Certified Residential Appraiser Practice Exam

Which approach relies on the principle of substitution?

1. Market Approach

2. Cost and Sales Approach

3. Income Approach

4. Comparative Approach

The correct answer is: Cost and Sales Approach

The correct choice is the Cost and Sales Approach, as it fundamentally relies on the principle of substitution. This principle asserts that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute property, which is particularly relevant in real estate appraisal. In the context of the Cost and Sales Approach, appraisers assess the cost of constructing a similar property, taking into account both direct construction costs and indirect expenses. The idea is to provide an estimate of value based on what it would cost to create a similar asset in the current market, thus reflecting the value a buyer would assign to a property that can be replaced by similar means. Although the Market Approach and the Comparative Approach are often grouped together and focus on analyzing the sale prices of comparable properties to derive value, they don’t operate on the same principle of substitution as strongly as the Cost and Sales Approach. The Income Approach, on the other hand, bases its valuations on the income-producing potential of a property, rather than substitution. The Cost and Sales Approach uniquely emphasizes what it would cost to create a similar property, making it a direct application of the substitution principle in the context of real estate valuation.