Cost Estimation: Reproduction vs. Replacement & Direct vs. Indirect Costs

Chapter: Cost Estimation: Reproduction vs. Replacement & Direct vs. Indirect Costs

Introduction
The cost approach to value posits that a property’s value is derived from the cost to create a substitute property, adjusting for depreciation. This chapter delves into the critical components of cost estimation within the cost approach, specifically examining the distinction between reproduction and replacement costs, and differentiating between direct and indirect expenses. A clear understanding of these concepts is essential for accurate valuation.

1. Reproduction Cost vs. Replacement Cost: A Scientific Examination

1. 1 Definitions & Theoretical Basis

   • Reproduction Cost (CR): The estimated cost to construct an exact duplicate or replica of the existing building as of the effective appraisal date, utilizing the same materials, construction standards, design, layout, and quality of workmanship. Crucially, this includes all existing deficiencies, superadequacies, and obsolescence.
   • Replacement Cost (CREP): The estimated cost to construct a substitute for the existing building as of the effective appraisal date, employing contemporary materials, standards, design, and layout. This approach may cure some existing obsolescence.

   The theoretical foundation of the cost approach rests on the principle of substitution. A rational buyer will pay no more for a property than the cost to acquire an equivalent substitute. Reproduction cost represents the idealized, albeit often impractical, scenario of perfectly replicating the subject property. Replacement cost, on the other hand, recognizes the realities of modern construction practices and materials.

   Formally, we can express the relationship between Market Value (MV), Cost (C) and Depreciation (D) in its most basic form as:
   MV = C - D

   Where C is either CR or CREP.
   Depreciation is covered in later sections, but it is important to note that the method used to derive C will have an impact on how depreciation is calculated.
   1. 2 Scientific Principles Governing Cost Estimation

   The choice between reproduction and replacement cost is dictated by factors such as:

   • Age of the Structure: Older structures often necessitate replacement cost due to the unavailability of original materials or obsolete construction techniques.
   • Uniqueness: Highly unique or historically significant structures may warrant reproduction cost if the replication of original details is paramount.
   • Intended Use vs. Current Highest and Best Use: Divergence between the original intended use and the current highest and best use may favor replacement cost, as a modern substitute may better align with the current market demands.
   • Obsolescence: The use of CREP can eliminate the need to measure some forms of functional obsolescence such as superadequacies and poor design. However, the appraiser must carefully measure the remaining depreciation that persists in a replacement structure.
     1. 3 Practical Applications & Comparative Analysis

   Consider a historical building constructed in 1920 using specific brick and ornate architectural details.

   • Reproduction Cost Scenario: Obtaining the identical brick type might require sourcing from a specialty manufacturer at a significantly higher cost. Skilled labor capable of replicating the original architectural details may also be scarce and expensive. Furthermore, modern building codes may necessitate modifications that were not present in the original construction, adding further complexity.

   • Replacement Cost Scenario: A modern building with comparable square footage and functionality could be constructed using readily available materials and standard construction techniques. The architectural style would likely be simplified, eliminating the need for specialized craftsmanship.

   Experiment:

   • Objective: To quantify the cost difference between reproduction and replacement.
   • Methodology: Obtain detailed cost estimates from construction professionals for both scenarios, itemizing materials, labor, and other relevant expenses.
   • Expected Outcome: The reproduction cost will generally be higher than the replacement cost, potentially significantly so, particularly for older or highly customized structures.

   Example
   Imagine a 50-year old office building lacking modern HVAC systems.

   • Reproduction Cost approach would include the cost to install the older inefficient systems. Then require an additional deduction for functional obsolescence.

   • Replacement Cost approach would include the cost to install modern and efficient HVAC systems. The cost will be lower because new efficient HVAC systems will cost less and have lower operating costs. Also the additional deduction for functional obsolescence is avoided.
     1. 4 Mathematical Considerations
     The cost to reproduce the historical building (CR) can be modeled as:

   CR = Σ (Qi * Pi) + LC + OC

   Where:

   • Qi = Quantity of the ith material or component.
   • Pi = Price of the ith material or component (including potentially higher prices for specialty items).
   • LC = Labor costs (reflecting specialized skills).
   • OC = Other Costs (including permits, insurance, etc.)

   The cost to replace the building (CREP) can be modelled as:

   CREP = Σ (Q’i * P’i) + L’C + O’C

   Where:

   • Q’i = Quantity of the ith material or component (using modern substitutes).
   • P’i = Price of the ith material or component (using modern substitutes).
   • L’C = Labor costs (reflecting standard construction skills).
   • O’C = Other Costs (including permits, insurance, etc.)

   This is a simplified model, real-world application would require greater detail.
   1. 5 Avoiding Double-Counting and Inconsistencies

   Regardless of the chosen cost basis (CR or CREP), consistent application is critical. Failure to do so can lead to double-counting of depreciation or other errors. The appraisal report must clearly identify the cost basis to prevent misunderstanding.

2. Direct Costs vs. Indirect Costs: A Comprehensive Breakdown

2. 1 Definitions & Categorization

   • Direct Costs (Hard Costs): Expenses directly attributable to the physical construction of the improvement. These include the cost of materials, labor, and the contractor’s profit.
   • Indirect Costs (Soft Costs): Expenditures necessary for construction but not directly part of the construction contract. These encompass architectural and engineering fees, loan origination fees, carrying costs during construction, appraisal and legal fees, leasing and marketing costs, and developer’s overhead and anticipated profit.

   It is important to note that a construction contingency is considered a hard cost.
   2. 2 Scientific Principles & Cost Accounting

   Cost accounting principles dictate that all costs associated with a project, both direct and indirect, must be accounted for to accurately determine the total cost of development. The allocation of indirect costs can be complex, often relying on percentage allocations or detailed cost studies.

   Total project cost TC can be summarized as:

   TC = DC + IC + EI

   Where:

   DC = Direct costs
   IC = Indirect Costs
   EI = Entrepreneurial Incentive (or profit)
   2. 3 Practical Applications & Cost Allocation

   Direct Costs:

   • Materials: Lumber, concrete, steel, roofing materials, windows, doors, plumbing fixtures, electrical wiring, etc.
   • Labor: Wages for carpenters, electricians, plumbers, masons, roofers, etc.
   • Equipment: Rental or depreciation costs for construction equipment (cranes, excavators, bulldozers, etc.).
   • Contractor’s Profit & Overhead: The general contractor’s markup for managing the project, including administrative expenses, insurance, and profit.

   Indirect Costs:

   • Architectural & Engineering Fees: Design and engineering services required for the project.
   • Permit Fees: Building permits and other regulatory approvals.
   • Financing Costs: Loan origination fees, interest payments during construction, and other financing-related expenses.
   • Insurance & Taxes: Property insurance and real estate taxes during the construction period.
   • Legal & Appraisal Fees: Legal services for contract review and appraisal services for financing purposes.
   • Marketing & Leasing Costs: Expenses associated with attracting tenants or buyers.
   • Developer’s Overhead & Profit: The developer’s administrative expenses and profit margin.

   Experiment:

   • Objective: To analyze the impact of indirect costs on the total project cost.
   • Methodology: Develop a detailed cost breakdown for a hypothetical construction project, including both direct and indirect costs. Vary the indirect cost components (e.g., financing costs, marketing expenses) and observe the effect on the total project cost.
   • Expected Outcome: Indirect costs can represent a significant portion of the total project cost, potentially exceeding 20-30% or more, depending on the project complexity and market conditions.

   Example:
   Consider a new apartment complex development. Direct costs would include the physical construction of the building, while indirect costs would encompass expenses such as architectural fees, permitting costs, and marketing expenses to attract renters.
   2. 4 Entrepreneurial Incentive and Profit

   A critical component of indirect costs is the entrepreneurial incentive or profit. This represents the economic reward necessary to induce an entrepreneur to undertake the risks and coordination involved in the project. This is the profit or loss realized

   • Market Value – Total Cost of Development = Profit (or Loss)

   The entrepreneurial incentive is distinct from the contractor’s profit, which is typically included in direct costs. Estimating entrepreneurial incentive requires careful market research and analysis of comparable developments. The incentive is anticipated, while profit is earned.
   A high-risk speculative project will require greater entrepreneurial incentive than a low-risk project with demonstrable population growth.
   2. 5 Contingency Costs
   Construction contingencies are hard costs allocated to cover unforeseen items such as material price escalations, weather delays, or other unexpected issues.

3. Conclusion

Accurate cost estimation is paramount to the reliable application of the cost approach. Understanding the nuances between reproduction and replacement costs, as well as the distinction between direct and indirect expenses, is crucial for real estate professionals. By applying scientific principles, conducting thorough market research, and carefully analyzing cost data, appraisers can develop credible and defensible value opinions.