What it means
Value is not a fact waiting to be read off a label, so valuers use structured approaches to make an estimate defensible. Each approach looks at the same asset through a different lens, and the fact that they rarely agree exactly is a feature rather than a fault.
The cost approach asks what it would cost today to build or buy an equivalent asset, then deducts for age, wear and outdated design and adds the value of the land. It suits specialised buildings and new construction where no comparable sales exist and no rental income is generated.
The sales comparison approach starts from recent sales of similar assets and adjusts each one for differences in size, condition, location and date of sale. It carries the most weight where there is an active market with plenty of transactions, which is why it dominates residential valuation.
The income approach converts expected earnings into a capital value, usually by dividing stabilised net operating income by a capitalisation rate drawn from the market, or by discounting a forecast of future cash flows. It is the natural choice for investment property and operating businesses, where a buyer is really purchasing an income stream.
Reconciliation is the final step and the one non-specialists tend to miss. The valuer weights the approaches according to how reliable the underlying data is in that particular case, and states a single opinion of value rather than averaging three numbers mechanically.
In practice
Real-world examples.
Example
A bank lending against a suburban warehouse relies mainly on the sales comparison approach, because eleven similar units in the same estate have changed hands in the past two years. The income approach is calculated as a cross-check, and the two figures land within 4% of each other, which gives the credit committee confidence.
Example
An insurer valuing a purpose-built chemical processing plant uses the cost approach, since nothing comparable has ever been sold and the plant produces no separable income. The figure is a rebuilding cost rather than a market price, which is exactly what an insurance policy needs.
Example
A buyer valuing a dental practice uses the income approach, taking maintainable earnings of $420,000 and applying a market multiple of 3.5 to reach $420,000 x 3.5 = $1,470,000. The seller's preferred figure, based on the cost of the equipment and fit-out, is far lower and never enters the negotiation.
Formula
Calculation
Cost approach: value = replacement cost - accumulated depreciation + land value
Sales comparison: value = adjusted price per unit x size of subject asset
Income approach: value = net operating income / capitalisation rate
Take an office building with net operating income of $360,000 and a market capitalisation rate of 8%. The income approach gives $360,000 / 0.08 = $4,500,000.
The cost approach values replacement at $4,000,000, deducts $700,000 of depreciation for a twenty year old fit-out and adds land at $1,300,000, giving $4,000,000 - $700,000 + $1,300,000 = $4,600,000. Three comparable sales at $310, $295 and $325 per square foot average ($310 + $295 + $325) / 3 = $310, and the building measures 14,000 square feet, so the sales comparison approach gives 14,000 x $310 = $4,340,000. Weighting the income approach at 50%, sales comparison at 30% and cost at 20% reconciles to ($4,500,000 x 0.50) + ($4,340,000 x 0.30) + ($4,600,000 x 0.20) = $2,250,000 + $1,302,000 + $920,000 = $4,472,000.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Threadmill Estates, an invented hotel owner, needed a valuation to refinance a 90 room property. Its own accountant had built a figure from the cost approach: land at $2,500,000 plus replacement cost of $14,000,000 less $5,500,000 of depreciation, giving $2,500,000 + $14,000,000 - $5,500,000 = $11,000,000.
The lender's valuer treated the hotel as what it was, a trading asset, and applied the income approach. Stabilised net operating income of $1,080,000 at a market capitalisation rate of 9% gave $1,080,000 / 0.09 = $12,000,000, comfortably above the cost figure because the hotel traded well for its size.
The reconciliation weighted the income approach at 70% and the cost approach at 30%, producing ($12,000,000 x 0.70) + ($11,000,000 x 0.30) = $8,400,000 + $3,300,000 = $11,700,000. The fictional owner learned an uncomfortable lesson: for an income-producing asset, the cost of building it is the least persuasive of the three stories a valuer can tell.
Watch out
Common mistakes.
- Averaging the three approaches instead of weighting them by how reliable the evidence is in the specific case being valued.
- Using the cost approach for an established income-producing property, where buyers price the earnings rather than the bricks.
- Treating comparable sales as directly usable without adjusting them for date, size, condition and location differences.
Questions
People also ask.
Which approach gives the most accurate value?
None of them universally; the most reliable is whichever rests on the best data, so an active sales market favours comparison and a stable income stream favours the income approach.
Why do valuers bother with more than one approach?
Because agreement between independent methods is evidence that the conclusion is sound, and a wide divergence is a signal that an assumption needs revisiting.
Is a market value the same as a price?
No, market value is an opinion of what an asset should fetch between willing parties under normal conditions, while a price is what one particular buyer actually paid, possibly under pressure.
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