In a perfect world estimating the value of a property would be extremely easy. You would find similar comparable properties that have sold recently from your property’s immediate area and they would show you exactly what the value of your property should be.
But in the real world, this almost never happens.
In a previous post, we talked about the importance of calculating your market statistics and determining your time adjustments. Here we will cover the next step in the process to determine a property’s value.
You have to make adjustments to the comparables you use.
In this post, we are going to show you the way the average agent approaches property adjustments, and show you a smarter way to do it. We are also going to show you how to apply your adjustments to comparable properties and make sure they are valid.
There are three common ways the average agent approaches property adjustments for comparables.
Let’s see if you’re guilty of using any of these methods…
#1: Completely ignore them
#2: Use price per square foot
#3: Use a simple “rule of thumb”
Obviously, method #1 isn’t a good plan. In the case of real estate value, ignorance certainly isn’t bliss.
Method #2 seems reasonable at first glance but when actually applied can be extremely inaccurate.
Let’s say you have a comp that’s 2,000 sq ft and it sold for $400,000. That would be a price per square foot of $200, right?
If your property is 2,400 sq ft, using this method you would assume that it would be worth $480,000.
The problem is that many times this difference in square footage won’t be worth anywhere near that amount.
There could be a number of reasons.
Maybe both homes offer the same amount of rooms, and sometimes a smaller home with a better floor plan can even seem larger. In that case, a buyer may not even realize it’s larger, and therefore they would be unlikely to pay significantly more for it.
Also, the price per square foot when calculated by dividing the total square footage by the sale price factors the value of all the amenities of the home; including the kitchen, bathrooms, mechanicals, land, etc. into the price. But adding additional square footage, especially if it’s not a large amount of square footage, is unlikely to add any of those other features of the home, right?
Sure, using price per square foot can work if your comparables are all nearly identical homes in the same area on very similar lots. But obviously, those types of comps are hard to find in most scenarios.
Now that we know methods #1 and #2 are no good, how about method #3?
Using a rule of thumb method is not a bad plan. In fact, we recommend using a “rule of thumb” type approach as a part of your process (more on this below).
The problem with method #3 for most agents is that they have been using the same rule of thumb values for years. And in all price ranges, quality levels, and locations of homes (or at least they make very insignificant changes between properties).
Many times they were given that rule of thumb by their mentor or by an appraiser years ago. It may have been accurate on that specific property or at that specific time. However over time, and as the properties change, the rule has most likely become less and less accurate.
Let’s say you are using $35 per square foot as your rule of thumb for gross living area and $5,000 per garage stall.
And you’ve been using those values for the last decade.
What has the median home price done over that same time frame?
Probably increased, a lot, right?
Even if the value hasn’t increased much in your area, would it make sense to use these same adjustments on a $200,000 starter home and a $2,000,000 custom home?
But that’s what so many agents do.
And the reason for this is that they don’t have a great way to verify that these adjustments aren’t valid anymore, or valid on a specific property.
So now that we’ve covered the flaws of the three most common methods, what’s next?
How should you calculate adjustments?
The goal of estimating property value is to try to think the way a typical buyer would think and try to determine what they would be willing to pay.
Now, over time you will get better and better at doing this instinctively, but even after you’ve been in the game for years, it can still be extremely difficult at times.
To make things harder, if the property needs an appraisal, the lender doesn’t care what you think the typical buyer in the market will do. They only care what can be proven that the typical buyer has done in the past.
Since we can’t fully get into the minds of every buyer in the market, the only thing that we can do is examine past sales and try to figure out why they sold for the prices that they sold for.
We do this by breaking down the market data and calculating property adjustments from it.
Remember how up above we said that we recommend using a rule of thumb type method as part of our process?
Well, here is our full process…
We recommend using a statistical analysis technique called hedonic regression analysis to break down the market data and calculate your adjustments.
Hedonic regression analysis is a lot like the way the brain works. To use it we break a property down into a number of different elements and then assign a contributory value to each element.
This is where the rule of thumb comes into play…
Using hedonic regression we are going to calculate our starting adjustments, aka rules of thumb, that we will apply to our comparables (more on this below).
First, we need to calculate a median price per square foot for the market.
Wait a minute… didn’t we say above that using price per square foot was not a good method?
You’re right, we did say that.
Remember, the reason for that was because using the price per square foot overestimates the value of additional square footage due to all the other factors of a property that add value, in addition to the square footage.
In our method, we have to find the median price per square foot, so that we can break it down into a number of categories to assign the appropriate value to each.
Here’s how you calculate it:
Take the median sold price for your market data and divide it by the median square footage of a home in the market data.
For example, if the median sold price of a home in your market is $425,000 and the median square footage is 2,500 sq ft, you have a median price per square foot of $170.
The reason we use the median is that we are trying to find the most supportable price per square foot that a buyer in the market was willing to pay. Using a single property to calculate the price per square foot can result in an outlier, on either the high or the low end, if that property is not representative of the market or that transaction was not representative of the typical buyer in the market.
Now that we have that calculated, set it aside for a few minutes, we will come back to it.
Next, we need to break our entire property down into its main elements.
We use the following six categories:
We are going to assign a percentage to each of these, with the total of all categories being equal to 100%.
Let’s talk about how to figure out these numbers…
Land
We recommend you start with the allocation method based on the county assessor. While many times the county assessor is not very accurate or up to date as to what the lot is worth, many times they are very accurate as to the percentage of value it contributes to the property as a whole.
So take the land value listed by the county (for example $100,000) and divide it by the total value of the property listed by the county (for example $500,000). It’s important to make sure you use the total value of the property as the denominator, not just the value of the improvements. In this case, the land would show an allocation of 20%.
Depending on your county assessor, you may have to add the improvements and lot values together if they don’t list the estimated total value so that you can complete the calculation.
Typically the land value will not be over 30% of the total value of a property.
In our local market we have found the following to be the case majority of the time when examining the county assessor allocations:
Take a look at the allocation used in your area and see what the assessor has. Most likely you will find a pattern where they use a similar percentage for properties of a similar type. Yours may be higher or lower than what is used by the assessor in our area, but you will most likely be able to find a trend.
You can also look back through prior sales to see if you can find the value a lot sold for before the home was built, and then find the value the entire property sold for after the home was built, and use those numbers to calculate the land allocation.
This can sometimes be hard in residential neighborhoods as the land may have sold long before the initial construction or may have sold as a multi-lot package from the developer. In this case, use a percentage similar to what we use in our area and then adjust from there.
Unfinished Basement/Foundation
We recommend you start somewhere between 5% to 10%. Generally, we start at about 8% and tweak it from there.
You can also use a cost service such as Marshall & Swift to see what dollar value they list for basement foundation per square foot.
If you do this you would then want to compare it to their price for finished basement, and above grade square footage. This would allow you to determine what percentage would result in a similar comparison to the finished basement and above grade square footage you calculate below (Gross Living Area).
While it may seem counterintuitive, sometimes you may use a similar or even a larger percentage for this category when you only have a slab or crawl space foundation than you use when you have a basement.
The reason for this is that when you have a basement you also many times have finished square footage. So the amount of value that is contributed to the property by the slab or crawl space may be similar, or more, than the amount that is contributed by a basement if it is unfinished.
This also varies in different locations, as in some areas it may be very popular to have an unfinished basement, while in others it is much more popular to have a house on a slab or crawl space (for example in an area with a lot of retirees as they may not want the basement).
Gross Living Area
Gross living area is the same as above grade square footage, just a different way to say it. It is all square footage that is fully above the ground (and in some areas may include square footage that is partially below ground in the case of a multi-level design home such as a tri-level or 4-level).
We recommend starting somewhere between 25% and 35%.
As mentioned above you can also use a cost service to determine their price per square foot of cost for above grade living area, and then use that number to calculate a percentage to use here.
You can also use a paired sale analysis where you find two very similar homes, that are from a similar location and time of sale, and have similar overall finishes, but are different in square footage, and then use that to calculate the contributory value.
Here’s an example…
Let’s say home #1 is 2,000 square feet and sold for $400,000 and home #2 is 2,500 square feet and sold for $425,000. Both homes are in the same neighborhood, on similar size lots, and have similar finishes and updates.
In this case, we can take the $25,000 difference in price ($425,000 – $400,000) and divide it by the 500 square foot difference in size (2,500 sq ft – 2,000 sq ft) to find the approximate contributory value of the square footage. In this case, it would be $50 per square foot.
You can then take the $50 and divide it by the market median price per square foot we calculated above to determine the contributory percentage. In this case $50/$170 = 29%.
Finished Basement
We recommend starting out somewhere in the 10% to 15% range and tweaking from there.
You can also use the same methods mentioned above in the gross living area section (cost service or paired sale analysis).
If your property, and all of your comparables, have unfinished basements, or no basements at all, you will want to set this category to 0%.
Garage
The methods for calculating the contributory value of a garage are the same as the methods mentioned above for gross living area and basement.
We generally start somewhere in the range of 15% to 20%.
The more common a garage is in an area, the lower the percentage will most likely be. In areas where a garage is uncommon, the contributory percentage of a garage may be much higher.
For example, in a neighborhood where most homes don’t have a garage, you may find that you need a 25% contributory value for garages to give a large enough adjustment to support and explain the increased sale price of a property that had a garage.
Miscellaneous
Miscellaneous value is made up of all the extras or upgrades found in a home.
Things like central air conditioning, fireplaces, hardwood flooring, tile flooring, granite countertops, stainless steel appliances, porches, patios, decking, stucco exterior, walkout basements, tile roofs, and any other amenities or upgrades found in the market would be included in this category.
We recommend starting somewhere in the 5% to 15% range. We generally start at 10% on most properties and tweak from there.
As the value of the homes increase, the percentage associated with the amenities may or may not increase, even though the number of amenities themselves most likely will.
It is because a 10% contributory percentage for miscellaneous amenities of a $200,000 home means that $20,000 of value is from its amenities, whereas a 10% contributory percentage from an $800,000 home means that $80,000 of value comes from the amenities.
In fact, in some cases, as a home gets more expensive the percentage contributed by the amenities may actually get smaller. Not all homes that cost more have significantly more amenities.
You will then want to break the amenities down a bit further. We recommend doing the two following things:
First, determine what percentage of the total amenities are from interior amenities, and what percent are from exterior amenities.
Next, calculate the contributory percentage from individual amenities. The formula for this would be =(((median price per square foot x miscellaneous contributory %) x percentage of exterior/interior amenities) x median square footage) x individual amenity percentage.
Here is an example: If you are giving 10% of the total $170 per square foot to miscellaneous amenities, with 50% being contributed by interior amenities, and the central air representing 15% of the total interior amenities, with a median market square footage of 2,650 sq ft you would have the following calculation (($170 x 10%) x 50%) x 2650) x 15%) = $3,400.
Tip: You can build out a sheet in excel that can automate this process for you, or use a tool like Comp Adjuster to make this process extremely easy.
How can you determine the percentage of contribution for each comparable?
Much like the other percentages discussed above, you can use a paired sale analysis to isolate an adjustment from the market. For example, if you are able to use a paired sale in the neighborhood to determine that the Central A/C adjustment should be $3,400, you could then reverse engineer it to figure out that you need to use 15% as your percentage.
Similarly, you can use a cost service, or new construction home option pricing, to have a good starting point. Remember the goal is not to find the exact number at this point, the goal is to have a good starting point that we can test when we apply it to the comparables.
Even though cost does not always equal value, many times it can be a good starting point to work from.
As we said above, hedonic regression is designed to work the same way your brain works. If you know that central air contributes 15% of the value of interior amenities, then you can compare other features to decide if they would contribute more or less.
Maybe a fireplace is felt to offer similar value, a wet bar slightly more, granite countertops a lot more, and tile flooring a little less. You could then choose percentages that would correlate with these comparisons.
Once you have calculated all of your adjustments it is time to apply them to your comparables.
This is the most important part of the process because this is where we find out if the adjustments are valid or not.
The more you do this, the more confident you will become in the starting numbers you calculated. But at first, you will most likely have to go back and tweak the numbers a few times.
Here’s how it works…
You are going to apply the adjustments you calculated to each comparable. As you do this the goal is to see the adjusted sales price range of your comparables get tighter.
What does that mean?
When you pick your comparables, before making any adjustments, you will have a range of sold prices. This is your unadjusted price range. Let’s say you have four comparables that sold for $405,000, $425,000, $415,000 and $435,000. Your unadjusted price range is from $405,000 to $435,000, or a $30,000 price range.
As you make the adjustments to each comparable, you would then have an adjusted price for that comparable. If comp #1 started at $405,000 but adjusted up $10,000 due to being smaller, your adjusted price would now be $415,000. If none of the other comparables required an adjustment, your adjusted price would now be $415,000 to $435,000, which means your range just got tighter by $10,000.
This is just an example, as is it unlikely for multiple comps to not require any adjustments, but hopefully that helps explain the idea of the price range.
Typically each comp will require a number of adjustments.
We want to start off by applying all the adjustments we calculated above.
We recommend using an appraisal grid as an example of the adjustment categories.
Start off by applying your time adjustments. If you haven’t read our post on calculating time adjustments yet, you can read it here.
Time adjustments should be applied from the contract date of the comparable property until the valuation date of the subject property (this is most likely just the current date unless you are trying to forecast the value of a home that will be listed in the near future or the past).
So if your calculated time adjustment is 10% and your comparable sold 3 months ago, it would receive approximately a 2.5% of sale price adjustment. This means that a home that sold for $425,000 three months ago would most likely have sold for $435,600 if it sold at the time of the calculation.
Next, you will work your way through the categories applying adjustments for things like site size (land), gross living area, unfinished basement, and finished basement square footage.
You can then also apply adjustments for amenities (specifically things like fireplaces, central air conditioning, porches/patio/decks, stucco exterior, upgraded roofing, etc).
Once you’ve made all of the adjustments that were calculated through your contributory percentages, the remaining adjustments that may be needed include quality, condition, location, and view.
Each of these adjustments is a bit more subjective and will be driven by the comparable properties you were examining.
Ideally, you want to make sure you have at least one comparable that is similar to your property in each of these categories, and other comparables that bracket these features if possible. This allows you to make adjustments to the other properties to help bring them more closely in line with the property that is similar.
For example, if comparable number one is of similar quality but inferior in condition whereas comparable number two is similar in quality and similar in condition we can make an adjustment for the difference between the two properties as this would bring them in line with each other, and this would show us a provable adjustment for condition.
The same can be done with view and location.
As a rule of thumb in our area, we start out with a 1% of sale price adjustment for view and location per “factor”. A Factor can be either positive or negative.
Positive factors include things such as golf courses, open space, mountains, lakes, etc. Negative factors include things such as busy roads, commercial buildings, power lines, etc.
So if one comparable back to a golf course and a lake we would consider those two positive factors that are superior to a subject property that backs to other homes.
The same is true with a view. If one comparable has a mountain view it would receive a 1% adjustment as compared to a subject property that does not have a good view.
What about condition and quality?
We generally start out with a 5% or 10% adjustment for differences in condition levels. For example, if our subject property has been well taken care of but does not feature many updates we would consider it to be in average condition.
If a comparable has been updated significantly we would consider it to be in good condition. In this case, we would start out with a 5% negative adjustment for that comparable to bring it down in value as it is superior to our property.
Once we have made this adjustment to this comparable, as well as condition adjustments to other comparables, we would see if those adjustments appear to be large enough, or perhaps too large. We could then tweak it from there to potentially bump up to a 10% adjustment, or drop down to a 2.5% adjustment, depending upon what the data shows us.
The same is true for quality. We generally start with a 2.5% to 5% adjustment for different levels of quality. A comp that is good overall quality would most likely require a negative adjustment in comparison to a subject property that is average overall quality.
The key here is to be consistent within the valuation itself. It doesn’t really matter what quality level or condition level you call your property and your comparables. As long as you are consistent and apply adjustments consistently, you will be ok.
Over time you will have an easier and easier time with these more subjective adjustments.
In the meantime, only make adjustments you are comfortable with. The more fully you can adjust your comparables, the more likely you will be able to tighten your adjusted sales price range, and calculate a more accurate opinion of value.
If you are having a hard time adjusting a specific item, try to put what seems like a reasonable adjustment and go from there. If it increases the adjusted price range, it is proof that the adjustment is not needed or is too large.
Assuming some of your comps require adjustments for an item, while others don’t, even if your adjustment is slightly too large or too small, the range of comps will help to smooth out the impact of the adjustment.
In this post, we talked about the shortfalls of the way the average agent approaches adjusting comparable properties. We broke down our method for you as to how to use statistical analysis to determine and support adjustments. We also showed you how to apply the adjustments and verify that they are valid.
If you want an easy way to calculate these adjustments, check out our Comp Adjuster tool. We offer a free trial on it so you can try it risk-free and see just how easy it can be to calculate adjustments and apply them to your comparables.
In our next post, we are going to cover the best way to calculate your property’s value from all of your adjusted comparables.
See you in the next post!
