Evaluating real estate is done three general methodologies used: the cost approach, the income approach, and the comparables approach. Real estate evaluations (a.ka. appraisals) are very prevalent in the real estate industry because transactions occur so infrequently. Each approach has it unique merits and uses.
This approach holds that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. Within this approach there are also two methods, replacement cost and reproduction cost. Replacement cost refers to recreating something with the same utility, but allowing for modern design and upgraded materials.
For example let’s say there was a building that used unique hand-made brick from the 1920s from a very obscure company. If were apply the replacement method, one would likely use more cheaper manufactured bricks to estimate the cost. If you were to use reproduction cost method however, you would have to account for creating an exact replica, finding matching copies of handmade bricks from that obscure company, if that is possible. Reproduction cost is typically higher. You typically see the cost approach applied to explain the tax appraised value of a property.
The income approach is used to value commercial and investment properties. The approach uses past history calculate the profitability of a particular property to estimate its future performance. Investors typically use the capitalization rate, among a myriad of other tools to evaluate the income potential of a property.
This is the most common approach visibly seen in residential real estate. Real estate agents may throw around the term ‘Comparative Market Analysis’ or CMA. Appraisers, a more humble bunch, may call it the adjustment method. The comparables approach hinges on the idea that a reasonable person will not pay more for a property than what it would cost to purchase a comparable substitute property. That said, if you can find another property already sold with the same exact features, attributes, location, utility, construction, and other qualities, it would be safe to assume that property in question would go for the same price.
The problem is that you can never find a property that is identical to another, namely because of location. But despite that, you can find properties with similar features in a similar location, all sold in a similar period (preferably recently), and eventually you would get a scatter plot of data within a price range. From there, agents may use experience within those specific markets to identify a narrower range your property could possibly fit.
Appraisers would attempt to find a handfull of very similar properties and begin making “adjustments” to the comparable properties’ sold prices for specific characteristics unique to the subject property. Eventually he or she will go through every recognizable difference and come up with a final “Adjusted” value of the property.