How does the principle of substitution apply to the income approach?
Correct Answer
D) Value equals the cost of buying a comparable income stream
For the income approach, substitution means value can be estimated by the investment necessary to acquire, without undue delay, a substitute property offering a comparable income stream.
Why This Is the Correct Answer
Option D is correct because, under the income approach, substitution means value is estimated by the investment necessary to acquire, without undue delay, a substitute property offering a comparable income stream. An investor would not pay more than the cost of an equivalent income stream. This links substitution to capitalization of income.
Why the Other Options Are Wrong
Option A: Value equals the original cost of constructing the building
Option A is wrong because the original cost of constructing the building is a historical cost, not the investment needed to buy a comparable income stream today.
Option B: Value is the median of local sale prices for similar buildings
Option B is wrong because the median of local sale prices is a summary statistic of sales, not how substitution works in the income approach.
Option C: Value is the replacement cost of the improvements less depreciation
Option C is wrong because replacement cost less depreciation describes the cost approach, not the income approach application of substitution.
Buy the same income
An investor will not pay more than it costs to buy a comparable income stream elsewhere.
How to use: Use this when a question asks how substitution works in the income approach.
Exam Tip
Match each approach to its substitute: a similar sale, a similar building cost, or a similar income stream.
Common Mistakes to Avoid
- -Confusing the income approach with the cost approach
- -Using historical construction cost as a measure of value
- -Treating a simple median price as an income-based value
Concept Deep Dive
Analysis
This question tests how substitution applies within the income approach. Value can be estimated by the investment needed to acquire, without undue delay, a substitute property offering a comparable income stream. The other choices describe the cost approach, sales data or historical cost.
Background Knowledge
Substitution supports all three approaches: buying a comparable property in the sales comparison approach, building one in the cost approach, and buying an equivalent income stream in the income approach. Investors compare income-producing properties by the return they offer for the price paid.
Real-World Application
An investor considers buying a rented duplex. The appraiser compares it with other rental properties producing similar net income and risk, noting that the investor would not pay more than those alternatives cost.
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