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As the name suggests, the sales comparison approach to real estate evaluation involves examining recent sales of comparable properties (comps) to get a sense of what a certain property is worth. As a basic example, if you own a three-bedroom, 1,200-square-foot single-family home, you might look for the two or three most recent sales in the same neighborhood that have similar characteristics.
Owners and real estate agents use the sales comparison approach to help determine the market value of a property as well as help guide how much a property's listing price should be to get maximum value for the seller. Buyers and their agents also often use sales comparisons to determine how much to offer for a particular property.
Of course, no two properties are exactly the same, so adjustments are often made to level the playing field. For example, if a comparable property in the same neighborhood just sold for $200,000, but it had a finished basement and your basement is unfinished, you (or more likely, an appraiser) might decide that your valuation should be adjusted downward by $10,000 to compensate for the difference.
Shortcomings of the sales comparison approach
There's no perfect way to determine the fair market value of real estate, and the sales comparison approach is no exception. There are a few shortcomings of this approach that can make the estimate not quite as accurate as you might hope.
Location: As mentioned, the sales comparison approach uses nearby and similar properties (comparable sales), but location can still make a big difference in home values. Maybe one home is next to an attractive public park or is more walkable to a grocery store. Things like this make a difference.
Time: You may need to go back several months to find comparable properties to evaluate. And a lot can change in a real estate market's conditions in that time. Think of the United States in February 2020 and May 2020 -- two very different economic climates. And there's also some seasonality, as many markets are more active during the summer.
Sale conditions: When you're looking at recent residential property sales, you generally just see the sale price of the similar property, but not any of the unique circumstances surrounding that number. For example, maybe the seller paid $10,000 toward the buyer's closing costs, which would make the effective sale price lower. Or maybe the property owner sold the property to a friend and gave them a discount.
Subjective opinions: What defines a property in "good" condition? What about an "average" condition property? If I were to ask a dozen people these questions, I'd probably get a dozen slightly different answers. Since the respective condition of each comparable property is a factor in the analysis, this makes the sales comparison approach somewhat a matter of opinion.
Other factors: There are many different variables that can influence the market value of a property, in both positive and negative ways. For example, if the property in question is comparable (on paper) to a recent sale but has some factor that is likely to turn off buyers -- say, an odd paint color or overgrown landscaping -- it could affect the actual market value.
Other real estate valuation methods
In addition to the sales comparison approach, there are two other common real estate valuation methods and one that combines several different approaches.
- Cost approach: The cost approach to real estate valuation essentially tries to determine how much it would cost to build the property from scratch, adjusting for its current condition.
- Income approach: This is a commonly used valuation method in real estate investing (especially when it comes to commercial real estate) and attempts to determine a property's value by using its expected rental income and the current market average cap rate.
- Formal appraisal: A sales comparison approach is usually a part of a formal real estate appraisal, but an appraisal incorporates several different valuation methods, as well as a professional's opinion of a property's value, to get an accurate picture of how much it is truly worth.
How to use the sales comparison approach
The bottom line is that while a sales comparison can be an excellent way to get a ballpark estimate of what a property is worth, it is just that -- an estimate. It isn't a perfect approach to real estate valuation and should be used in conjunction with other methods to get as accurate of a picture of the property's value as possible.
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