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This is the second of two articles highlighting the approaches that an appraiser uses when appraising agricultural or rural property and the reconciliation of the approaches.

The appraisal process employs three basic approaches to value:

  1. Cost Approach
  2. Income Approach
  3. Sales Comparison Approach

Cost Approach

The Cost Approach is based on the Principle of Substitution; the proposition that a prudent buyer would pay no more for a property than the cost to acquire a similar site and construct improvements of equal desirability and utility.

In the cost approach, the current reproduction/replacement cost of the improvements, less accrued depreciation, plus land value, may yield an indication of value. (Land Value + Depreciated Improvement Value = Indication of Value).

Depreciation consists of a loss of value from any source, including:

  1. Physical Deterioration
  2. Functional Obsolescence
  3. External Obsolescence

Physical Deterioration is the result of normal wear and tear from use and the elements. Often, the age/life method will be used, whereby the appraiser will divide the effective age by the total economic life to determine a percentage of life used and can then determine the physically depreciated value of the improvements. The effective age can be less than, the same, or greater than the actual age of the improvement. Physical deterioration applies to deferred maintenance, short-lived items, and long-lived items which can be curable or incurable.  

Functional Obsolescence is caused by a flaw in the materials or design of the structure which limits functional use and utility. Improvement features that may be an indication of functional obsolescence include, but are not limited to, small doors, low wall height, components that don’t work properly, an improvement that is overbuilt for the area (super-adequacy), and/or an improvement that is underbuilt for the area (inadequacy). Like physical deterioration, functional obsolescence can be curable or incurable.

External Obsolescence is a limit on the utility or sale of a property due to negative influences outside of the property. This can be due to an oversupplied market, poor location, detrimental neighborhood influences, etc. External obsolescence is generally considered to be incurable (the property owner cannot do anything to fix it); however, it may not be permanent.

The cost approach is typically developed in the appraisal of improved properties where there is good cost information and total depreciation can be supported. This approach to value is typically considered to provide a good indication of value when the subject has specialized improvements and/or when comparable improved sales are limited in the subject market area.

Income Approach

On a piece of agricultural real estate, like a farm, the Income Approach might be used. The Income Approach is based on the Principle of Anticipation. This is when the present value is a correlation to the future benefits. In other words, the income approach assumes the price a buyer will pay today is directly correlated to the income the buyer anticipates in the future.

In the income approach, appraisers most commonly utilize Direct Capitalization Analysis and Discounted Cash Flow Analysis to determine an indication of value. Direct capitalization is a method which converts an estimate of a single year’s income by dividing the net income by an appropriate capitalization rate. Discounted cash flow analysis is a method that discounts anticipated future cash flows to present value. The method that is most appropriate may depend on the property type and the anticipated quality and durability of the income stream.

Both, the direct capitalization, and discounted cash flow analyses involve the same basic steps:

  1. Forecast the expected cash flow(s) from the investment
  2. Select an appropriate Capitalization Rate or Discount Rate
  3. Capitalize or Discount the anticipated cash flow(s) to yield an indication of value

The appropriateness and selection of the capitalization rate/discount rate is critical in arriving at an estimate of value.

The income approach is typically developed and weighted for properties that have reliable or predictable cash flow and income. This approach to value can be questionable in rural property valuation, as property characteristics, that may not be observed in the anticipated cash flow, can significantly impact value (i.e., property location, farm-ability, etc.).

Sales Comparison Approach

Like the cost approach, the Sales Comparison Approach is based on the Principle of Substitution; being that a buyer would pay no more for a property than the cost of acquiring an existing property with the same utility/attributes. The sales comparison approach to value involves direct comparison of the property being appraised to similar properties that have sold in the subject area.

The sales comparison approach analyzes the market by comparing sales of properties like the property being appraised and making adjustments to the comparable sales for difference in transactional and property characteristics. Adjustments can include but are not limited to, financing, passage of time, location, land, buildings, size, condition, etc. The adjustments for any of these factors are applied to the sale price of the comparable sales and correlated into an indication of value.

This approach to value is the best reflection of the actions of market participants if the property is in an area with an active market. It can become more questionable in market areas which are stagnant or for property which lack true comparable sales.

Lastly, a final value estimate is reconciled from one, two, or all approaches used and considers the availability, comparability, and analysis of the market data. It’s important to note that all three approaches are market-based approaches and all the data used to analyze the subject is derived from bona fide sales.

If you have any questions about appraisals or want to talk to a loan officer about purchasing a piece of ag real estate, contact us or find an office in your area.

 

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