Valuation Methodologies: The Market Sales Approach

Three methodologies are normally used in the determination of the market value of a property. These methodologies include: market sales, cost, and income approach.

Section 23.0101 of the Texas Tax Code provides: "In determining the market value of property, the chief appraiser shall consider the cost, income, and market data comparison methods of appraisal and use the most appropriate method."

Note that the Code does not require that the chief appraiser use the methodology that results in the lowest value. It only requires that she consider all three alternative methods and then "use the most appropriate method."

However, a Texas court of appeals has indicated that these three appraisal methods are not necessarily the only methods of determining market value. In Houston R.E. Income Properties XV, Ltd. v. Waller County Appraisal District, 123 S.W.3d 859 (Tex. App. Houston [1st Dist.] 2003), the court held that it may be appropriate to blend more than one of the methodologies in order to determine the fair market value for property tax purposes. In that particular case, the trial court blended the income and market sales approaches; but there is nothing to indicate that any of the three (or all three) methodologies could not be blended in some manner to arrive at a final determination of value.

Theoretically, if a property is valued under all three methodologies and each of those methodologies is applied correctly, the three value estimates should be similar (not necessarily identical, but similar). If there is an extreme variance in values, then it typically means that some methodology was not applied correctly or something was overlooked. Unfortunately, this can be the case more often than not when dealing with appraisal districts.

Because appraisal districts have to value hundreds or thousands of properties each year (depending on the size of the district), they often apply a mass appraisal approach just to get the work done. Though the appraisal district is required to appraise each property "based upon the individual characteristics that affect that property's market value," these individual characteristics often do not show up or are not considered until a value notice has been sent and a protest filed.

The value of property is typically determined as of January 1 of the tax year. Except in the case of special valuation property (such as agricultural land, timber land, etc.), property is appraised at its market value. Even with special valuation property, the market value must be determined in the event that a change of use occurs in the future and triggers a recapture (or rollback) of prior year taxes.

Market value is defined in Section 1.04(7) of the Tax Code as "the price at which a property would transfer for cash or its equivalent under prevailing market conditions if:

(A)exposed for sale in the open market with a reasonable time for the seller to find a purchaser;
(B)both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforceable restrictions on its use; and
(C)both the seller and purchaser seek to maximize their gains and neither is in a position to take advantage of the exigencies of the other."

In valuing property, it is important that an appraiser use and follow this definition. An appraiser should not determine the leased fee value of the property (essentially determining the value of the contract leases in place) or the investment potential of the property or the business value of the property or any other value that strays from the market value definition provided in the Tax Code.

In coming issues, we will summarize and examine the various approaches to property value determination. This article concerns the "market sales" approach.

In Section 23.013, the Tax Code refers to this methodology as the "market data comparison method of appraisal." It sometimes is also called the sales approach, the market approach, or the sales comparison approach.

The market sales approach estimates the value of a particular property by comparison to recent sales of similar properties. Section 23.013 of the Tax Code requires that, if the chief appraiser uses the market sales approach, she must use comparable sales data and adjust the comparable sales to the property being valued.

One problem with the market sales approach is whether there exist any truly comparable sales; another problem is whether there exist enough truly comparable sales to form an estimate for valuation. In the case of a specialized purpose property or in the case of a declining real estate market, there may be no sales or there may be only a single sale. Without an array of sales data, the market sales approach becomes more prone to error.

Another potential problem is determining the actual sale price of property. Often, the price publicly reported for a property is inaccurate or misleading. Special financing considerations or special terms in the total sales transaction might result in the cash equivalency of the price being different from that quoted or even that shown on a closing statement. In some cases, what is publicly reported as a sale might not even be a sale at all, but some creative financing plan. If the sale price and all terms of the sale cannot be accurately determined, then the sale becomes suspect as a unit of comparison.

However, the most difficult issue with the market sales approach is determining the appropriate adjustments that must be made to each sales comparison. Unless there is an identical property located across the street or next door to the subject property that recently sold, adjustments must be made to the sales price. Even with the identical property, there might be some necessary adjustment (such as the sale of a fully leased office building versus a subject property that is half leased).

Adjustments to a sale price can be made based on location of the property, size of the property, condition of the property, age of the property, available uses of the property, zoning, available uses, time of the sale, etc. However, the more adjustments that have to be made to a sale, the less likely that the sale is truly comparable.

Once a determination is made as to what to adjust for, then a decision has to be made as to what actual adjustment to make. Such adjustments might have some objective basis (such as size), but more often than not are subjective. Therefore, it is not unusual to see two different appraisers valuing the same property and adjusting for the same factors, but allowing different rates of adjustment. In some cases, the appraisers might even disagree if the appropriate adjustment for a factor should be up or down.

Typically, in using the market sales approach, an appraiser will create an array of the comparable sale prices and adjust each price up or down for each unit of adjustment. So, if a sold property's location is considered better than the subject property, then the sale price will be adjusted downward to better reflect a comparison with the subject. Conversely, if a sold property's condition is considered worse than the subject property, then the sale price will be adjusted upward to reflect the comparison.

An upward adjustment means the subject property is considered better than the sale property for that unit of comparison. A downward adjustment means the subject property is considered worse than the sale property for that unit of comparison. The up-down adjustment is based on the assumption that if the subject property is better for a unit of adjustment, then a buyer would pay more for the subject than for the comparable, and vice versa.

After all adjustments have been made, the appraiser should come up with a relatively narrow range of adjusted values. This range would then reflect the general market value of the subject property under the market sales approach. If the range is too wide, then it becomes more likely that the sales data does not reflect comparable market sales or the adjustments have not been applied correctly or uniformly.

While it is better to have a narrow range of adjusted values, one must take care that the comparables are not being adjusted in order to force the properties into the range; i.e., appraising to a value versus appraising the property itself.

The market sales approach is most appropriate in valuing real estate in an active market. In such a market, there should be enough sales of comparable properties to select an appropriate array of sales not requiring significant adjustments. As market activity decreases, the approach will become more and more inaccurate, because of fewer sales and thus fewer available comparables.

Typically, personal property is not valued using the market sales approach except in a complete appraisal by a qualified appraiser. The reason for this is purely a matter of efficiency. Very seldom does a property owner, tax consultant, or appraisal district employee have the time to determine comparable sales and appropriate adjustments for each piece of furniture or equipment or other item of personal property located at a business.

In effect, the market sales approach is also the value methodology used in an equalization analysis of a property. Section 42.26 of the Tax Code provides that a property is appraised unequally if "the appraised value of the property exceeds the median appraised value of a reasonable number of comparable properties appropriately adjusted." The median appraised value is the value that is in the middle of an array of adjusted properties when the properties are ordered from lowest value to highest value.

The methodology in an equalization analysis is essentially the same as under the market sales approach with a few major differences.

First, the equalization analysis does not use sales to determine its array of comparables. Instead, the certified appraised value as determined by the appraisal district is effectively considered to be the sale price as of January 1 of the tax year in issue. In other words, the equalization analysis begins with an assumption that the appraisal district properly and correctly determined the market value of the comparable properties. How those values were determined is unimportant.

Second, there may be fewer adjustments to consider. Because the appraised value is considered the sale price, no adjustments need be made regarding any special financing terms or regarding the timing of the sale. The appraised value is considered the cash price as of January 1.

However, it is still necessary to determine an adequate number of proper comparable properties, proper units of comparison, and make adjustments based on those units of comparison. And, this is where the equalization analysis sometimes runs into trouble. If there are not an adequate number of comparable properties appraised by the appraisal district, then it may be impossible to determine an equalized value. If the property is the sole property of its type (for example, the only shopping mall) located in the county, then it is difficult to say that the property is appraised unequally.

If you have any questions about the contents of this article, please contact the GPD Property Tax Section at propertytax@gpd.com.