The Direct Comparison Approach
The direct comparison approach in determining the market value of a property is the most appropriate for mortgage financing and is therefore relied heavily upon in the appraisal report. This method uses the principle of substitution as its basis. The concept is that if an appraiser knows the price that was paid for a comparable property (an appraisal typically uses three comparables) that is similar to the subject property and has recently sold in the same neighbourhood as the subject property, the subject property should have a market value equal to that comparable property.
The direct comparison approach would be simple if not for the fact that properties are heterogeneous or unique. While two houses may be located next to each other on the same street each will have differences, from its size to such characteristics as a finished basement, the number of bedrooms and washrooms, the type of heating, appliances, and so on.
Because of these differences, the appraiser must make adjustments to the sales price of the comparable property. The following example illustrates this point.
A 2 bedroom, 2 storey home was recently sold for $400,000. An appraiser is being asked to appraise the house next to it for mortgage financing. The homeowner feels that, as the property next door sold for $400,000, his home should be worth more since he has a larger back yard. The appraiser, while using the recently sold house next door as a comparable property, must also use two other properties that are similar to the subject and have recently sold.
In this case the appraiser will determine the characteristics of the comparable property and compare them to the subject property and adjust the value of the comparable property to make it more like the subject property. Once this has been completed the adjusted value of the comparable property should be approximately equal to the market value of the subject property. The following chart provides an example as to how this calculation is completed. In the left column are the characteristics of the properties. In the column to the right is the description of the subject property. The far column describes the comparable property and lists the adjustments to the value necessary to make the comparable property more like the subject property.
- If the comparable characteristic is superior to the subject, subtract from the comparable property’s value
- If the comparable characteristic is inferior to the subject, add to the comparable property’s value
Note that to compare characteristics the appraiser must obtain information from several sources on both the subject and comparable properties.
In calculating the adjusted value the appraiser will add the total adjustments and either add or subtract them from the sale price of the comparable property. In this example the adjustments equal -$15,000 ($5,000 – $20,000 + $5,000 – $5,000) and that amount is therefore subtracted from the sale price of $400,000, resulting in an adjusted value of $385,000.
Mortgage brokering in Ontario is regulated by the Financial Services Commission of Ontario (FSCO) and requires a license. To obtain a license you must first pass an accredited course. The Real Estate and Mortgage Institute of Canada Inc. (REMIC) is accredited by FSCO to provide the course. For more information please visit us at www.remic.ca/getlicensed or call us at 877-447-3642.
Therefore, based on this simplified example, the direct comparsion approach for the market value of the subject property should be $385,000.
In an actual appraisal, the appraiser will use three comparable properties and will either average the adjusted values or rely more heavily on the most similar property to determine the market value.