The Cost Approach

1
The Cost Approach

• Real Estate 614
• Real Estate Appraisal
• Dr. Longhofer

2
The Cost Approach

• Begin by estimating the cost of any improvements
  on the land
• Reproduction cost is the cost to construct the
  building today, replicating it in exact detail
• Replacement cost is the cost required to
  construct a building of equal utility, using
  modern construction techniques, materials, and
  design
• Subtract from this the cost of any accrued
  physical, functional, or external depreciation
• Add in the value of the site as raw land to get
  the indicated value using the cost approach

3
Estimating Construction Costs

• Comparative-unit Method For relatively
  standardized structures, the size of the building
  is multiplied by the per-square foot cost of that
  type of construction
• Segregated-cost Method The costs of the
  individual components in the building are used to
  estimate the overall replacement cost
• Quantity-survey Method Identifies the exact
  materials required to reproduce the structure to
  estimate the cost
• Index Method Assumes that the replacement cost
  is simply the original construction cost times a
  cost index

4
Categories of Accrued Depreciation

• Physical deterioration is the result of wear and
  tear, weathering from the elements, vandalism and
  neglect
• Functional obsolescence refers to features,
  design, and other elements of the building that
  are not up to modern standards it also includes
  features in excess of what the market can support
  (superadequacies)
• External (economic) obsolescence refers to loss
  of value due to influences outside the property

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Estimating Accrued Depreciation

• Lump-sum age/life method
• Easy to apply
• Does not explicitly account for each particular
  type of depreciation (esp. econ. obsolescence)
• Breakdown method
• Complex and time consuming to apply
• Explicitly considers each type of depreciation
• Helps to avoid double counting

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Age/Life Method

• This method estimates depreciation as a lump sum
  based on assumed straight-line depreciation
• Economic life is estimated using rules of thumb
  based on past experience or published sources
• Effective age is usually used in place of actual
  age, but this varies

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Age/Life Method Example

• Reproduction cost new 245,000
• Total economic life 55 years
• Effective age 20 years
• accrued depreciation 20/55 36.4
• Accrued depreciation 89,180
• Depreciated value of improvements 155,820
• Land value 39,000
• Estimated market value 194,820

8
Modified Age/Life Method

• Sometimes the age/life method is modified by
  subtracting out curable physical and functional
  depreciation before calculating the lump sum
  depreciation of the rest
• The idea is that the owner will cure these
  problems because it adds more value than it costs

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Modified Age/Life Method Example

• Reproduction cost new 245,000
• Physical and functional depreciation, curable
  12,500
• Adjusted cost 232,500
• Total economic life 55 years
• Effective age 17 years
• accrued depreciation 17/55 30.9
• Accrued depreciation 71,843
• Depreciated value of improvements 160,657
• Land value 39,000
• Estimated market value 199,657

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Comments on Age/Life Method

• The general relationship between age and
  depreciation varies from market to market
• Use local patterns, not national ones
• Although this method assumes straight line
  depreciation, this is not typically accurate
• The amount of depreciation changes from year to
  year
• Location of a property within a given market area
  does not appear to affect depreciation rates

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Comments on Age/Life Method

• Effective age (based on subjective appraiser
  judgment) appears to be more accurate than
  physical age
• Depreciation rates of between 0.70 and 1.25
  percent per year seems to be a useful benchmark
  for properties that are not too old
• Depreciation rates can be estimated from
  comparable sales (market extraction)

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Market Extraction Example

• Sale price of property 1,520,000
• Less Land value 300,000
• Less Contributing value of site improvements
  150,000
• Depreciated value of improvements 1,070,000
• Reproduction cost of improvements 1,500,000
• Less Depreciated value of improvements 1,070,000
  
• Accrued depreciation 430,000
• Depreciation 430,000 / 1,500,000 28.67
• Annual depreciation rate (20 years old) 1.43

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Breakdown Method

• In the breakdown method, the physical, functional
  and external factors contributing to the loss in
  value of the improvements are isolated and
  estimated separately
• This is particularly important for external
  obsolescence, which may vary for a property over
  time

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Categories of Depreciation

• Physical deterioration
• Curable (deferred maintenance)
• Incurable
• Short-lived
• Long-lived

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Categories of Depreciation

• Functional obsolescence
• Curable
• Deficiencies
• Defects
• Superadequacies
• Incurable
• Deficiencies
• Defects
• Superadequacies

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Categories of Depreciation

• External obsolescence
• Locational
• Economic

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Steps in Breakdown Method

1. Identify each component cost and total cost new
   classify as short- or long-lived
2. Estimate cost of deferred maintenance (curable
   physical deterioration)
3. Estimate cost of curable functional obsolescence
4. Estimate impact of incurable physical
   deterioration on short-lived items

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Steps in Breakdown Method

1. Estimate the impact of long-lived incurable
   physical deterioration
2. Estimate cost of incurable functional
   obsolescence
3. Estimate the impact of external obsolescence
4. Add up total depreciation and estimate property
   value

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Curable Physical Deterioration

• The depreciation associated with deferred
  maintenance is simply the cost of curing the item
• Generally, deferred maintenance will apply to
  short-lived components
• In some cases, long-lived components may have
  deferred maintenance as well treat these the
  same way

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Incurable Physical Deterioration of Short-lived
Components

• For each component, depreciation is calculated
  using the age/life method based on the effective
  age and useful life of the component
• Make sure you subtract off the cost of deferred
  maintenance from each component before you
  calculate depreciation (avoid double counting)

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Incurable Long-lived Physical Deterioration

• Use the age/life method to estimate the
  depreciation due to physical deterioration of the
  long-lived components
• Begin with the total reproduction cost of the
  improvements
• Subtract off the cost of curing deferred
  maintenance
• Subtract off the adjusted cost (after curing
  deferred maintenance) of short-lived components

22
Curable Functional Obsolescence

• Deficiencies are items or features that are
  missing and would be required by the market
• The loss from a deficiency is the difference
  between the cost of installing the item today and
  what it would have cost to include the item when
  the building was constructed

23
Curable Functional Obsolescence

• Defects are items that are present but do not
  meet modern standards
• The loss in value due to a defect is the cost of
  the item new less the undepreciated cost of the
  existing item (the part of the cost that has not
  yet been depreciated)

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Curable Functional Obsolescence

• Superadequacies are features or components that
  exceed modern standards
• Excess cost adjustment method Loss equals the
  added cost associated with the item less the
  depreciation already taken
• Rent loss method Loss equals the capitalized
  difference in NOI between what it would take to
  support the item compared to market rent, less
  depreciation already taken

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Incurable Functional Obsolescence

• The loss associated with incurable functional
  obsolescence is calculated using the rent loss
  method

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Incurable External Obsolescence

• This, too, is calculated using the rent loss
  method, with some modifications
• Use the difference between the buildings rent
  and market rent for comparable properties
• No need to subtract off depreciation already
  taken because external obsolescence relates to
  factors outside the property
• The loss is generally allocated between land and
  building

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Add Up Total Depreciation and Calculate Market
Value

• Physical deterioration
• Incurable short-lived components
• Incurable long-lived components
• Functional obsolescence
• External obsolescence
• Total depreciation

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Add Up Total Depreciation and Calculate Market
Value

• Reproduction cost new
• Total depreciation
• Depreciated value of improvements
• Contributing value of site improvements
• Land value
• Value indication from cost approach