Determining an accurate valuation is crucial when buying, selling or financing real estate. Two common approaches used by appraisers are the sales comparison method and the income capitalization method. Understanding how each methodology works provides insight into your property’s potential value range.
Sales Comparison Approach
The sales comparison approach is a market-based technique that values a property based on recent sales of comparable homes. The valuator analyses and adjusts for differences between the subject property and recently sold comparable properties nearby.
How it Works
- Identify recent sales of similar properties in the same area
- Compare features like size, bedrooms, location and condition
- Make adjustments for any inferior or superior features compared to the subject property
- Derive a value indication for the subject property based on adjusted sales prices of comparables
This method provides a good valuation estimate in standard markets with ample comparable sales data available. However, it relies heavily on the expertise of the appraiser in selecting appropriate comparables and making accurate adjustments.
Income Capitalization Approach
The income capitalization approach values commercial and investment properties based on the income they could potentially generate.
How it Works
- Estimate the property’s potential gross income if fully rented out
- Deduct operating expenses to determine net operating income
- Apply a capitalization rate to the net income to derive a property value
This method is ideal for income-producing properties where comparable sales are limited. However, the inputs like market rents and expenses require objective research and the capitalization rate should reflect the local investment market.
Which Method is Best?
For most residential valuations, the sales comparison approach provides the most accurate valuation estimate as buyers determine value primarily based on comparative sales. The income approach is more applicable for commercial property valuations where the leasing profile dictates value.
Using both methods provides a balanced perspective and cross-check on value for a property that has both comparative sales data as well as income potential. Professional appraisers can advise which methodology is most suitable depending on the property type, characteristics and available data.
