Cost Approach Fundamentals: Reproduction vs. Replacement Cost

Chapter 2: Cost Approach Fundamentals: Reproduction vs. Replacement Cost

2.1 Introduction

The cost approach is a valuation technique that estimates the value of a property by summing the estimated land value and the depreciated cost of the improvements. This chapter focuses on a critical aspect of the cost approach: differentiating between reproduction cost and replacement cost. Both concepts aim to estimate the cost of constructing an improvement, but they differ significantly in their application and implications for depreciation analysis.

2.2 Theoretical Underpinnings

The cost approach is rooted in the principle of substitution, which posits that a rational buyer will not pay more for a property than the cost to acquire a substitute property of equal utility. This assumes a competitive market where buyers have choices. In the context of the cost approach, the “substitute” is a newly constructed improvement. The accuracy of the cost approach hinges on the reliable estimation of costs and accurate measurement of depreciation.
The formula for the Cost Approach is:
Property Value = Land Value + (Cost of Improvement - Accrued Depreciation).
Where:
Land Value is the estimated market value of the land as if vacant and available for its highest and best use.
Cost of Improvement is either the Reproduction Cost or the Replacement Cost, as defined below.
Accrued Depreciation includes physical deterioration, functional obsolescence, and external obsolescence.

2.3 Reproduction Cost

2.3.1 Definition

Reproduction cost is the estimated cost to construct an exact replica of the existing building, using the same materials, construction standards, design, layout, and quality of workmanship, as of the effective appraisal date. This includes all deficiencies, superadequacies, and obsolescence present in the subject property.
Reproduction Cost = Direct Costs + Indirect Costs + Entrepreneurial Incentive.

2.3.2 Scientific Basis

The concept of reproduction cost aligns with historical cost accounting. It seeks to recreate the original construction conditions as closely as possible. However, this can present challenges due to changes in building codes, material availability, and construction techniques over time. The scientific rigor lies in accurately researching and pricing the original materials and construction methods, often requiring specialized expertise and historical data.

2.3.3 Practical Applications and Related Experiments
Suppose you are appraising a historic building constructed in 1920 using specific architectural details that are no longer common. To estimate the reproduction cost, you would need to:
* Research historical records to identify the original building materials (e.g., specific types of lumber, brick, or decorative elements).
* Obtain quotes from suppliers specializing in historical or custom-made materials.
* Consult with contractors experienced in historical restoration to estimate labor costs and construction techniques.
* Consider the cost of replicating obsolete systems, such as original plumbing or electrical wiring, even if they are not up to current standards.

2.3.4 Challenges in Estimating Reproduction Cost

Estimating reproduction cost can be complex due to several factors:
* Obsolete Materials: Some materials used in the original construction may no longer be available or may be prohibitively expensive to obtain.
* Code Compliance: Replicating a building exactly might violate current building codes, requiring modifications that deviate from the original design.
* Specialized Labor: Skilled craftsmen with expertise in historical construction techniques may be scarce and command high wages.

2.4 Replacement Cost

2.4.1 Definition

Replacement cost is the estimated cost to construct a substitute for the existing building, using contemporary materials, standards, design, and layout, as of the effective appraisal date. This approach aims to create a modern equivalent that provides the same utility as the original building, potentially curing some existing obsolescence.
Replacement Cost = Direct Costs + Indirect Costs + Entrepreneurial Incentive.

2.4.2 Scientific Basis

Replacement cost aligns with the economic principle of opportunity cost. It focuses on the most efficient way to provide the same function as the existing building, given current market conditions and technology. This approach simplifies the cost estimation process and can reduce the complexity of depreciation analysis, particularly regarding functional obsolescence.

2.4.3 Practical Applications and Related Experiments

Consider the same historic building from the previous example. To estimate the replacement cost, you would:
* Design a modern building that provides the same functional utility as the historic building (e.g., same square footage, number of rooms, and intended use).
* Use contemporary materials and construction techniques that meet current building codes and standards.
* Obtain quotes from suppliers and contractors for modern materials and construction methods.
* Consider the cost of incorporating modern amenities and systems, such as energy-efficient HVAC, modern plumbing, and updated electrical wiring.

2.4.4 Advantages of Using Replacement Cost

Replacement cost offers several advantages over reproduction cost:
* Simpler Estimation: Using contemporary materials and methods simplifies the cost estimation process, as data is more readily available.
* Reduced Depreciation: Replacement cost may eliminate the need to measure some forms of functional obsolescence, as the modern substitute incorporates current design standards.
* Lower Cost: Replacement structures are typically less expensive than reproductions due to the use of more readily available and less expensive materials and techniques.

2.5 Direct and Indirect Costs

Whether using reproduction cost or replacement cost, it is imperative to account for both direct (hard) and indirect (soft) costs. Direct costs are directly attributed to the physical construction of the building; indirect costs are expenditures necessary for the construction process but not directly related to the physical labor or materials.

2.5.1 Direct Costs (Hard Costs)

Direct costs include:
1. Materials: The cost of all materials used in construction, such as lumber, concrete, steel, roofing, and fixtures.
2. Labor: The cost of wages and benefits paid to construction workers.
3. Equipment: The cost of renting or purchasing construction equipment, including depreciation.
4. Contractor’s Profit: The profit margin earned by the general contractor.
5. Subcontractor’s fees: The payments to specialized contractors for specific work such as electrical, plumbing, or HVAC installation.

2.5.2 Indirect Costs (Soft Costs)

Indirect costs include:
1. Architectural and Engineering Fees: The cost of hiring architects and engineers to design the building and prepare construction documents.
2. Permits and Fees: The cost of obtaining building permits and other regulatory approvals.
3. Financing Costs: Interest payments on construction loans and loan origination fees.
4. Insurance: The cost of liability insurance and builder’s risk insurance during construction.
5. Legal and Accounting Fees: The cost of legal and accounting services related to the project.
6. Marketing and Leasing Costs: The cost of marketing the property and leasing units.
7. Developer’s Overhead: Administrative and operational expenses of the developer.
8. Appraisal Fees.
9. Title Insurance.

2.6 Entrepreneurial Incentive/Profit

Entrepreneurial incentive is the profit required to motivate an entrepreneur to undertake the development project. It is the difference between the expected market value of the completed project and the total cost of development (land value + direct costs + indirect costs). This can be written as:
Entrepreneurial Incentive = Expected Market Value – (Land Value + Direct Costs + Indirect Costs)
The entrepreneurial incentive reflects the risk and expertise involved in the project and is determined by market conditions.

2.7 Choosing Between Reproduction and Replacement Cost

The decision to use reproduction cost or replacement cost depends on the specific characteristics of the property and the appraisal assignment:

2.7.1 Factors to Consider

1. Age and Uniqueness: Reproduction cost may be more appropriate for older, historically significant buildings or unique properties where exact replication is essential to maintaining value. Replacement cost is often preferred for newer, more standard buildings.
2. Intended Use: If the intended use of the property has changed since its original construction, replacement cost may be more relevant as it reflects current market demands and standards.
3. Data Availability: If accurate data on historical materials and construction methods is difficult to obtain, replacement cost may be a more practical option.

2.7.2 Consistency

Regardless of the cost basis selected, it is crucial to apply it consistently throughout the cost approach to avoid double-counting depreciation or introducing other errors. The chosen cost basis should be clearly identified in the appraisal report.

2.8 Conclusion

Understanding the differences between reproduction cost and replacement cost is fundamental to applying the cost approach effectively. Reproduction cost provides a theoretical basis for measuring depreciation from all causes, while replacement cost offers a more practical and often less complex approach to estimating value. The choice between the two depends on the specific characteristics of the property and the objectives of the appraisal assignment.