The three different types of approaches, or methods, to conducting an appraisal are the cost, market comparison, and income approaches. These approaches are economic models that represent different ways of estimating the value of property. Appraisers use their expertise to determine the approach that is most relevant for the type of property at issue. Valuing property is more of a technique than a factual exercise, and the appraisal approach provides the context through which the appraiser renders his expert opinion.
Property value can only be definitively established when the property is sold. Until an actual purchase is made to establish the price an actual buyer pays on the open market, any discussion of the value of the property is speculative. An appraisal attempts to use valuation models to estimate what the property is worth or would sell for under certain circumstances. The property's worth does not always equal the price a buyer would pay under current or future market conditions, so any appraisal is an expert judgment call rendered under certain constraints.
One of the key constraints is the valuation approach. The appraiser has to decide which economic construct can provide the best value estimation. Decisions to use one appraisal approach rather than another often depend on the type of property at issue and the context in which the appraisal is conducted. Very rarely is only one appraisal approach the only way to value the property.
The cost approach establishes value by determining the actual replacement cost of the property. It takes into account the costs to purchase the land and replicate the improvements using currently available labor and materials. This appraisal approach is most often used on unique property and by insurance companies when structuring a payout of policy proceeds. In this instance, the valuation question is not what the property would sell for on the open market but what the owner would need to rebuild the exact structure.
Market comparison, or the comparable sales approach, is used to value single-family dwellings. It establishes value by comparing the property to similar properties that have sold recently in the local market. Each piece of property is functionally and situationally unique, and no comparison of similar properties can fully determine a likely selling price. Appraisers use their best judgment to pick comparable properties and to estimate market value based on actual sales.
The income approach establishes property value based on an extrapolation of the value of the property's current and future income stream. This appraisal approach is most often used to value commercial property, such as multi-unit apartment buildings. Appraisers take the rent roll, for instance, and use its current worth, the likely vacancy rate, and the likely rate increases over time to reach an expert opinion on the value of the property.