Approved-source preservation: The complete recovered Valuation & Market Analysis manuscript remains verbatim in Chapter 7. This chapter develops the three approaches as a separate applied lesson without replacing that source.

Learning Objectives

• Explain the sales comparison, cost, and income capitalization approaches.
• Select the approach most relevant to a property and assignment.
• Apply substitution, contribution, highest and best use, and anticipation within the approaches.
• Make basic comparable-sale adjustments in the correct direction.
• Calculate replacement cost, depreciation, net operating income, capitalization rate, and indicated value.
• Explain reconciliation and why it is not a simple average.
• Distinguish appraisal practice from a broker’s comparative pricing work.

Key Vocabulary

Term	Definition
Sales Comparison Approach	An approach comparing the subject with similar recently sold properties and adjusting for meaningful differences.
Comparable Sale	A property transaction sufficiently similar and relevant to help indicate subject value.
Adjustment	A dollar or percentage change to a comparable to reflect a difference from the subject.
Cost Approach	Land value plus current improvement cost minus depreciation.
Replacement Cost	Cost to construct a building of equivalent utility using current materials and standards.
Reproduction Cost	Cost to construct an exact replica using substantially the same design and materials.
Depreciation	Loss in value from physical deterioration, functional obsolescence, or external obsolescence.
Physical Deterioration	Value loss from wear, age, damage, or deferred maintenance.
Functional Obsolescence	Value loss caused by design, layout, features, or utility problems within the property.
External Obsolescence	Value loss caused by influences outside the property.
Income Capitalization Approach	An approach converting expected income benefits into a value indication.
Net Operating Income (NOI)	Effective gross income minus operating expenses, before debt service, income taxes, and depreciation expense.
Capitalization Rate	The relationship between one year’s NOI and value.
Direct Capitalization	Value indication found by dividing stabilized NOI by an appropriate capitalization rate.
Gross Rent Multiplier (GRM)	A market-derived ratio relating sale price to gross rent.
Reconciliation	The reasoned weighting of approach indications into a final value opinion.

Core Lesson

Approaches Are Different Lenses

No approach creates value by itself. Each organizes market evidence through a different question: What are buyers paying for substitutes? What would the land and improvements cost, after depreciation? What are the anticipated income benefits worth? The appraiser selects and weights approaches according to property type, data quality, assignment purpose, and buyer behavior.

Sales Comparison Approach

The sales comparison approach is especially persuasive when buyers commonly compare similar properties, including many owner-occupied homes and vacant parcels. The process is: define the subject, research transactions, verify data, select comparables, compare relevant elements, adjust the comparables, and reconcile an indication.

Adjustment Direction

Adjust the comparable—not the subject. If the comparable is inferior, add to its price. If the comparable is superior, subtract from its price.

CBS–CIA: Comparable Better? Subtract. Comparable Inferior? Add.

Example: subject has a garage; comparable lacks one. The comparable is inferior, so add the supported garage adjustment to the comparable. Adjustments should be market-supported, not based automatically on construction cost.

Elements of Comparison

Common elements include property rights conveyed, financing terms, conditions of sale, market conditions, location, physical features, economic characteristics, use, and non-realty components. A sale under unusual pressure may require different treatment from an arm’s-length transaction.

Cost Approach

The cost approach applies the principle of substitution: a rational buyer generally will not pay substantially more than the cost to acquire comparable land and construct an equivalent improvement, allowing for time and risk. It can be useful for new buildings, special-purpose properties, insurance-related assignments, and properties with limited sales.

Land value + Improvement cost new − Depreciation = Indicated value

Land is valued as vacant under its highest and best use; land is not depreciated. Improvement cost may be replacement or reproduction cost. Add appropriate indirect costs and entrepreneurial considerations when the assignment requires them, then deduct all forms of depreciation.

Three Forms of Depreciation

• Physical: worn roof, damaged finishes, aging systems.
• Functional: poor layout, obsolete design, inadequate utility.
• External: adverse traffic, declining industry, incompatible neighboring use.

Curable means the value gain from correction justifies cost under the relevant analysis; incurable means correction is impractical or not economically justified. External obsolescence is often incurable because the cause lies outside the owner’s control.

Income Capitalization Approach

Income-producing property is purchased for anticipated benefits. The income approach analyzes the quantity, quality, durability, and risk of income.

Build NOI Correctly

Start with potential gross income. Subtract vacancy and collection loss, add other property income, and arrive at effective gross income. Subtract operating expenses to find NOI. Debt service, owner income taxes, and accounting depreciation are not operating expenses in the standard appraisal NOI calculation.

Potential gross income − Vacancy/collection loss + Other income = Effective gross income
Effective gross income − Operating expenses = NOI

Direct Capitalization

Value = NOI ÷ Capitalization rate
Rate = NOI ÷ Value
NOI = Rate × Value

A lower capitalization rate, with the same NOI, produces a higher value indication because the market is accepting a lower return for the perceived risk and growth profile. The rate must be market-supported and consistent with the income definition.

GRM

GRM is a simplified gross-income tool often used for small residential rentals. Sale price divided by gross monthly rent produces a multiplier; subject rent multiplied by the market-derived GRM produces an indication. Because GRM ignores operating expenses, it should not substitute for NOI analysis when expenses materially differ.

Reconciliation

Reconciliation is not averaging. An appraiser evaluates the relevance and reliability of each approach, the quantity and quality of evidence, the consistency of the data, and how typical market participants behave. A nearly new special-purpose property may give the cost approach more weight. An apartment property with reliable income may emphasize income capitalization. A subdivision home with abundant recent sales may emphasize sales comparison.

Appraisal and Brokerage Pricing

An appraisal is a regulated professional value opinion developed under applicable appraisal standards and law. A CMA or broker price analysis supports listing or offer strategy using brokerage market data. A broker should label the work accurately, avoid presenting it as an appraisal, and stay within licensure and competence.

Indiana Law Spotlight

Partially verified against current authority. Indiana Code Title 25 and the current administrative framework separately regulate real estate brokers and credentialed real estate appraisers. The Indiana Professional Licensing Agency maintains distinct official licensing information for the Indiana Real Estate Commission and the Real Estate Appraiser Licensure and Certification Board. This supports the chapter's central practice rule: a broker must accurately identify brokerage pricing work and must not imply an appraiser credential or certified appraisal that the broker does not hold or provide.

Still open: Verify the section-level statutory exemptions and limits for CMAs and BPOs; permitted assignment purposes; required labels and disclosures; compensation conditions; appraisal-review authority; federally related transaction requirements; credential classifications and assignment limits; current professional-standard incorporation; and any pending or newly effective rulemaking. Whether a particular lender, court, estate, tax, condemnation, or other assignment requires a credentialed appraisal remains assignment-specific.

Official sources: Current Indiana Code Title 25; Indiana Real Estate Appraisers Board; Indiana Real Estate Commission; 876 IAC Article 3.

National Exam Alert

Memorize adjustment direction and IRV. The comparable is adjusted to the subject. Value equals income divided by rate.

Common Exam Trap

Do not subtract mortgage payments when calculating appraisal NOI. Do not depreciate land. Do not average the three approaches automatically.

PASS FIRST Memory Trick

CBS–CIA: Comparable Better, Subtract; Comparable Inferior, Add.
IRV triangle: Income over Rate × Value.

Broker Insight

Before choosing a price, identify which approach mirrors the likely buyer. Investors ask about NOI and return; owner-occupants compare substitutes; unique or new improvements may require cost reasoning. Data quality controls the confidence of the conclusion.

Chapter Summary

• Sales comparison adjusts comparable transactions to the subject.
• Cost equals land plus improvement cost new minus depreciation.
• Income capitalization converts anticipated income into value.
• NOI excludes debt service and owner-specific income taxes.
• Value equals NOI divided by capitalization rate.
• GRM uses gross rent and does not account for expense differences.
• Reconciliation weights evidence rather than averaging.
• Indiana's separate broker and appraiser regulatory structure is partially verified; precise CMA/BPO exemptions, assignment purposes, disclosures, compensation conditions, appraisal-review authority, federal overlays, and current rulemaking remain queued.

Practice Questions

1. The subject has a garage and the comparable does not. The supported adjustment is made by:
   1. Subtracting from the subject
   2. Adding to the comparable
   3. Adding to the subject
   4. Ignoring the difference
2. A comparable has a superior renovated kitchen. Adjust the comparable by:
   1. Adding
   2. Changing subject rent
   3. Multiplying by the tax rate
   4. Subtracting
3. Which approach is often most relevant for an owner-occupied home with many similar sales?
   1. Sales comparison
   2. Income only
   3. Cost only
   4. Tax assessment
4. Cost approach formula is:
   1. Rent × tax
   2. NOI ÷ rate
   3. Land + cost new − depreciation
   4. Price − land only
5. Which is not depreciated in the cost approach?
   1. Roof
   2. Building
   3. Land
   4. Parking improvement
6. A poor floor plan is:
   1. Physical deterioration
   2. Functional obsolescence
   3. External obsolescence
   4. Appreciation
7. A nearby incompatible industrial use causes value loss. This is:
   1. Functional
   2. Physical
   3. Accrued rent
   4. External obsolescence
8. Effective gross income is $120,000 and operating expenses are $45,000. NOI is:
   1. $75,000
   2. $120,000
   3. $165,000
   4. $45,000
9. NOI is $60,000 and cap rate is 8%. Value is:
   1. $480,000
   2. $750,000
   3. $7,500,000
   4. $68,000
10. A property sells for $800,000 with NOI $64,000. Cap rate is:
    1. 6%
    2. 10%
    3. 8%
    4. 12.5%
11. Which is excluded from standard appraisal NOI?
    1. Mortgage debt service
    2. Management expense
    3. Property insurance
    4. Maintenance
12. With the same NOI, a lower cap rate produces:
    1. Lower value
    2. Higher vacancy automatically
    3. No value
    4. Higher value
13. GRM primarily relates sale price to:
    1. Depreciation
    2. NOI
    3. Gross rent
    4. Tax rate
14. Why can GRM mislead when comparing rentals?
    1. It ignores gross rent
    2. It ignores operating-expense differences
    3. It requires NOI
    4. It is a deed
15. Which cost is an exact replica?
    1. Replacement
    2. Opportunity
    3. Operating
    4. Reproduction
16. Reconciliation means:
    1. Reasoned weighting of indications
    2. Always averaging
    3. Choosing the highest number
    4. Using assessed value
17. A new special-purpose school with few sales may emphasize:
    1. Tax bill
    2. GRM only
    3. Cost approach
    4. Commission
18. An apartment complex purchased for income commonly emphasizes:
    1. Legal description
    2. Fixtures only
    3. Escheat
    4. Income capitalization
19. A broker’s CMA should be represented as:
    1. A court order
    2. Brokerage pricing analysis, not automatically an appraisal
    3. A tax assessment
    4. A title policy
20. Which principle supports each approach by comparison with alternatives?
    1. Substitution
    2. Escheat
    3. Avulsion
    4. Accession

Detailed Answer Explanations

1. B. The inferior comparable lacks the subject’s garage, so add the supported amount to the comparable.
2. D. The comparable is superior; subtract its supported advantage to make it more like the subject.
3. A. Buyers of similar owner-occupied homes typically compare substitutes, making sales comparison highly relevant.
4. C. The cost approach adds land value to improvement cost new and subtracts all depreciation.
5. C. Land is valued separately and is not depreciated in the cost approach.
6. B. Layout and design inadequacy is functional obsolescence because it originates within the property’s utility.
7. D. The negative cause is outside the property, so the loss is external obsolescence.
8. A. $120,000 − $45,000 = $75,000 NOI.
9. B. $60,000 ÷ 0.08 = $750,000.
10. C. $64,000 ÷ $800,000 = 0.08, or 8%.
11. A. Debt service reflects financing, not property operations, and is excluded from standard NOI.
12. D. Dividing the same income by a smaller rate produces a larger value.
13. C. GRM is sale price divided by gross rent and can be used with subject gross rent.
14. B. GRM does not subtract expenses, so properties with different expense burdens may not be comparable by GRM alone.
15. D. Reproduction cost replicates the original; replacement cost provides equivalent utility with current standards.
16. A. Reconciliation evaluates relevance and reliability; it is not mechanical averaging.
17. C. New or special-purpose improvements with limited sales often make cost evidence more relevant.
18. D. Investors focus on anticipated income and risk, so income capitalization is central.
19. B. A CMA is brokerage pricing work unless it satisfies and is offered under applicable appraisal authority.
20. A. Substitution says buyers compare acceptable alternatives rather than pay materially more for equivalent utility.

Mastery Checklist

• I can select the most relevant approach for a property type.
• I can adjust comparables in the correct direction.
• I can calculate the cost approach.
• I can classify physical, functional, and external depreciation.
• I can build NOI and exclude debt service.
• I can use IRV and GRM.
• I can explain reconciliation.
• I can distinguish appraisal from brokerage pricing analysis.
• I can identify Indiana scope statements requiring verification.
• I can score at least 80% and explain every answer.