties with the subject and making a dollar or percentage adjustment to comparables to account for the differences with the subject property.
The adjustments are usually readily available for an appraiser, as they are provided with a list of valuations for each type of feature.
After determining the adjusted value of each comp, the appraiser weighs the reliability of each comp. and the factors underlying how the adjustments are made.
The weighting finally yields an optimal value range based on the output of the comps analysis. More details on the steps are discussed below.
STEP 1 - Identify comparable sales
To conduct an appropriate appraisal, experts usually recommend picking 3 to 6 comparables. Principal sources of data to retrieve comparable sales are tax records, title records, and local listing services.
There are specific guidelines in selecting comparables, many of which are set by a recognized authority organization, such as the Federal National Mortgage Association (FNMA).
For example, a property might have to be located within one mile of the subject to qualify as a comparable for a mortgage loan appraisal.
Perhaps the size of the comparable must be within a certain percentage of improved area concerning the subject.
Here are the main metrics to qualify as a comparable:
- Resembles the subject in size, shape, design, utility, and location
- The properties have sold recently, generally within six months of appraisal. The time of sale criterion is important since sales that happened too far in the past will not reflect appreciation or recent changes in the market.
- The properties have sold in an arms-length transaction. This means that the two parties involved in the transaction should be unaffiliated and unrelated, acting independently and in their own self-interest.
- For example, a father and daughter home sale transaction cannot be qualified as a good comparison. This is because there is a high risk of this transaction being biased.
STEP 2 - Compare comparables to the subject and make adjustments to comparables
This is a critical stage in the process. It consists of three distinct substeps, which are detailed in full depth below.
1. Adjusting comparables
To take competitive differences with the subject property into account, the appraiser modifies the sales prices of the comparables.
Therefore, changes should only be made to comparable prices, not the subject.
Note: the sale price of the comparable is known while the value and price of the subject are not. Adjustments are made by increasing or decreasing their value.
2. Adding or deducting the value
If the comparable is superior to the subject in some way, a certain amount is subtracted from its sale price. In an adjustment category, this eliminates the comparables' competitive advantage.
For instance, a comparable has a parking garage while the subject lacks one.
The appraiser subtracts a certain amount, let's say $5000, from the comparable sales price to make up the gap. Be aware that the adjustment accounts for the parking garage's contribution to market value.
Note: Neither the cost of the parking garage nor its depreciated value is included in the adjustment amount.
3. Adjustment Criteria
The principal factors that call for an adjustment are:
- Time of sale: If there have been significant changes in market situations, market prices, or financial accessibility after the date of the comparable sales, an adjustment may need to be made. This modification most frequently considers appreciation.
- Location: If the subject's location and the comparison site differ in any way, such as neighborhood desirability and look, zoning constraints, or general price levels, an adjustment may be made.
- Physical Characteristics: Marketable variances in lot size, square footage of the livable area, number of rooms, layout, age, condition, building style, quality, landscape, and other features may be taken into account.
- Transaction characteristics: Discrepancies in mortgage loan terms, whether or not the mortgage is assumable, and owner financing may be adjusted for.
STEP 3 - Weighing comparables
An adjusted price for the comparable that represents the value of the subject is obtained by adding/deducting the relevant adjustments from the sale price of each comparable.
The approach's final step entails carrying out a weighted analysis of each comparable-indicated value.
To weigh comparables, an appraiser largely uses expertise and judgment. There is no set formula for choosing a value from the set of all examined comparables. However, there are three quantitative metrics.
1. The total number of adjustments
The comparable with the fewest alterations overall tends to be the most similar to the subject, making it the best value indicator. A comparable will become less accurate as a measure of value if it requires too many changes.
2. Single adjustment amounts
The difference between the subject and the comparable for a particular item is represented by the monetary amount of the adjustment.
The comparable loses its value as a signal of worth when a significant modification is required. The comparability serves as a stronger value indicator the smaller the modification.
3. Total net adjustment amount
The total net value change from all adjustments put together is the third measurement of reliability in the weighting of comparables.
A comparable is a good indicator of value if the sum of its adjustments changes the reported value only marginally. The comparable is a worse indicator of value if overall changes result in a significant difference in dollars between the sale price and the adjusted value.
Following is a YouTube video explaining the Sales Comparison Approach:
Limitations of Comparative Sales Analyses
The comparative sales analysis helps value properties in several situations because it considers a variety of comparables and provides conclusions that are generally accurate at a particular point in time.
This is done by performing a thorough evaluation of the many components of the comparables.
It is considered the foundation of a real estate professional's comparative market analysis. It is also useful for individual homeowners who want to get a fair price for their property.
However, the sales comparison approach may not always be the most effective way to determine an indicative value.
Examples include unique or special-use properties with characteristics such as historic homes, one-of-a-kind designs, extremely large or small homes, or other elements that make comparisons challenging.
When it comes to commercial properties that produce periodic cash flows, a method like the income approach may offer a better alternative for real estate professionals.
This is because it computes the capitalization rate, a popular performance metric in the industry.
The sales comparison approach may also be hindered by certain market factors. Economic recessions, a lack of precise data, and the inability to recognize arms-length transactions are a few examples of such risks.
- Sales comparison analysis (SCA) is more applicable to residential properties and land.
- SCA compares surrounding properties to similar properties that have recently sold, in an effort to calculate the fair value
- A minimum of 3 comparable homes are required to conduct a comparable sales approach.
- The typical reach of a comp. search begins in the nearby neighborhood, extending to more distant locations if required.
- Adjustments should be made to the comparables, not the subject.
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