Tennessee Realtor State Practice Exam

On which principle of value is the sales comparison approach based?

1. Cost

2. Investment

3. Substitution

4. Income

The correct answer is: Substitution

The sales comparison approach is fundamentally based on the principle of substitution. This principle asserts that a buyer will not pay more for a property than the cost of acquiring a comparable substitute property. In practice, this means that when determining the value of a property, appraisers look at recent sales of similar properties in the same area to estimate its value. By analyzing what buyers have paid for similar properties, they can establish a reasonable market value for the property in question, assuming all else is equal. The rationale behind the principle of substitution is straightforward: if two properties are similar in terms of features, location, and condition, a buyer will choose the less expensive option. This perspective helps ensure that pricing remains aligned with market conditions, which reflects buyer behavior and market dynamics. Other principles, such as cost, investment, and income, focus on different aspects of property valuation. The cost approach relates to the expenditure required to replace or reproduce a property, while the investment principle looks at the potential returns that a property might generate over time. The income principle focuses on the income-producing capability of a property, particularly in commercial real estate scenarios. However, these principles do not directly form the basis of the sales comparison approach, which is strictly tied to the principle of substitution.