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Appropriate uses of economic characteristics in the sales comparison approach.

Recent refinements in sales comparison approach methods have led to confusion and frustration among appraisers who often find that, in actual practice, matched-pair analysis seldom provides conclusive adjustments for any but the largest value influences resulting from physical and locational characteristics. As a result, many adjustments used in appraisal reports are subjective and not supported by empirical market evidence. While the reality may be that market participants are not precise in their evaluation of physical and locational characteristics, lack of quantitative support for adjustments made in the sales comparison approach is a common criticism of appraisal reports.

Many appraisers use mathematical formulas as a substitute for opinions or subjective judgment in order to substantiate their conclusions. If market activity can be simulated in this manner, it is an appropriate method. In some cases, however, methods are being used that are not in accordance with recognized sales comparison approach methods as taught in Appraisal Institute courses and texts. An area of particular confusion involves the comparison of net operating income (NOI) projections and operating ratios of the subject with those of comparable sales.

The levels of income, vacancy, and operating expense of a property and their resulting ratios compose the economic profile of a property. This profile may provide insight into the possibilities of external and functional obsolescence or into other physical characteristics that require evaluation before comparison.




According to The Appraisal of Real Estate, ninth edition, the sales comparison approach comprises the following steps.

1. Research the market to obtain information on sales transactions, listings, and offerings to purchase properties similar to the subject property.

2. Verify the information by confirming that the data obtained are factually accurate and that the transactions reflect arm's-length market considerations.

3. Select relevant units of comparison (e.g., dollars per acre, per square foot, or per income multiplier) and develop a comparative analysis for each unit.

4. Compare the subject property and comparable sales properties using the elements of comparison and adjust the sale price of each comparable appropriately or eliminate the property as a comparable.

5. Reconcile the various value indications produced from the analysis of comparables into a single value indication or a range of values. an imprecise market may indicate a range of values. (1)

This general procedure is virtually universally accepted by appraisers and users of appraisal reports. After research verification and selection of the units of comparison, the elements of comparison are evaluated. The following six elements of comparison should be considered in the sales comparison approach.

1. Real property rights conveyed;

2. Financing terms;

3. Conditions of sale;

4. Date of sale;

5. Location; and

6. Physical characteristics.

Income characteristics can also be used to aid in the analysis of the sale of an income-producing property. Arraying of income multipliers is recommended in The Appraisal of Real Estate, ninth edition, (2) and some Appraisal Institute courses discuss arraying comparables by other aspects of their economic profiles.






The purpose of this article is to evaluate and clarify the use of income characteristics to refine adjustments for locational and physical characteristics in the sales comparison approach. The primary aspects of actual income and expenses for leased properties are typically adjusted under the first element of comparison, property rights conveyed. Properties encumbered by long-term leases are usually sold on a leased-fee basis. Nonmarket aspects of the leases that encumber a sale may affect actual income, expenses, or both. The comparison sales must be analyzed to determine the level and duration of lease rates and expense treatments because they may affect sale prices and thus the units of comparison. (3)

In addition to property-rights considerations, variations in income, vacancy, and operating expense levels from market standards may reveal functional or other obsolescence as a physical characteristic, or may reveal locational value influences such as external obsolescence. Such aspects of a comparable sale are adjusted as physical or locational characteristics.

By arraying the comparables according to their economic profiles, deviations from the expected pattern become evident and can be further researched. Such factors of operations as atypical income, vacancy, expense, or NOI levels may surface through direct comparison of these items or through ratio analysis. While mathematical analysis may only reconfirm condition evident from physical inspection, such as recent rehabilitation of improvements, it may also provide clues to value influences that are not visible in a typical comparable property inspection or through a typical verification process. Such value influences may include physical superiority or inferiority of improvement components, functional obsolescence (either by deficiency or superadequacy), and external obsolescence.

Recall that in the cost approach, the method used to estimate external and functional obsolescence is the capitalization of net income loss resulting from a particular value influence or the application of a gross income multiplier to rent differentials. It follows that a property that displays atypical ratios may be experiencing value loss resulting from obsolescence, assuming adequate property management. Several examples follow that illustrate the uses of ratios as the basis of adjustment for physical characteristics.

For instance, to use vacancy levels as a criterion to discover functional obsolescence, sales of several apartment buildings are researched and verified.

Good operating data are available for a number of recent sales. The economic details of the most appropriate comparable sales are included in Table 1.

Note the relationship between gross income multipliers and sale price per square foot, presented here in ascending order.
Sale Income Sale Price per
No. Multipliers Square Foot
3 2.81X $17.56
4 3.72X $21.40
1 3.77X $22.63
2 3.81X $22.10

Clearly, sale 3 does not fit the general pattern in a number of ways beyond simply the low sales price per square foot and the low gross


income multiplier. For example, while the ratio of operating expense to gross potential income of the comparables is similar, the ratio of NOI to gross potential income is considerably lower for sale 3. This is attributable to the extraordinarily high vacancy and collection loss category of that sale. Additional research indicates that 8% vacancy and collection loss is the market standard.

The variance in sale 3 implies that further investigation is necessary. Subsequent research reveals that the sale complex has several three-story, garden-style walk-up buildings in a market where virtually all apartments are two story, including the subject and the other sales comparables. Further, this comparable's third-story units are usually only 50% to 60% occupied while the first-floor and second-floor units are at market occupancy levels. Thus, incurable functional obsolescence is evident, as the market historically rejects these third-floor units. This information should then be discussed with the principals of the sale to determine the effect on value. (4)

In some cases, significant physical features, materials, or equipment may not be apparent in a casual inspection, and such unapparent items may influence sale prices. Assume, for example, that the details of several office building sales have been verified that appear to be highly similar, both to one another and to the subject. When comparables are arrayed by economic profiles, similar operating expense levels, except for electric costs, are revealed. One property consistently reflects a significantly lower electric expense level, provoking further research. It is learned that a state-of-the-art climate control system lowers electric expenses on this sale comparable, a permanent advantage. (The cost and feasibility of the superior system is not an issue at this point.) The impact of this feature on value can be discussed with the principals. It can then be properly reflected as a superior feature in the adjustments for physical characteristics.

In addition to functional obsolescence, external obsolescence may be apparent as it causes NOI ratios that deviate from the general pattern. External obsolescence is usually a locational influence. As an example of external obsolescence consider the following set of circumstances. The subject is an office/warehouse building in a small industrial park on a freeway in an urban area. Because of the small size of the specific park within which the subject is located and the lack of market activity, there are no recent arm's-length sales within the park. Thus, sales from similar small industrial parks along the same freeway are researched. The details of sale on a number of comparable office/warehouse buildings are arrayed according to their economic profiles. The comparables are highly similar physically, though one has an exceptionally high operating expense ratio. Further, the rent appears lower than typical on a per-square-foot basis. Upon investigation, it is discovered that this property is in an industrial park surrounded on three sides by a recently opened landfill. This factor does not affect the subject or any other sale comparable. The landfill has created a nuisance, and rents have been lowered to maintain occupancy in the industrial park. The landfill is to have a 60-year life, easily exceeding the remaining economic file of the offices and warehouses in the park. While rents have been reduced, expenses are only nominally affected. Ad valorem taxes are slightly lower because the tax assessor has recognized the negative influence and adjusted tax assessments. Off-site management is based on a percentage of collected rents and has declined proportionally. Other costs, such as utilities, maintenance, and insurance, are not any lower as a result of the negative influence. Accordingly, the operating expense ratio is higher and the residual NOI is depressed. As in the other examples, this information should be discussed with the principals to gain insight into the factor's value influence.

The level of detail necessary to perform such comparisons of economic characteristics is not usually available on comparable sales. The Appraisal of Real Estate, ninth edition, specifies six elements that should always be considered, listed in the first part of the article. Economic characteristics are not required to be compared, except as they are part of the real property rights conveyed. Arrays of income and expense characteristics for each comparable sale are recommended as they may lead to a better understanding of the data. Deviations from recognizable patterns can usually be explained, and a thorough confirmation with the principals of the sale is the best and most direct manner by which to ascertain the impact of an atypical feature on value. The buyer, who may disclose the value impact in specific terms, is the preferred source. Insight can sometimes be obtained through the seller, who may have dealt with a number of potential buyers and discussed the atypical feature with them.





The accepted method for the sales comparison approach includes the selection of appropriate units of comparison. The use of several independent units of comparison is sometimes possible and may increase the reliability of the approach. Each unit of comparison is to be evaluated based on the six elements of comparison discussed earlier.

Occasionally, references in courses and literature to the use of income and associated ratios as the basis for analysis of units of comparison are confused by appraisers with the use of income ratios as a unit of comparison. The Appraisal of Real Estate, ninth edition, refers to the use of multipliers as a unit of comparison and provides examples of the use of the gross income multiplier. (5) Gross income multipliers are relied on in the market and can be an independent unit of comparison. Direct comparison of NOIs is not independent, however, as it produces the same results as direct capitalization.

The following method has recently become prevalent in several regions of the United States and is referred to by its users as a net operating income multiplier analysis. This analysis is applied after adjustments are made for property rights, financing, conditions of sale, and date of sale. It is sometimes incorrectly used as an aggregate substitute for locational and physical difference adjustments. Consider the data presented in Table 2.

At this point in an analysis, the sales typically have been adjusted for property rights, financing, and market conditions. Some users of NOI multipliers do not adjust for time, stating that the influence of time is reflected in NOI differences. Further, some do not adjust for financing or property rights conveyed, stating that these, too, are reflected in NOI differences. In reports in which these elements of comparison are adjusted separately, the adjustment usually precedes the use of the multiplier.

As shown in Table 2, the range of indicated sale price per square foot for the comparables is $24.36 to $42.26 per square foot. The sales are of properties in good condition and near market occupancy at the time of sale.

A typical NOI multiplier presentation based on the market data in Table 2 would be as follows.

In order to adjust the sale price per square foot (SP/SF) unit of comparison for differences between the subject and the comparables in their various income-producing abilities, a multiplier can be obtained by dividing the subject's net operating income per square foot (NOI/SF) by that of each comparable. The multiplier is then multiplied by the indicated SP/SF. This tends to be a


self-adjusting valuation tool, quantifying differences among the comparables. The data for the six sales are presented in Table 3.

The indicated range of adjusted SP/SF is $21.37 to $24.62 per square foot, which is below the unadjusted sale price per square foot range. Although these sales vary considerably in location, their adjusted value indications per square foot produce a fairly narrow range. Sale 1 is felt to be the most similar to the subject because it is the only sale in the city. Sale 2 and sale 3 are located in an adjacent suburb and benefit from their proximity to the local community college. Sale 4, sale 5, and sale 6 are located near major industrial employers. However, sale 1 had an inferior occupancy rate at the time of sale. Thus, a value per square foot, $23.00, slightly above its adjusted value per square foot is felt to be appropriate. Although this value per square foot is lower than the unadjusted value-per-square-foot range, the lower value is felt to be appropriate given its location as well as high operating expenses per square foot resulting from the small size of the project.

Based on the preceding considerations, the value indication from the sale-price-per-square-foot method is estimated to be as follows:

93,375 square feet X $23.00/square foot = $2,147,625 rounded to $2,150,000

The appeal of this presentation is that it is clear, understandable,


and mathematically precise. It is also extremely brief, taking little time or thought to peruse. It allows a novice appraiser to prepare a sales comparison approach with little training or supervision.

Few appraisers who use this method, however, realize that the results are actually a restatement of direct capitalization. In the theory of proportional mathematics, the NOI multiplier is actually an equivalent mathematical formula to that used in direct capitalization. The classic capitalization formula is I/R=V (income divided by the capitalization rate equals value). In this example, the income is stated on a square foot basis and equates to the subject's NOI per square foot. The rate is the capitalization rate extracted from the comparable sales. The value is restated as the adjusted sale price/square foot. Thus, the adjusted sale price per square foot could also be calculated as shown in Table 4.
TABLE 4 Calculation of Adjusted Sales Price
Sale Subject NOI/ Comparable Adjusted Price/
No. Square Foot [R.sub.0] Square Foot
1 $2.60 0.1166 $22.30
2 $2.60 0.1150 $22.61
3 $2.60 0.1056 $24.62
4 $2.60 0.1056 $24.62
5 $2.60 0.1217 $21.36
6 $2.60 0.1194 $21.77
 NOTE: Subject NOI/SF divided by comparable [R.sub.0] equals
adjusted price/SF.

A comparison of the results of this direct capitalization of the subject's NOI with the results of the NOI multiplier (see Table 3) proves that the latter process provides identical results, with minor differences resulting from rounding. It is important to avoid using the same analysis in two approaches and calling it two different things.

Another occasional misuse of comparative NOI has evolved from the arraying of comparable properties by income multipliers (6) and operating expense ratios. The purpose of arraying, as taught by the Appraisal Institute, is to isolate and analyze deviations from the recognizable pattern. This is part of the research and analysis process presented earlier in the "Appropriate Applications of Economic Profiles in the Sales Comparison Approach" portion of this article. Occasionally, however, the array is improperly used as the basis for selecting a price per unit. The sale having the most similar gross income, vacancy level, and operating expense ratio on a square-foot basis is called the most comparable and the unit indicator from this sale is applied to the subject.

Variations of this faulty method are NOI/unit or NOI/room for multi-family properties and NOI/room for hotels, motels, nursing and retirement homes. In addition, some reports use a similar adjustment multiplier on the gross income multiplier (NOI/subject's gross income / NOI/comparable's gross income) and refer to it as a gross income multiplier adjustment.

The technique of using NOIs to indicate a value for the subject is familiar to appraisers because, as previously discussed, it forms the basis for direct capitalization. Such a practice is not acceptable as a substitute for sales comparison, but may enhance other units of comparison. Substituting the comparison of NOI for locational and physical adjustments not only violates the method taught by the Appraisal Institute, (7) but produces results identical to those of the income approach. Direct capitalization and yield capitalization are the appropriate approaches for a comparative analysis of the quantity and quality of NOI. In direct capitalization, while there is no precise stipulation of holding periods, income patterns, or changes in the value of the original investment, they are implicit in the overall rates used because they are derived from similar investment properties. In yield capitalization, these assumptions are specified. Every discussion of the comparative quantity and quality of the pro forma NOI has parallel considerations for the selection of the [R.sub.0] for direct capitalization or the selection of an appropriate internal rate of return for discounted cash flow analysis.

The NOI multiplier analysis reflects identical assumptions as direct or yield capitalization. It is thus dangerous to present the analysis as the sole unit of comparison in the sales comparison approach because there is no unit of comparison independent of the income approach. Any potential errors of the income approach are hidden rather than exposed by the sales comparison approach, with the income approach then dominating the value analysis. This is particularly a problem in those parts of the country experiencing market-wide external obsolescence. External obsolescence estimates are based on a comparison of the cost approach with the income approach, or the required income for feasible replacement and projected NOI. An inappropriate or incorrect analysis of income, combined with the use of faulty NOI multiplier analysis, results in inaccurate conclusions in all three approaches to value when obsolescence is present. These factors defeat the purpose of multiple approaches, which is to check and to expose weaknesses in each other.

(1) American Inst. of Real Estate Appraisers, The Appraisal of Real Estate, 9th ed. (Chicago: American Inst. of Real Estate Appraisers, 1987), 315.

(2) Ibid., 316, 324, 331-334, 336-337, 471, 474, 481-485.

(3) It should be noted that actual historical information may reveal property-rights variances in areas other than contract rents or pass-throughs (leasehold).

(4) The recommended method of estimating functional obsolescence is direct capitalization of the difference in NOI by the building capitalization rate. Functional obsolescence is curable when the cost to replace the undesirable aspect of the feature is less than the anticipated increase in value the change will bring. However, market evidence generated by comparison is preferable to such mathematical substitutes.

(5) The Appraisal of Real Estate, 9th ed., 316, 324, 331-334, 336-337.

(6) Three kinds of income multipliers are discussed in The Appraisal of Real Estate, 9th ed.: the potential gross income, effective gross income, and gross rent. See pages 316, 324, 331-334, 336-337, 471, 474, 481-485.

(7) Ibid., 9th ed., 471.

Mark W. Galleshaw, MAI, is a member of the Appraisal Institute's faculty and has previously published in The Appraisal Journal. His appraisal firm, Mark Galleshaw Company, maintains offices in Dallas, Texas, and Washington, D.C.
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Author:Galleshaw, Mark W.
Publication:Appraisal Journal
Date:Jan 1, 1992
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