Cost Estimation and Depreciation in Appraisal

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Chapter 8: Cost Estimation and Depreciation in Appraisal

I. Introduction

The Cost Approach to value is a fundamental appraisal methodology that estimates the value of a property by summing the estimated land value with the depreciated cost of the improvements. This approach rests on the principle of substitution, which posits that a rational buyer will pay no more for a property than the cost to acquire a comparable substitute. This chapter delves into the intricacies of cost estimation and depreciation, providing a scientific understanding of the principles and techniques employed by appraisers.

II. Cost Estimation: Recreating Value

Cost estimation aims to determine the current cost of constructing a replica or a suitable replacement for the existing improvements. Two primary types of cost are considered: reproduction cost and replacement cost.

• Reproduction Cost: The estimated cost of constructing an exact replica of the subject property, using the same materials, design, and construction methods as the original. This is often challenging due to technological advancements and material availability changes.

• Replacement Cost: The estimated cost of constructing a building with equivalent utility to the subject property, using current materials, design, and construction techniques. This approach is generally more practical and aligned with the principle of substitution.

A. Components of Cost

A comprehensive cost estimate encompasses both direct and Indirect Costs❓❓, as well as entrepreneurial profit.

1. Direct Costs (Hard Costs): These are directly attributable to the physical construction of the building.

   • Materials (lumber, concrete, roofing, etc.)
   • Labor (carpentry, plumbing, electrical, etc.)
   • Equipment rental or purchase
   • Subcontractor fees

2. Indirect Costs (Soft Costs): These are not directly related to the physical construction but are essential for project completion.

   • Architectural and engineering fees
   • Permit and inspection fees
   • Financing costs (interest on construction loans)
   • Insurance
   • Legal and accounting fees
   • Developer’s overhead

3. Entrepreneurial Profit: The profit a developer expects to receive for their expertise, coordination, and risk-taking. It represents the incentive necessary for undertaking the project. This is often expressed as a percentage of total costs.

   • Example: If total costs are \$1,000,000 and the entrepreneurial profit is estimated at 10%, the profit would be \$100,000.

B. Cost Estimation Methods

Appraisers employ several methods to estimate construction costs, each with its own level of detail and applicability.

1. Comparative Unit Method (Square Foot Method): This is a widely used method for its simplicity, especially in residential appraisals. It involves multiplying the building area (square footage) by a cost per square foot derived from comparable new construction.

   • Formula: Total Cost = Area (sq ft) * Cost per sq ft

   • Example: From the PDF:

     • 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
     • Site Improvements: \$8,500
     • Site Value: \$35,000
     • Total Cost Estimate = \$91,200 + \$8,500 + \$35,000 = \$134,700

   • Considerations:

     • Different areas (living, garage, etc.) have different unit costs.
     • Site improvements (driveway, landscaping) are estimated separately.
     • Unit costs can be derived from market analysis (sales of comparable new homes) or cost estimating manuals.
     • Adjustments are crucial to account for variations in construction features, building size and shape complexity, time, and geographical location.

     • Understand which costs are included in the unit cost and adjust accordingly.

     • Mathematical Representation of Adjustment:

       • Adjusted Cost per sq ft = Base Cost per sq ft * (1 + Adjustment Factor)
       • Example: Base Cost = \$55.50, Location Adjustment = +11%
       • Adjusted Cost = $55.50 * (1 + 0.11) = $61.61
     • Experiment:
       • Find three recently sold houses and collect the next data.
       • Sale price, site value, square footage of the living area and the garage.
       • Calculate the price per square foot for each comparable house.
       • Analise the data to have the prices.

   • Market Analysis Example: From the PDF, a new 1500 sq ft rambler sold for \$120,000. Site value is estimated at \$30,000.

     • Building Value = \$120,000 - \$30,000 = \$90,000
     • Unit Cost = \$90,000 / 1500 sq ft = \$60/sq ft

2. Unit-in-Place Method: This method involves estimating the cost of each major building component (foundation, walls, roof, etc.) separately, based on the installed cost of each unit.

   • Formula: Total Cost = Σ (Quantity of Component * Unit Cost of Component)

   • Example: From the PDF:

     • Floors: 5,000 sq ft @ \$7/sq ft = \$35,000
     • Walls: 300 linear ft @ \$200/linear ft = \$60,000
     • And so on for other components…
     • Total Direct and Indirect Costs = \$249,500

   • Considerations:

     • Unit costs for each component are obtained from cost manuals, builders, or costing services.
     • Ensure consistent measurement units (linear feet for walls, square feet for painting, etc.).
     • Adjustments for time, location, and excluded costs are necessary.
     • Less adjustment compared to square foot methods.

3. Quantity Survey Method: This is the most detailed and accurate method, involving a complete itemization of all costs, including labor, materials, equipment, and overhead for each component. It’s similar to the unit-in-place method but with a greater level of detail.

   • Example: Instead of a single cost for wall framing, it breaks down into:
     • Framing lumber: Cost per board foot
     • Sheathing: Cost per square foot
     • Carpentry labor: Cost per hour
     • Scaffolding: Cost per day
     • Formula: Total Cost = Σ (Quantity of Material/Labor * Unit Cost of Material/Labor)
   • Usage:
     • Primarily used by contractors and builders for bidding.

4. Cost Index Trending: This method estimates the current cost by applying a construction cost index to the original construction cost.

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

   • Example: House built in 1980 for \$100,000. Index was 150 in 1980 and is now 200.

     • Current Cost = \$100,000 * (200 / 150) = \$133,333.33
       • Limitations:
     • Least reliable method due to potential discrepancies between the original cost and typical construction costs.
     • Useful for double-checking other cost estimation methods.

III. Depreciation: Accounting for Value Loss

Depreciation refers to the loss in value of an improvement compared to its cost, due to any cause. Accurate depreciation estimation is crucial for the cost approach to yield a reliable value indication.

A. Depreciation Terminology

1. Accrued Depreciation: The total depreciation that has occurred from the time the improvement was built until the effective date of the appraisal.

2. Actual Age (Chronological Age/Historical Age): The actual number of years the improvement has been in existence.

3. Effective Age: The apparent age of the improvement based on its condition and market perception. It may be the same, older, or younger than the actual age.

4. Economic Life (Useful Life): The period during which the improvement contributes to the property’s value.

5. Physical Life: The total lifespan of the improvement with normal maintenance, typically longer than the economic life.

6. Remaining Economic Life: The estimated time from the appraisal date until the end of the improvement’s economic life.

   • Relationship: Economic Life = Effective Age + Remaining Economic Life
   • Example: House built in 1980, economic life of 50 years. Appraised in 1994 (actual age 14 years). Remaining economic life estimated at 40 years. Effective age = 50 - 40 = 10 years.

B. Types of Depreciation

Depreciation is classified by its cause and whether it is curable.

1. Physical Deterioration: Loss in value due to wear and tear or damage to the physical components.

   • Examples: Broken windows, leaky roof, peeling paint.
   • Curable: Cost to correct is less than the resulting increase in value (e.g., repainting).
   • Incurable: Cost to correct exceeds the resulting increase in value (e.g., cracked foundation).
   • Short-lived Items: Components with economic life same as the physical life (paint or carpet), require replacement during the economic life of the building.
   • Long-lived Items: Components expected to last as long as the building, but physical life is longer than economic life (foundation).

2. Functional Obsolescence: Loss in value due to design defects or outdated features.

   • Examples: Poor floor plan, inadequate insulation, lack of modern amenities.
   • Deficiencies: Features lacking that are now considered necessary.
   • Superadequacies: Over-improvements where the cost exceeds the value added (e.g., excessive wall framing).
   • Curable: Defect can be remedied at a cost less than the increase in value (e.g., adding insulation).
   • Incurable: Remedy is prohibitively expensive (e.g., low ceiling heights).

3. External (Economic) Obsolescence: Loss in value due to factors outside the property.

   • Examples: Proximity to a noisy airport, location in an industrial area, declining local economy.
   • Generally considered incurable as the property owner has no control.

C. Methods of Estimating Depreciation

1. Economic Age-Life Method (Straight-Line Method): Assumes a constant rate of depreciation over the economic life.

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

   • Example: Reproduction cost \$220,000, economic life 60 years, effective age 15 years.

     • Depreciation Rate = 15 / 60 = 0.25 (25%)
     • Depreciation = 0.25 * \$220,000 = \$55,000
     • Depreciated Value = \$220,000 - \$55,000 = \$165,000
     • Adjustments:
       • Cost to cure curable physical and functional defects assumed equal to the cost of curing the defects
       • The ratio of effective age to economic life is applied to the remaining cost of the improvement

   • Appropriateness: Best for measuring physical deterioration.

2. Sales Comparison Method: Compares sales prices of similar properties with and without the defect. The price difference represents the depreciation.

   • Example: Houses with a poor floor plan sell for \$110,000, while those with functional floor plans sell for \$120,000. Depreciation due to the floor plan is \$10,000.

3. Capitalization Method: Similar to the sales comparison method, but uses income differences. The difference in income between properties with and without the defect is capitalized to estimate depreciation.

   • Example: Properties near an airport rent for \$800/month, while those in better locations rent for \$900/month.
   • \$100 difference * 12 months = \$1200 annual difference. Capitalized at 8%: \$1200 / 0.08 = \$15,000 depreciation.
   • Multiplier method: Property sells for 150 times the monthly gross. Loss in rent 100 * 150 multiplier = depreciation of \$15,000.

4. Cost to Cure Method: Estimates depreciation based on the cost to remedy curable items.

   • Example: Cost to replace worn-out carpeting is the depreciation due to that item.
   • Verification: Ensure the repair is physically and legally possible, and the cost doesn’t exceed the value increase.

5. Observed Condition Method (Breakdown Method): Estimates each type of depreciation separately using various techniques.

IV. Practical Application: The URAR Form

The Uniform Residential Appraisal Report (URAR) includes a section for the Cost Approach, requiring:

1. Estimated Site Value
2. Estimated Reproduction or Replacement Cost New (based on square footage)
3. Depreciated Cost of Improvements
4. “As-is” Value of Site Improvements

The form allows for comments on cost estimates, site valuation, square footage calculations, and remaining economic life.

V. Conclusion

Cost estimation and depreciation are crucial components of the Cost Approach to value. By understanding the principles, methods, and challenges involved, appraisers can develop credible and reliable value indications. This chapter provided a scientific foundation for these concepts, equipping you with the knowledge to navigate the complexities of the Cost Approach in appraisal practice.

VI. Chapter Quiz

1. Which cost estimating technique estimates the labor rates and man hours necessary to install the plumbing system in a house?
   a. Unit-in-place method
   b. Cost index trending method
   c. Quantity survey method
   d. Comparative unit method

2. Which of the following is the most commonly used method by appraisers to estimate the cost of residential properties?
   a. Cost index trending
   b. Quantity survey method
   c. Comparative unit method
   d. None of the above

3. The unit costs used with the unit-in-place method include the costs of:
   a. labor.
   b. materials.
   c. equipment.
   d. all of the above.

4. If construction costs are 10% higher in the local market than the average costs listed in a costing manual, the appraiser should adjust the unit costs used in the cost estimate by:
   a. multiplying them by 10%.
   b. multiplying them by 110%.
   c. multiplying them by 90%.
   d. dividing them by 90%.

5. A poor floor plan design is an example of:
   a. deferred maintenance.
   b. a superadequacy.
   c. functional obsolescence.
   d. economic obsolescence.

6. Which of the following types of depreciation is always incurable?
   a. Physical deterioration
   b. Functional obsolescence
   c. External obsolescence
   d. None of the above

7. Worn out carpeting in a house would most likely fall into the category of:
   a. curable physical deterioration.
   b. incurable physical deterioration.
   c. curable functional obsolescence.
   d. incurable functional obsolescence.

8. Estimates of depreciation are generally more reliable in the case of:
   a. older homes.
   b. newer homes.
   c. larger homes.
   d. smaller homes.

9. The effective age of an improvement:
   a. depends on the actual age of the improvement.
   b. is the difference between actual age and economic life.
   c. is the difference between actual age and remaining economic life.
   d. is the difference between economic life and remaining economic life.

10. Depreciation may be measured by:
    a. market comparison.
    b. income capitalization.
    c. cost to cure.
    d. any of the above.