Appraisal Methodology: Market Approach, Income Approach, Cost Approach

a man with the appraisal

Overview

Compliance with the Uniform Standards of Professional Appraisal Practice, industry best practices, and common sense dictate that any machinery and equipment appraisal should consider the three fundamental approaches to value: the market approach, the income approach, and the cost approach. These valuation methodologies are explained here.

Market Approach

The Market, or Sales Comparison, approach indicates value by analyzing recent sales and auction results, or offering/listing prices, of properties that are similar, or comparable, to the subject property. If the comparable assets are not exactly like the subject asset, such as by having 6,000 more hours for an excavator, or by being 5 years older than the subject truck, the selling prices of the comparables are adjusted to equate them to the characteristics of the subject asset. The methodology is to analyze actual sales and actual auction results and sales listings/offerings of similar assets, determine their relative comparability to the subject asset, adjust the data to make them equivalent/comparable, then tabulate the results. 

Professional Appraisal Services

The used equipment market consists of used machinery dealers and brokers, auctions, and website machinery sales websites where equipment is purchased and sold. The Market Approach, or sales comparison approach, is most reliable when there is an active market providing a sufficiently large number of sales and listings data points that can be verified using reliable sources. Examples of assets generally having such markets are cars, trucks, construction equipment, corporate aircraft, and forklifts. The subject active market should demonstrate real fair market value, and arms-length free market transactions rather than contrived sales made by suspicious parties. 

In the example active construction market, consider a subject asset: a 2018 Caterpillar 320 crawler excavator with 8,000 hours, being purchased for $175,000. You find a comparable asset: a 2018 Caterpillar 320 excavator with 12,000 hours, offering a price of $150,000. Your analysis of many comparable Caterpillar 320 sales leads you to conclude that an additional hour of use decreases the value of a Caterpillar 320 by $5. So you increase/adjust the comparable price by $20,000 to account for hours, leading to an adjusted price of $170,000 for this comp. 

Certain assets lend themselves to easy examination by the Market Approach. Construction comparable sales, auction results, and Certified Equipment Appraiser are easily available at rockanddirt.com, machinerytrader.com, and other resources. Other assets are more difficult to ascertain comparable market sales for – this includes obscure medical equipment, for example. For these, you can consult with a specialized equipment broker who buys and sells these all the time to get comparable sales and listing results.

Income Approach

The value of an asset can be estimated by calculating the expected future financial benefit to the equipment owner. The difficulty in the Income Approach is that it is often difficult to attribute income that is directly related to the asset being valued, and the fact that income forecasting is often not reliable. Investment decisions, such as the purchase of an asset, are generally based on the expected return to the investor which will be generated by the asset. Before making such an investment, the investor must understand the future benefits of purchasing the asset. Since the benefits will generally occur over time, the investors decision will be based on the present value of the future economic benefits. 

The Income Approach is often used not only when income can be associated with an asset, but when the Market Approach is difficult or problematic. 

A good example of assets that are typically and most efficiently valued by the Income Approach is solar project valuation. Solar farms are generally valued by taking the present value of ten years of power that is expected to be produced by the solar facility. 

Cost Approach

In the Cost Approach, the appraiser adjusts the replacement cost (new) of the asset being appraised for the loss in value due to physical deterioration, functional obsolescence, and economic obsolescence. The cost approach is based on the principle of substitution: a prudent buyer will not pay more for an asset than the cost of acquiring a substitute property of an equivalent utility. 

The three forms of depreciation are present to a greater or lesser extent depending on the asset type:

Physical deterioration is a form of depreciation where the loss in value or usefulness of a property is due to the using up or expiration of its useful life caused by wear and tear, deterioration, exposure to various elements, physical stresses, and similar factors. 

Functional obsolescence is a form of depreciation in which the loss in value or usefulness of a property is caused by inefficiencies or inadequacies of the property itself when compared to a more efficient or less costly replacement property that new technology has developed. Symptoms suggesting the presence of functional obsolescence are excess operating cost, excess construction (excess capital cost), over-capacity, inadequacy, lack of utility, or similar conditions.

Economic obsolescence (sometimes called “external obsolescence”) is a form of depreciation where the loss in value of a property is caused by factors external to the property. These may include such things as the economics of the industry; availability of financing; loss of material and/or labor sources; passage of new legislation; changes in ordinances; increased cost of raw materials, labor, or utilities (without an offsetting increase in product price); reduced demand for the product; increased competition; inflation or high-interest rates; or similar factors.

Analysis by the Cost Approach requires estimation of the forms of depreciation, and fundamentally on the estimation of the useful life of the asset and salvage value of the asset. The Cost Approach is often used, even resorted to, when market comps are not available and the Income Approach is not practical. 

Conclusion

Chris Nugent is an Accredited Senior Appraiser of the American Society of Appraisers. He holds a BA in Statistics from the University of California, Berkeley, and an MBA from Santa Clara University.BlueChip Asset Management is an appraisal and asset management services company that serves the ABL, banking, equipment finance, legal, and turnaround industries. Members of TMA, and CFA. Contact us for asset valuation assistance at 415-515-1110, www.bcamasset.com, or schedule a free 15-minute consultation.

The competent appraiser will always consider the Market Approach, the Income Approach, and the Cost Approach in any appraisal engagement. Often the Market Approach is sufficient for the determination of value, but it is often the best approach to use a combination of the three approaches to value for the best result.