Chapter 8: Cost Estimation & Depreciation: Mastering the Cost Approach

I. Introduction

The cost approach is one of the three fundamental approaches to value, alongside the sales comparison approach and the income capitalization approach. This chapter delves into the scientific underpinnings and practical applications of the cost approach, focusing on cost estimation and depreciation. This approach is rooted in the principle of substitution, which dictates that a rational buyer will pay no more for a property than the cost of acquiring an equivalent substitute. Mastering the cost approach requires a comprehensive understanding of construction costs, depreciation factors, and their impact on property value.

II. The Foundation: Reproduction Cost vs. Replacement Cost

At the heart of the cost approach lies the estimation of either the reproduction cost or the replacement cost.

• Reproduction Cost: This refers to the cost of constructing an exact replica of the subject property using the same materials, design, and construction techniques, including any outdated or obsolete features.
• Replacement Cost: This involves estimating the cost of building a structure of equivalent utility using current materials, design, and construction standards.

While reproduction cost offers a historical perspective, replacement cost reflects modern construction practices and is generally more applicable. The choice between the two depends on the specific appraisal scenario and the availability of data.

III. Cost Estimation Methods

Several methods are used to estimate construction costs, each with its own level of detail and accuracy.

A. Comparative Unit Method (Square Foot Method)

This is a relatively simple and widely used method, especially for residential properties. It involves multiplying the area of the building by a cost per unit area (e.g., cost per square foot).

1. Process:

   • Measure the building area. Accurate dimensions are crucial. Mobile technology has significantly improved measurement accuracy.
   • Determine the appropriate unit cost. This can be derived from market analysis of comparable new construction or from cost estimating manuals.
   • Apply the unit cost to the building area:
     • Total Cost = Building Area (sq ft) x Cost per sq ft

2. Example:

   • 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
   • Add site improvements, site value.

3. Mathematical Representation:

   • Let TC represent the total cost of the building.
   • Let A represent the total area of the building.

   • Let C represent the unit cost per square foot.

   • Then, TC = A x C

4. Determining Unit Costs: Unit costs can be derived in two ways:

   1. Market Analysis: Gather sales data on comparable new homes. Subtract the site value from the sales price, and divide the result by the square footage of the comparable.

      • Unit Cost = (Sales Price - Site Value) / Building Area

   2. Cost Estimating Manuals or Services: Utilize published cost manuals from companies like Boeckh Publications, F. W. Dodge Corporation, Marshall and Swift Publication Company, and R. S. Means Company.

      • These manuals provide average unit costs for various building sizes and styles. Online accessibility has increased the efficiency of this method.

5. Factors Influencing Unit Cost:

   • Building Size: Unit costs per square foot are typically higher for smaller buildings due to fixed costs like kitchens and bathrooms being spread over a smaller area.
   • Building Design: More complex designs (e.g., L-shaped buildings) have higher perimeter wall lengths relative to their area, leading to higher unit costs.

B. Unit-in-Place Method

This method involves estimating the cost of individual building components (e.g., foundation, walls, roof) and summing them to arrive at the total cost.

1. Process:

   • Identify and measure the quantities of various building components.
   • Determine the unit cost for each component, considering materials, labor, equipment, and overhead.
   • Multiply the quantity of each component by its unit cost and sum the results:
     • Total Cost = Σ (Quantity of Component i x Unit Cost of Component i)

2. Example:

   • Floors: 5,000 sq ft @ $7/sq ft = $35,000
   • Walls: 300 linear ft @ $200/linear ft = $60,000
   • Roof structure: 5,000 sq ft @ $15/sq ft = $75,000
   • Sum the costs of all components.

3. Mathematical Representation:

   • Let TC represent the total cost of the building.
   • Let Qi represent the quantity of component i.
   • Let Ci represent the unit cost of component i.

   • Let n represent the number of components.

   • Then, TC = Σ (Qi x Ci), where the summation is from i=1 to n.

C. quantity survey method❓❓

This is the most detailed and accurate cost estimation method, often used by contractors and builders. It involves a comprehensive breakdown of all costs, including labor, materials, equipment, and overhead, for each building component.

1. Process:

   • Estimate the quantities of all materials required.
   • Determine the unit cost of each material.
   • Estimate the labor hours required for each task.
   • Determine the hourly labor rate.
   • Calculate equipment costs, including rental or depreciation.
   • Add overhead and profit.
   • Sum all costs to arrive at the total cost.

2. Mathematical Representation:

   • Let TC represent the total cost of the building.
   • Let Mi represent the quantity of material i.
   • Let Ci represent the unit cost of material i.
   • Let Lj represent the labor hours for task j.
   • Let Rj represent the hourly labor rate for task j.
   • Let Ek represent the cost of equipment k.
   • Let OH represent overhead costs.

   • Let P represent profit.

   • Then, TC = Σ (Mi x Ci) + Σ (Lj x Rj) + Σ Ek + OH + P, where the summations are over all materials and labor tasks, respectively.

D. Cost Index Trending

This method is used to estimate the current cost of a building when its original construction cost is known. It uses construction cost indexes to adjust for changes in costs over time.

1. Process:

   • Determine the original construction cost.
   • Find the construction cost index value at the time of construction.
   • Find the current construction cost index value.
   • Calculate the cost adjustment factor:
     • Cost Adjustment Factor = Current Index Value / Original Index Value
   • Multiply the original cost by the cost adjustment factor:
     • Current Cost = Original Cost x Cost Adjustment Factor

2. Example:

   • Original cost: $100,000 (in 1980)
   • Index value (1980): 150
   • Current index value: 200
   • Cost adjustment factor: 200 / 150 = 1.33
   • Current cost: $100,000 x 1.33 = $133,000

IV. Depreciation: Understanding Value Loss

Depreciation refers to the loss in value of an improvement compared to its cost due to any reason. It is the difference between the market value of the improvement and its cost.

A. Depreciation Terminology

1. Accrued Depreciation: The total amount of depreciation that has occurred between the time the improvement was built and the effective date of the appraisal.
2. Actual Age: The chronological or historical age of the improvement.
3. Effective Age: The apparent age of the improvement, based on its current condition and the market’s perception of its condition.
4. Economic Life: The total period during which the improvement will contribute to the value of the property.

5. Remaining Economic Life: The period from the effective date of the appraisal until the end of the improvement’s economic life.

   • 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: Depreciation caused by wear and tear, damage, or aging of the physical components of the improvement.

   • Curable: The cost to correct the deterioration is less than the added value that would result.

   • Incurable: The cost to correct the deterioration exceeds the added value.

     • Long-lived items: Components expected to last the building’s life (e.g., foundation).

     • Short-lived items: Components needing replacement during the economic life (e.g., paint, carpeting).
       2. Functional Obsolescence: Depreciation caused by design defects, outdated features, or inefficiencies within the improvement.

       • Curable: The defect can be remedied at a cost less than the resulting increase in value.
       • Incurable: The defect cannot be practically or economically remedied.

     • Deficiencies: Inadequate features (e.g., poor insulation).

     • Superadequacies: Over-improvements (e.g., excessively high-end finishes).
       3. External (Economic) Obsolescence: Depreciation caused by factors outside the property, such as negative influences from surrounding properties or poor economic conditions.

   • Generally considered incurable, as the property owner has little or no control over these factors.

V. Methods of Estimating Depreciation

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

This method assumes that an improvement depreciates at a constant rate over its economic life.

1. Process:

   • Estimate the effective age and economic life of the improvement.
   • Calculate the accrued depreciation rate:
     • Accrued Depreciation Rate = Effective Age / Economic Life
   • Multiply the accrued depreciation rate by the estimated cost:
     • Depreciation = Accrued Depreciation Rate x Cost

2. Mathematical Representation:

   • Let D represent depreciation.
   • Let EA represent effective age.
   • Let EL represent economic life.

   • Let C represent the cost of the improvement.

   • Then, D = (EA / EL) x C

3. Accounting practices vs. Appraiser’s perspective: Appraisers typically utilize a realistic and economically sound life for a building when determining depreciation, whereas Accountants, on the other hand, may use the shortest life allowed by the IRS.

B. Sales Comparison Method

This method uses market data from comparable sales to estimate depreciation.

1. Process:
   • Identify comparable properties with the same defect as the subject property.
   • Identify comparable properties without the defect.
   • The difference in selling prices represents the amount of depreciation.

C. Capitalization Method

Similar to the sales comparison method, but uses income data from comparable rental properties.

1. Process:
   • Identify comparable rental properties with the defect.
   • Identify comparable rental properties without the defect.
   • The difference in income is capitalized to determine the amount of depreciation.
   • Depreciation = (Difference in Income) / Capitalization Rate

D. Cost to Cure Method

This method estimates depreciation based on the cost to cure curable items.

1. Process:
   • Identify curable physical deterioration and functional obsolescence.
   • Estimate the cost to cure these defects.
   • The total cost to cure represents the amount of depreciation.

E. Observed Condition Method (Breakdown Method)

This method estimates each type of depreciation separately, using various techniques.

1. Process:
   • Estimate physical deterioration using the age-life method or cost to cure.
   • Estimate functional obsolescence using sales comparison or cost to cure.
   • Estimate external obsolescence using sales comparison or capitalization.
   • Sum the depreciation from each category to determine total depreciation.

VI. Practical Application and Experimentation

A. Experiment: Analyzing Depreciation of a Residential Property

1. Objective: To estimate the depreciation of a residential property using different methods.

2. Materials:

   • Detailed information on a subject property (age, condition, features).
   • Sales data on comparable properties.
   • Cost estimating manuals.
   • Capitalization rates for the local market.

3. Procedure:

   • Estimate the replacement cost of the subject property using the square foot method or unit-in-place method.
   • Estimate depreciation using the age-life method, sales comparison method, and cost to cure method.
   • Compare the results from each method and analyze the differences.

4. Analysis:

   • Discuss the strengths and weaknesses of each method.
   • Explain how market conditions and specific property characteristics influence depreciation estimates.

B. Case Study: Applying the Cost Approach to an Older Building

1. Objective: To apply the cost approach to estimate the value of an older building with significant depreciation.

2. Scenario:

   • An older commercial building with functional obsolescence (e.g., outdated layout, inadequate electrical capacity) and external obsolescence (e.g., location in a declining neighborhood).

3. Procedure:

   • Estimate the replacement cost of the building using the unit-in-place method or quantity survey method.
   • Estimate depreciation due to physical deterioration, functional obsolescence, and external obsolescence.
   • Apply the cost approach formula to estimate the value of the building.

4. Analysis:

   • Discuss the challenges of estimating depreciation for older buildings.
   • Explain how market data and local economic conditions influence the appraisal.

VII. Conclusion

Mastering the cost approach requires a comprehensive understanding of cost estimation methods, depreciation factors, and their impact on property value. While the cost approach may be less reliable than the sales comparison or income approaches, it provides a valuable check and balance in the appraisal process, especially for unique or specialized properties. Continued advancements in mobile technology and data analysis will further enhance the accuracy and efficiency of the cost approach in the new golden age of appraisal.