What makes a sale a comparable sale?
Many are familiar with the use of comparable sales, or “comps” in residential real estate appraisals. In this blog entry, I will explain how this technique is used.
A discussion of comparable sales begins with an explanation of why this approach is used in the valuation of real estate. Comparable sales reflect actual market reaction to similar residences, offering insight into anticipated market reaction to the property being appraised. If you are appraising a 1,600 square foot, split level home in a suburban subdivision and discover that four almost identical homes in that subdivision recently sold for $275,000, you are likely conclude that home being appraised is worth $275,000. After the negotiation process has been completed, buyers and sellers have repeatedly agreed on that price for similar homes. Most buyers are motivated to purchase at the lowest price possible, while sellers are looking for the highest possible sale price. The final negotiated sale price reflects those market forces in action. Comparable sales give us a glimpse at how the market might react to our home.
The next step is to understand what a comparable sale is. The key word is comparable. In active markets, such as Philadelphia, Montgomery County and Delaware County, PA, numerous sales have often occurred. The sales we want to examine are those that are most similar to the home being evaluated. Remaining sales are just that, sales, but not necessarily comparable sales. If the goal is to anticipate market reaction to the home being appraised, the comparable sales should be those that are most similar to that house. Sale price is never a good criteria for selecting comparable sales. An estimate of value for the property is what we are working towards. Backing out of a hopeful value will usually lead to an estimate that is skewed by personal bias.
What similarities make a sale a comparable sale? Three things are most often considered when making that determination: Location, physical property characteristics, and the date that the sale occurred.
We have all heard the saying, “location, location, location” are the three most important things in real estate. This does not lose its meaning in the process of comparable sale selection. Selecting sales from different neighborhoods reflect market reaction to homes in that neighborhood. In the City Of Philadelphia, market appeal of a specific location can change quickly. In some cases it can change by the street, or even the block. In suburban areas, such as Montgomery and Delaware Counties, PA, location appeal is also variable. Generally speaking, within suburban markets, municipal boundaries and school district location offers a good determinate of location appeal.
It is equally important that the comparable sales have similar physical characteristics to the property being appraised. While out on appraisals, I am often told, “Houses around the corner are selling for a million dollars.” Upon further investigation, the homes around the corner are newly built, 4,000 square foot, high end residences. They have little similarity to the 60 year old 1,200 square foot ranch style house I am appraising. These sales offer some assistance in the estimation of market value. One would expect the 1,200 square foot home to sell for less … a lot less! How much less is anyone’s guess. The million dollar homes offer little help in estimating a specific value for the ranch home.
Market conditions can change quickly. The most recent sales are the best reflection of current market conditions. For most residential appraisals, sales that occurred within the past 12 months are sought out. Sales that occurred within the past 90 days are even better.
The next step is to verify information about the comparable sales. One can’t rely on information given by neighbors, or even multiple listing services and other publications. Often, information is recorded or repeated in error. I see this frequently in my appraisal practice. Before evaluating a comparable sale, all information needs to be verified for accuracy. This can been accomplished through public tax records and deed recordings, interviews with the real estate agents involved in the sale and actual observations of the property by the appraiser. As an appraiser, the goal is to know as much about the comparable sales as the property being appraised. Detailed research of the comparable sales ensures a reliable comparison.
At this point we are ready to take a look at the comparable sales, and see what they tell us about the marketability and potential value range for our property. Unlike the example above with the suburban split level home, in the real world one will seldom have four recent sales of near identical homes, within the same subdivision. The goal now is to equate the comparable sales to the property being appraised. Monetary adjustments are made to the sale price of the comparable sales to accomplish this. Positive adjustments are made for value impacting features that are inferior to the home. Negative adjustments are made to the comparable sales for value impacting features that are superior to the home. Adjusted sale prices represent potential sale price of the house being appraised, with significant value impacting features held equal.
Actual adjustment amounts to comparable sale prices are approximated based on available market data. One technique used is known as Matched Pair Analysis. Consider the example of the split level residence. If one of the comparable sales had a two car garage and sold for $280,000, while the others had a one car garage and sold for $275,000, it could be concluded that buyers of this type of home would likely pay an additional $5,000 for a second garage bay. If our home has a one car garage, we would adjust the sale price of that comparable sale by $5,000. The adjusted sale price would be $275,000, reflecting its likely sale price if it had a one car garage. If the home with a two car garage also sold for $275,000, one might conclude that the second garage bay adds no value to the house. It is not uncommon for a feature to make a home more desirable, but not necessarily more valuable. Adjustments are made only for characteristics that have a measurable impact on market value.
Matched pair analysis becomes difficult in real world situations where multiple differences are noted in the comparable sales. Sensitivity analysis, a variation of matched pair analysis, is often used. Sensitivity analysis is employed by varying adjustments for each characteristic until a narrow price range is produced. Another method used is to calculate the actual cost of a feature, then subtracting physical depreciation. This method works best when adding this feature to a house has a high level of feasibility, such as a finished basement. Use of statistical regression models are being increasingly used by appraisers to measure market reaction to specific property features.
The sales comparison approach can be a powerful tool used by real estate appraisers because it relies on actions taken by actual buyers and sellers in the marketplace. This is important because the appraiser’s role is not to determine value of a home but rather, report the value that has been determined by market forces in action.