According to the URAR, what information must an appraiser document when utilizing the cost approach?

Cost Approach: Methods and Depreciation

Chapter Introduction: Cost Approach - Methods and Depreciation

The cost approach to value represents a fundamental and scientifically rigorous methodology employed in real estate appraisal. This chapter, "Cost Approach: Methods and Depreciation," within the "Mastering Real Estate Appraisal: Foundations and Best Practices" training course, provides a comprehensive exploration of this vital appraisal technique. The cost approach estimates value by summing the estimated land value with the depreciated cost of constructing a new improvement. It relies on the principle of substitution, positing that a rational buyer will pay no more for a property than the cost to acquire an equivalent substitute. Its scientific basis resides in the application of cost accounting principles, engineering economics, and statistical analysis to quantify construction costs and depreciation.

The scientific importance of the cost approach stems from its capacity to provide an independent indication of value, particularly for unique or specialized properties where comparable sales data are limited. Furthermore, it serves as a critical check on value conclusions derived from other appraisal approaches, such as the sales comparison and income capitalization methods. Understanding the cost approach is essential in situations where construction costs are a primary driver of value, such as newly built properties or those undergoing significant renovations.

This chapter will delve into the various methods used to estimate construction costs, including the square foot method, the unit-in-place method, and the quantity survey method. Each method offers a different level of detail and accuracy in cost estimation, and their application is dependent on data availability and the complexity of the subject property. We will also explore cost index trending as a tool for updating historical construction costs to current levels, acknowledging its limitations regarding reliability.

A crucial aspect of the cost approach is the accurate estimation of depreciation, which reflects the loss in value due to physical deterioration, functional obsolescence, and external obsolescence. This chapter will define the types of depreciation, the terminology used, and discuss methods for quantifying each type, including the economic age-life method, sales comparison, capitalization, and cost-to-cure.

Upon completion of this chapter, participants will be able to:

• Scientifically apply various cost estimation methods to determine the reproduction or replacement cost of improvements.
• Critically analyze and quantify the different types of depreciation affecting real property value.
• Objectively integrate land value with the depreciated cost of improvements to arrive at a reliable value indication.
• Understand the strengths and weaknesses of the cost approach and its appropriate applications in real estate appraisal practice.
• Apply the principles of the cost approach in accordance with industry standards and best practices to ensure professional competence.

By mastering the methodologies and principles presented in this chapter, participants will gain the necessary scientific foundation to confidently and accurately apply the cost approach in real estate appraisal practice.

Cost Approach: Methods and Depreciation

Here's the scientific content for your chapter, focusing on accuracy, depth, and practical application:

Chapter 8: Cost Approach: Methods and Depreciation

I. Introduction to the Cost Approach

• The cost approach is a valuation method that estimates the value of a property by summing the estimated land value and the depreciated cost of improvements. It's based on the principle of substitution: a buyer won't pay more for a property than the cost of building a new one or acquiring a similar substitute.
• The cost approach is most applicable to:
  • New or relatively new properties.
  • Special-purpose properties where there are limited sales data for comparison (e.g., schools, churches).
  • When the improvements represent the highest and best use of the land.

II. Fundamental Concepts

• Reproduction Cost: The cost of creating an exact replica of the subject property, using the same materials, design, and construction methods. Often used when valuing historic properties.
• Replacement Cost: The cost of constructing a building with equivalent utility to the subject property, using modern materials, design, and construction standards. It avoids functional obsolescence inherent in the original design.
• Accrued Depreciation: The total loss in value of a property from all causes (physical deterioration, functional obsolescence, external obsolescence) from the time it was built to the effective date of the appraisal.
• Direct Costs (Hard Costs): Costs directly attributable to the construction of the building (e.g., materials, labor, equipment).
• Indirect Costs (Soft Costs): Expenses indirectly related to construction (e.g., architectural and engineering fees, permits, financing costs, insurance, legal fees, contractor's overhead, and profit).
• Entrepreneurial Profit: The developer's incentive to take on a project. It is the profit earned by the developer or entrepreneur for their expertise, risk-taking, and coordination of the project. It’s often expressed as a percentage of total costs.

III. Cost Estimation Methods: A Detailed Examination

• A. Comparative Unit Method (Square Foot Method)

  • Description: Estimates the cost of the building by multiplying the building's area (typically in square feet or square meters) by a cost per unit area.

  • Formula:

    Total Building Cost = Building Area (sq ft) * Cost per sq ft

  • Procedure:

    1. Measure the area of the building accurately. Include all finished and unfinished areas.
    2. Determine the appropriate cost per square foot. This can be derived from:

       • Market Analysis: Gathering data on sales of comparable new homes. Subtract the site value from the sales price, then divide the result by the square footage.

         Unit Cost = (Sales Price of Comparable - Site Value) / Building Area
         * Cost Estimating Manuals: Using publications from companies like R.S. Means, Marshall & Swift, or similar sources. These manuals provide average unit costs for different types of construction.
         3. Adjust the unit cost for:
         * Size: Unit costs typically decrease as building size increases due to economies of scale.
         * Shape: Complex shapes increase perimeter wall length, raising costs per square foot (see Figure 8-2 in the provided document).
         * Construction Quality: Adjust for higher- or lower-quality materials and workmanship.
         * Location: Factor in regional variations in labor and material costs. Use location factors from cost manuals.
         * Time: Account for inflation or deflation in construction costs using cost indexes.

  • Example (Based on provided document):

    • Living Area: 1280 sq ft @ $60/sq ft = $76,800
    • Garage: 576 sq ft @ $25/sq ft = $14,400
    • Total Building Cost = $76,800 + $14,400 = $91,200
    • Other Improvements = $8,500
    • Site Value = $35,000
    • Total Property Value = $91,200 + $8,500 + $35,000 = $134,700
  • Application Experiment: Gather data on recent new home sales in your area. For each sale, determine the living area, sale price, and estimated land value (using comparable land sales). Calculate the unit cost per square foot for each comparable. Analyze the data to determine a reasonable range of unit costs for similar homes in the area.

• B. Unit-in-Place Method

  • Description: Estimates the cost by summing the installed costs of individual building components (e.g., foundation, walls, roof, HVAC system). The unit cost includes materials, labor, equipment, and overhead.
  • Formula:
    Total Building Cost = Σ (Quantity of Component i * Unit Cost of Component i)

  • Procedure:

    1. Identify and quantify all major building components.
    2. Determine the unit-in-place cost for each component. Sources include cost manuals, contractor quotes, and historical data.
    3. Multiply the quantity of each component by its unit cost.
    4. Sum the costs of all components to arrive at the total building cost.
    5. Add indirect costs and entrepreneurial profit.
    6. Adjust for differences in time (current cost) and location (local cost), and also for any cost items that are not included in the unit cost figures (such as indirect costs and entrepreneurial profit). Adjustments for differences in construction features, size and complexity are generally not required in the unit-in-place method, since the procedure takes these differences into account.

  • Example (Based on provided document):

    • Floors: 5,000 sq ft @ $7/sq ft = $35,000
    • Walls: 300 linear ft @ $200/linear ft = $60,000
    • ...and so on (refer to Figure 8-4).
    • Total Direct & Indirect Costs = $249,500
  • Important Consideration: Ensure consistency in measurement units. Wall framing might be costed per linear foot, while painting is costed per square foot of wall surface.
  • Application Experiment: Select a specific building component (e.g., exterior wall framing). Obtain quotes from local contractors for the cost of framing a wall, including lumber, labor, sheathing, and all other associated expenses. Compare these quotes to published unit-in-place costs in a cost manual.

• C. Quantity Survey Method

  • Description: The most detailed and accurate method. It involves a complete itemization of all costs, including materials, labor, equipment, overhead, and contractor's profit.
  • Procedure:
    1. Prepare a detailed bill of materials, specifying the quantity and type of each material required.
    2. Obtain current prices for all materials from suppliers.
    3. Estimate the labor hours required for each task and apply appropriate wage rates.
    4. Calculate equipment costs, including rental or depreciation.
    5. Add indirect costs (permits, insurance, etc.).
    6. Add contractor's overhead and profit.
  • Use Case: Primarily used by contractors for bidding on construction projects. Appraisers may use it for complex or unique properties where accuracy is paramount.
  • Advantage: Most accurate method for cost estimation
  • Disadvantage: Requires a great deal of time and expertise to use
  • Formula:
    Total Cost = Direct Materials + Direct Labor + Direct Expenses + Indirect Costs + Profit

• D. Cost Index Trending

  • Description: Uses a construction cost index to estimate the current cost of a building based on its original construction cost.

  • Formula:
    Current Cost = Original Cost * (Current Index Value / Original Index Value)

  • Procedure:

    1. Determine the original construction cost of the building.
    2. Identify a relevant construction cost index (e.g., Engineering News-Record (ENR) Construction Cost Index).
    3. Obtain the index value for the year the building was constructed and the current index value.
    4. Apply the formula to calculate the estimated current cost.
  • Limitations: Least reliable method. It assumes that the original construction cost was typical and that the cost index accurately reflects changes in construction costs for the specific type of building in the specific location.
  • Use Case: Can be used as a quick check of cost estimates derived from other methods.
  • Example (Based on provided document):
    • Original Cost (1980): $100,000
    • Index Value (1980): 150
    • Current Index Value: 200
    • Current Cost = $100,000 * (200/150) = $133,333
  • Application Experiment: Find the original construction cost of a building in your area. Use a construction cost index to estimate the current cost of the building. Compare this estimate to the current assessed value of the building to see if they are reasonably similar.

IV. Estimating Depreciation: A Scientific Approach

• A. Depreciation Terminology

  • Depreciation: The loss in value of a property due to any cause.
  • Accrued Depreciation: The total depreciation that has occurred from the time the improvement was built to the effective date of the appraisal.
  • Actual Age (Chronological Age): The actual number of years that have passed since the improvement was constructed.
  • Effective Age: The age of an improvement based on its condition and utility, which may be different from its actual age. An exceptionally well-maintained building could have an effective age lower than its actual age. A poorly maintained building will have the opposite outcome.
  • Economic Life (Useful Life): The period during which an improvement contributes to the property's value.
  • Physical Life: The total length of time a building can exist physically, assuming normal maintenance. Usually longer than economic life.

  • Remaining Economic Life: The estimated number of years remaining in the improvement's economic life as of the appraisal date.

  • Relationships:

    • Economic Life = Effective Age + Remaining Economic Life
    • Effective Age = Economic Life - Remaining Economic Life
    • Remaining Economic Life = Economic Life - Effective Age

• B. Types of Depreciation

  1. Physical Deterioration: Loss in value due to wear and tear, damage, or deferred maintenance.
     • Curable: The cost to correct the deterioration is less than the resulting increase in value. (e.g., painting, replacing broken windows).
     • Incurable: The cost to correct the deterioration exceeds the resulting increase in value. Can be broken down into short lived and long lived components.
     • Short-Lived: Items that are expected to be replaced during the life of the building.
     • Long-Lived: Items that are expected to last the life of the building.
  2. Functional Obsolescence: Loss in value due to design defects, outdated features, or inefficiencies.
     • Curable: Can be remedied at a cost less than the resulting increase in value (e.g., adding insulation, updating kitchen cabinets).
     • Incurable: Cost to remedy is prohibitive (e.g., low ceiling heights, poor floor plan).
     • Superadequacy: is a form of over improvement; design features whose costs are greater than their contribution to value.
  3. External Obsolescence (Economic Obsolescence): Loss in value due to factors outside the property itself, such as neighborhood decline, environmental issues, or adverse economic conditions. Generally considered incurable because the property owner has no control over these factors.

• C. Methods of Estimating Depreciation

  1. Economic Age-Life Method (Straight-Line Method)

     • Description: Assumes depreciation occurs at a constant rate over the economic life of the improvement.

     • Formula:
       Depreciation = (Effective Age / Economic Life) * Reproduction Cost

       Depreciated Value = Reproduction Cost - Depreciation
       * Procedure:
       1. Estimate the reproduction cost.
       2. Estimate the effective age.
       3. Estimate the economic life.
       4. Calculate the accrued depreciation rate (Effective Age / Economic Life).
       5. Multiply the accrued depreciation rate by the reproduction cost to determine the total depreciation.
       6. Subtract the total depreciation from the reproduction cost to arrive at the depreciated value.
       * Application Experiment: Select a property with a known actual age. Research typical economic lives for similar properties. Assess the property's condition and estimate its effective age. Calculate depreciation using the age-life method and compare the result to the property's market value.
       * Alternative Version: Account for curable items separately.

       1. Estimate the cost to cure curable physical deterioration and functional obsolescence.
       2. Subtract the cost to cure from the reproduction cost.
       3. Adjust the effective age to reflect the effect of curing these defects.
       4. Apply the age-life method to the remaining cost to calculate incurable depreciation.
       5. Add the cost to cure to the incurable depreciation to determine the total depreciation.
          * Limitations: Oversimplifies the depreciation process. It doesn't account for variations in depreciation rates over time or for different types of depreciation.

  2. Sales Comparison Method (Paired Data Analysis)

     • Description: Compares sales prices of similar properties, some with the defect in question and some without. The price difference represents the depreciation due to the defect.
     • Example (Based on provided document): Comparable houses with poor floor plans sell for $110,000, while comparable houses with functional floor plans sell for $120,000. Depreciation = $10,000.
     • Requirement: Sufficient market data.

  3. Capitalization of Income Loss Method

     • Description: Estimates depreciation by capitalizing the loss in income caused by the defect.
     • Procedure:
       1. Determine the difference in income (rent) between comparable properties with and without the defect.

       2. Capitalize the income difference using an appropriate capitalization rate (derived from the market).

          Depreciation = Income Loss / Capitalization Rate
          3. Can also use a gross income multiplier (GIM).

          Depreciation = Income Loss * GIM
          * Use Case: Suitable for income-producing properties.

  4. Cost-to-Cure Method

     • Description: Estimates depreciation as the cost to cure curable physical deterioration or functional obsolescence.
     • Requirements: The cost to cure must be economically justified (i.e., the cost must be less than the resulting increase in value).
     • Example: Depreciation due to worn carpeting equals the cost of replacing the carpeting.

  5. Observed Condition Method (Breakdown Method)

     • Description: Estimates each type of depreciation (physical, functional, external) separately, using a combination of the other methods.
     • Procedure:
       1. Identify all sources of depreciation.
       2. Estimate the amount of depreciation for each source using the most appropriate method (straight-line, sales comparison, capitalization, cost-to-cure).
       3. Sum the depreciation from all sources to arrive at the total depreciation.
     • Use Case: Provides the most comprehensive and detailed analysis of depreciation.

V. Uniform Residential Appraisal Report (URAR) and the Cost Approach

• The URAR includes a specific section for the cost approach.
• Requires the appraiser to estimate:
  • Site Value
  • Reproduction or Replacement Cost New
  • Depreciated Cost of Improvements
  • "As-is" Value of Site Improvements
• The appraiser must document the sources of cost data, site valuation, and depreciation estimates. Addendums may be necessary to provide sufficient detail.

VI. Conclusion

The cost approach is a valuable tool in real estate appraisal, especially when combined with other approaches to value. Understanding cost estimation methods and depreciation analysis is essential for appraisers to arrive at credible and supportable value conclusions.

Scientific Summary: Cost Approach: Methods and Depreciation

This chapter from "Mastering Real Estate Appraisal" focuses on the cost approach to value, detailing methods for estimating construction costs and accounting for depreciation. The cost approach posits that a property's value is the sum of the land value and the depreciated cost of improvements.

Key Scientific Points:

• Cost Estimation Methods:
  • Comparative Unit (Square Foot) Method: Calculates cost by multiplying the building area (living space, garage, etc.) by a cost per square foot. This unit cost can be derived from market analysis of comparable new homes (sales price minus site value, divided by square footage), or from cost-estimating manuals. Adjustments are crucial to account for differences in construction quality, building size, complexity, location, and time. Smaller buildings generally have higher unit costs due to fixed costs spread over fewer square feet.
  • Unit-in-Place Method: Estimates the cost of individual building components (foundation, walls, roof, etc.) by multiplying the quantity of each component by its unit cost (material, labor, equipment, overhead). Adjustments are made for time and location but ideally not for complexity as it is accounted for in individual unit costs.
  • Quantity Survey Method: The most detailed approach, separately estimating the cost of labor, materials, equipment, and overhead for each construction component. Often used by contractors, it combines bids from subcontractors.
  • Cost Index Trending: Uses construction cost indexes to estimate current costs based on the original construction cost and changes in the index. This is quick but considered the least reliable method.
• Depreciation: Defined as the loss in value of an improvement due to any cause. Accrued depreciation is the total depreciation from the time of construction to the appraisal date. It is distinct from accounting "book depreciation."
• Age and Economic Life:
  • Actual Age: The chronological age of the improvement.
  • Effective Age: The apparent age based on condition and market perception. It can be more or less than the actual age based on maintenance and modernization.
  • Economic Life: The period during which an improvement contributes to property value.
  • Remaining Economic Life: The time remaining until the end of the economic life. The equation Economic Life = Effective Age + Remaining Economic Life is key.
• Types of Depreciation:
  • Physical Deterioration: Loss in value due to wear and tear or damage. Curable if the cost to remedy is less than the value added; otherwise, incurable. Long-lived items (foundation) versus short-lived items (carpeting) are considered.
  • Functional Obsolescence: Loss in value due to design defects (deficiencies or superadequacies) or outdated features. Curable if the cost to remedy is less than the value added; otherwise, incurable.
  • External (Economic) Obsolescence: Loss in value due to factors external to the property (e.g., proximity to a nuisance, economic downturn). Generally considered incurable.
• Methods of Estimating Depreciation:
  • Economic Age-Life (Straight-Line) Method: Assumes a constant rate of depreciation over the economic life. Depreciation is calculated as (Effective Age / Economic Life) * Cost. It is best suited for physical deterioration.
  • Sales Comparison Method: Compares sales of properties with and without the defect to quantify the depreciation amount.
  • Capitalization Method: Capitalizes the difference in income between comparable properties with and without the defect.
  • Cost to Cure Method: Assumes depreciation due to curable items equals the cost of curing the defects.
  • Observed Condition Method (Breakdown Method): Separately estimates each type of depreciation, utilizing other techniques as needed.

Conclusions:

The cost approach, while conceptually straightforward, relies heavily on accurate cost estimation and depreciation analysis. The selection of an appropriate cost estimation method depends on the level of detail required and available data. Accurately estimating depreciation is critical, but challenging, particularly for older properties with multiple depreciation factors. The cost approach is generally less reliable than the sales comparison or income approaches.

Implications:

• Appraisers must possess a strong understanding of construction costs, building design, and market dynamics.
• Careful data collection, verification, and adjustment are essential for accurate cost estimates.
• Accurate estimation of effective age and economic life are crucial for calculating depreciation.
• The choice of depreciation method should be appropriate to the type and cause of depreciation being measured.
• The cost approach is most reliable for newer properties with minimal depreciation and when market data is limited.
• The URAR provides a standardized format for reporting the cost approach. The URAR form requests information relating to site valuation and improvement cost, leaving room for comments as to cost estimate sources, square footage calculation, and estimated remaining economic life, requiring appraisers to supplement their reports with addenda.