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Real Estate Valuation Approaches for CFA Level III

Updated 8 October 2026 · Fact-checked

Real estate valuation approaches estimate a property's value in three ways: the income approach (direct capitalization or discounted cash flow), the sales comparison approach (adjusted prices of similar sold properties), and the cost approach (land plus replacement cost less depreciation). You pick the method that fits the property and the data available.

Understand Real Estate Valuation Approaches

A property has no daily market price. So you estimate its value with an appraisal. There are three standard approaches, and each answers a different question.

The income approach asks what the property's cash flows are worth. It suits income-producing property such as offices, retail and apartments. It has two forms. Direct capitalization divides one year of net operating income (NOI) by a cap rate. Discounted cash flow (DCF) discounts several years of NOI plus a terminal (resale) value at a discount rate.

The sales comparison approach asks what buyers paid for similar properties. You take recent sales, adjust each price for differences (size, location, condition, date of sale), and read off a value. It works best when there are many recent, similar transactions. It is weak in thin or fast-changing markets.

The cost approach asks what it would cost to rebuild. Value = land value + replacement cost of the building − accumulated depreciation (physical, functional and external obsolescence). It suits new, special-purpose or rarely traded property, such as a hospital or school, where income and comparables are scarce. It can mislead for older buildings because depreciation is hard to estimate.

In practice, appraisers often use more than one approach and reconcile the results. In the exam, link the choice of method to the property type and the data given. Type the number on its own if only a calculation is asked for.

Key rules to remember

Direct capitalization value
Value = NOI₁ ÷ Cap rate
Use forward (next-year) NOI if the cap rate is defined that way. Read the question to see which NOI is given.
Cap rate from a discount rate
Cap rate = Discount rate − Growth rate (constant growth in NOI)
Holds for a perpetual, constant growth in NOI. A higher growth rate lowers the cap rate and raises value.
Cap rate from market evidence
Cap rate = NOI ÷ Sale price
Taken from comparable sold properties with similar risk, then applied to the subject property.
Net operating income
NOI = Potential gross income − Vacancy and collection loss + Other income − Operating expenses
NOI is before debt service, income taxes, depreciation and capital expenditures.
DCF value
Value = Σ [NOIₜ ÷ (1 + r)ᵗ] + Terminal value ÷ (1 + r)ⁿ
Terminal value is often NOIₙ₊₁ ÷ terminal cap rate, less selling costs if stated.
Cost approach value
Value = Land value + (Replacement cost new − Accumulated depreciation)
Depreciation covers physical deterioration, functional obsolescence and external obsolescence.

How to solve Real Estate Valuation Approaches questions

Use this order for any valuation question, whether it is a calculation or a choice of method.

  1. 1Identify the property type and the data given: income figures, comparable sales, or construction costs.
  2. 2Choose the approach that fits the data and the property. Income-producing property points to income; many similar recent sales point to sales comparison; new or special-purpose property points to cost.
  3. 3For the income approach, build NOI first. Subtract vacancy and operating expenses. Exclude debt service, taxes, depreciation and capital expenditures.
  4. 4For direct capitalization, divide the right year's NOI by the cap rate. For DCF, discount each NOI and the terminal value at the stated rate.
  5. 5For sales comparison, adjust each comparable toward the subject. Adjust the comparable, not the subject, and apply the adjustments in the correct direction.
  6. 6For the cost approach, add land to the depreciated replacement cost.
  7. 7Check the answer for reasonableness and state the result with units and currency.
  8. 8If asked to justify, link the method to the property and name one limitation in a short sentence.

Quickest way: Match the method, then run one formula

When to use it: Use under time pressure on item sets and essays where the method is obvious from the data.

  1. Scan the vignette for the data type: NOI and cap rate means direct capitalization; a cash flow list means DCF; comparable sales means adjustments; construction cost means cost approach.
  2. Write the formula in one line before using numbers.
  3. For cap rates, remember value moves inversely to the cap rate.
  4. Type the number on its own in constructed response if no explanation is required. A correct number typed on its own earns full credit for a calculation.
  5. Do a quick sense check: does the value fall when the cap rate rises?

Common mistakes in Real Estate Valuation Approaches

  • Subtracting debt service or depreciation when calculating NOI

    Students confuse NOI with cash flow after financing or with accounting profit.

    Fix: NOI is before debt service, income taxes, depreciation and capital expenditures. Only operating expenses and vacancy come off.

  • Using the wrong year's NOI with the cap rate

    The vignette gives both current and next-year figures and students grab the first.

    Fix: Match NOI to the cap rate definition. If the cap rate is applied to forward NOI, use year-1 NOI.

  • Adjusting the subject property instead of the comparable

    The direction of the adjustment feels backwards.

    Fix: Adjust each comparable to look like the subject. If the comparable is better, adjust its price down.

  • Ignoring land value in the cost approach

    Students focus on the building cost and depreciation.

    Fix: Always add land value to the depreciated building cost. Land is not depreciated.

  • Choosing the cost approach for an ordinary income property in an active market

    Students think cost is the most objective method.

    Fix: Use cost mainly for new or special-purpose property. Income or sales comparison better reflects what investors pay for ordinary property.

  • Forgetting to discount the terminal value in DCF

    Students discount the annual NOIs and treat the resale value as already in present terms.

    Fix: Discount the terminal value by the same number of years as the final NOI.

Worked examples

Example 1

An office building has potential gross income of 2,000,000, vacancy and collection loss of 5% of potential gross income, and operating expenses of 600,000. The market cap rate for similar properties is 8%. Using direct capitalization on this NOI, estimate the value.

Show the solution
  1. Vacancy loss = 5% × 2,000,000 = 100,000.
  2. Effective gross income = 2,000,000 − 100,000 = 1,900,000.
  3. NOI = 1,900,000 − 600,000 = 1,300,000.
  4. Value = 1,300,000 ÷ 0.08 = 16,250,000.

Answer: The estimated value is 16,250,000.

Example 2

A property is expected to produce NOI of 100,000 in year 1 and 110,000 in year 2. At the end of year 2 it will be sold for 1,500,000. The investor's required discount rate is 10%. Estimate the value using DCF.

Show the solution
  1. PV of year-1 NOI = 100,000 ÷ 1.10 = 90,909.09.
  2. PV of year-2 NOI = 110,000 ÷ 1.10² = 110,000 ÷ 1.21 = 90,909.09.
  3. PV of sale price = 1,500,000 ÷ 1.21 = 1,239,669.42.
  4. Value = 90,909.09 + 90,909.09 + 1,239,669.42 = 1,421,487.60.

Answer: The DCF value is approximately 1,421,488.

Exam tips

  • Read the command word. 'Calculate' needs a number; 'justify' needs a reason tied to the property and data.
  • In essays, a correct number typed on its own earns full credit for a calculation, so type the number and move on.
  • Check which NOI year and which cap rate the question uses before dividing.
  • When asked to choose an approach, name the property type and the data availability in one sentence each.
  • Remember the direction: higher cap rate means lower value. For a given discount rate, higher growth means a lower cap rate and a higher value.

Real Estate Valuation Approaches in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Real Estate Valuation Approaches: frequently asked questions

What are the three real estate valuation approaches?

They are the income approach, the sales comparison approach and the cost approach. The income approach has two forms, direct capitalization and discounted cash flow. Appraisers often use more than one and reconcile the results.

When is the cost approach most appropriate?

It suits new or special-purpose property, or property that rarely trades, where income and comparable sales are scarce. It is less reliable for older buildings because accumulated depreciation is hard to estimate.

What is the difference between direct capitalization and DCF?

Direct capitalization converts one year of NOI into value using a cap rate. DCF values several years of NOI plus a terminal value by discounting at a required rate. DCF can handle uneven cash flows better.

How is a cap rate related to the discount rate?

With constant perpetual growth in NOI, the cap rate equals the discount rate minus the growth rate. So a higher growth expectation means a lower cap rate and a higher value.