Cost, market or income: The three approaches to true cash value
How is your property’s true cash value determined by your local government?
What is your home’s true cash value? Does it change every year? How is it calculated? These are important questions that every Michigan property owner should understand. Since 1893, the General Property Tax Act has been the basis for assessment administration in the state of Michigan. One of its requirements is the calculation of every property’s true cash value on an annual basis by a local certified assessing officer. In order to determine the true cash value of each parcel of property each year, the assessor employs the traditional three approaches to value. These are cost, market/sales comparison and income. While each approach has its own unique characteristics, their common task is to determine a property’s true cash value. According to Michigan’s General Property Tax Act (MCL 211.27), true cash value is defined as "the usual selling price at the place where the property to which the term is applied is at the time of the assessment.” The ultimate goal of the three approaches to value is to utilize the most appropriate approach for the specific property to arrive at its most accurate true cash value or usual selling price on an annual basis.
The cost approach to value is defined by the International Association of Assessing Officers (IAAO) as an indication of property value that is “the sum of the estimated land value and the estimated depreciated cost of the buildings and other improvements". While appearing simple on the surface, the exact methodology for calculating a cost approach value is somewhat complex. An assessor must first determine land values for a property that will include a review of all available vacant land sales data. The assessor must also consult the sale ratio studies prepared by their local unit and the county equalization department to determine how far away the current values are from the required 50 percent standard. This will determine the amount of change necessary to conform to local market conditions. Economic condition factors (ECF) are also calculated to adjust the construction costs of buildings to the local market. All of these principals are detailed in depth in the volumes of the Michigan Assessor's Training Manual, the Michigan Assessor's Manual, the standards of the International Association of Assessing Officers (IAAO) and the many instructional bulletins from the Michigan State Tax Commission.
IAAO describes the sales comparison approach as, "the sales comparison approach uses the market to estimate value by comparing the subject to similar properties that have recently sold ... and … similarities and differences that affect value ... must be considered when making adjustments to the sale prices of the comparable properties." The sales comparison approach is also commonly used by appraisers and real estate professionals in arriving at their own opinion of value. Just as with the cost approach, volumes of assessing material and state directives offer local assessors guidance and assistance in determining property values while comparing sales.
The final and third approach to value is that of income. This approach is somewhat specialized from the other two and has been defined by IAAO as, “ the capitalization process or the income approach, restates market value by converting the future benefits of property ownership into an expression of present worth. … Capitalization is the process of converting a series of anticipated future payments (income) into present value. Capitalization transforms net operating income produced by a property into the property value.” The income approach uses the basic formula that value is equal to income divided by a cap rate. This approach can become somewhat complicated with each part of the mathematical equation being subject to a multitude of formulas. Adequate knowledge in this approach to value can be years in the making. Additionally, semester long college courses are available solely in the income approach to value.
In short, the calculation of a property’s value for assessment and tax purposes can be a complex and technical field. While each of the three approaches utilize different techniques, the goal to determine true cash value is the same. Depending upon the nature of the subject property, one method may be given more weight than the others. This value calculation is the first step in the property tax system and determination of local governmental revenue. This statutorily defined process is very important in analyzing local property taxes. Thereby making the need for an informed citizenry on local property tax revenue of even greater importance.