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Approaches to Valuation

Information on terms used in valuing real property

Cost approach

The cost approach to valuation uses the cost to replace a building, less the accumulated depreciation of the building, to estimate a property's value.

Income approach

In simple terms, the income approach asks, "What is this property worth today based on an estimate of its current and future income potential over the economic life of the property?" The math to calculate the income approach is simple, but determining what values belong in each part of the equation can be much more difficult.

The Math: Value (V)= Income (I)/**Capitalization Rate **(R).

Income in this equation is the **net operating income**, and property tax costs are not included in the expenses.

Sales Comparison approach

The sales comparision approach to valuation estimates a property's value by comparing the property to other similar properties (the more similar the better) that have sold. Additions and subtractions are made to the comparable properties to account for any differences between the subject property and the comparable sales, and to account for changes in price over time. This approach is commonly emphasized in appraisals of residential property, and is an especially important tool in valuing land.

Mass Appraisal (sales-modified cost approach)

Unlike appraisers, who value one property at a time, assessors value all the property in our jurisdictions at once -- a process called mass appraisal.

Mass appraisal relies on standardized methods and tables and statistical analysis to value many properties at once, rather than preparing over 3,800 individual appraisals. Assessors use elements of the cost approach (replacement costs per sq. ft. for various features, and a depreciation rating based on the property's condition) to estimate the value of a given property. Features that have been shown to be strongly correlated with a property's market value (such as square footage, quality of construction, kitchen and bath quality, style and condition) are used as value indicators to estimate the overall value of a property.

Though it can appear the assessor is assigning specific cost values to individual elements of a house (and perhaps ignoring other elements completely), the purpose of these calculations is to estimate a property's overall market value. The calculation results for any particular element can seem objectively ... imperfect, let's say, especially when applied to property where the property's value is not typical (property with especially low and high valuations).

But the true test of a mass appraisal model (the collection of tables and equations used to estimate property values) is whether the model accurately predicts market value - and most importantly, whether the model results in similar properties having a similar **level of assessment**. This is where the sales-modified part of the mass appraisal method comes into play. Assessors perform **sales ratio studies** in order to analyze the accuracy of the estimates of value created by our

Assessing Measurement

Terms that

Assessment to Sale Ratio or Assessment Ratio (Sales Ratio, Level of Assessment)

The math of the** assessment to sale ratio **(often shortened to just the **assessment ratio**) is: **assessed value divided by sale price**, which results in a value of 1 if the two are exactly the same, a number less than one if the assessment is below the sale price, and a number greater than one if the assessment is above the sale price. The result is often converted into a percentage when studying multiple sales over a specific time period.

Example: 23 Assessing Way is assessed at $150,000 and sold for $200,000. The assessment to sale ratio, 150,000 ÷ 200,000, is 0.75. Stated another way, this property is assessed at 75% of market value. Market value in this case is used as a synonym for sale price, because sales are one of the best indicators of market value, though not the only one.

The assessment to sale ratio is used as a measure of the level of assessment in a community. When the assessor does a sales ratio study, the assessment ratios for a number of property sales over the study period are averaged and analyzed to determine the overall (average) level of assessment (such as, "Bath's assessment ratio is 100% of market value."). This is can also be referred to as the "sales ratio."

State law sets minimum and maximum average assessment ratios for Maine communities (70% and 110% respectively). These standards aren't measured by the assessment ratio of individual properties, but are based on the overall average assessment ratio for the municipality. See M.R.S. Title 36 §327.

Quality rating, Coefficient of Dispersion (COD)

An Assessment Quality rating is the phrase used by the State of Maine to describe a measurement of how similar the assessment to sales ratios are in a community. For this measurement, a lower number means better quality. A quality rating of over 20 is out of compliance with Maine's standards for assessment. See M.R.S. Title 36, §327.

The math of the quality rating is a bit complicated. In statistical terms, the quality rating is a measure of the "coefficient of dispersion (COD)," or the average difference a group of numbers has from the median of those numbers.

Example: The assessor has five sales with different assessment to sale ratios. 0.85, 0.90, 0.92, 0.99 and 1.02. Arranged from lowest to highest, the median is 0.92. The difference between each number and the median is: 0.07, 0.02, 0, 0.07, and 0.10. It doesn't matter if the difference from the median is a positive or a negative direction; for this statistic, you just want to know the distance from the median. These differences add up to 0.26, and divided by 5

Miscellaneous Assessing terms

This section contains a variety of assessing terms defined simply.

Capitalization Rate (Cap Rate)

A capitalization rate is usually expressed in percentage terms, and is used in calculating the income approach to valuation. The cap rate (the common shorthand for a capitalization rate) converts an estimate of future income into an estimate of market value, and is the ratio of net operating income to market value.

There are many ways to determine the appropriate capitalization rate for type of property, but for our purposes it is sufficient to say that determining the correct rate to use is probably the most difficult aspect of valuing commercial properties. In the best circumstances, the assessor would have known market sales of a commercial property as well as accurate information on the income and expenses applicable to managing the property.

Math: Capitalization Rate (R) = Net Operating Income (I) ÷ Valuation (V). Notice that this is the same equation used in the Income approach to valuation, just with the elements moved around.

Effective Tax Rate

Because the assessor does not include property taxes in the expenses when determining the net operating income, the assessor includes the effective tax rate in the capitalization rate we use to estimate the value of a commercial property.

**Math: **Property taxes are usually described in dollars per thousand (our tax rate this year is $16.90 for every $1,000 of a property's valuation). Effective tax rate is just expressing the same number as a percentage (think of it as the tax rate in dollars per $100 of valuation). The effective tax rate in 2022 was 2.04%; the effective tax rate in 2023 is 1.69%.

Valid, Market, Arm's Length, or Qualified Sales

At least 297 properties changed hands in Bath between April 1 of 2022 and April 1 of 2023. But many of these sales could not be used by the assessor in reviewing the quality of our assessments and updating property valuations. Only sales that are qualified (also referred to as valid sales, market sales, or arm's length sales) can be used in sales ratio studies.

The simple definition for a qualified sale is:

- Where both the buyer and seller of the property are:
- willing and not under undue duress from other factors, such as a pending foreclosure.
- informed (also described as prudent and knowledgeable) and acting in what they consider their best interests.

- The property is exposed to market for a reasonable period of time.
- Payments and financing are in cash or in typical financial arrangements for the market.

Other factors also affect whether a sale can be used by the assessor in studying the local market and determining the assessment ratio. If a property is purchased at a particular price, but is immediately improved by the new owner, the assessed value for the property and/or the sales price are likely to no longer be reflective of the property's actual value as of the date of assessment.