Cost Approach: Methods and Depreciation

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Mastering Real Estate Appraisal Principles: Cost Approach: Methods and Depreciation

Chapter Outline:

I. Introduction to the Cost Approach
II. Cost Estimation Methods
A. Comparative Unit Method (Square Foot Method)
B. Unit-in-Place Method
C. Quantity Survey Method❓❓
D. Cost Index Trending
III. Estimating Depreciation
A. Depreciation Terminology
B. Age and Economic Life
IV. Types of Depreciation
A. Physical Deterioration
B. Functional Obsolescence
C. External (Economic) Obsolescence
V. Methods of Estimating Depreciation
A. Economic Age-Life Method (Straight-Line Method)
B. Sales Comparison Method❓❓
C. Capitalization Method
D. Cost to Cure Method
E. Observed Condition Method (Breakdown Method)
VI. Uniform Residential Appraisal Report (URAR)
VII. Chapter Summary
VIII. Chapter Quiz

I. Introduction to the Cost Approach

The cost approach is one of the three primary approaches to value used in real estate appraisal. It’s based on the principle of substitution, which states that a buyer will pay no more for a property than the cost to acquire a substitute property of equal utility. The cost approach is most reliable when valuing new or relatively new properties, special-purpose properties, and properties where comparable sales data is scarce. The cost approach is less reliable for older properties where depreciation is significant and difficult to estimate.

The basic formula for the cost approach is:

Value = Cost of Reproduction or Replacement New - Accrued Depreciation + Site Value

Where:

• Cost of Reproduction New: The estimated cost of constructing an exact replica of the subject property at current prices.
• Cost of Replacement New: The estimated cost of constructing a substitute property with equivalent utility using current materials and construction standards.
• Accrued Depreciation: The total loss in value from all causes (physical deterioration, functional obsolescence, and external obsolescence) between the date of construction and the effective date of the appraisal.
• Site Value: The estimated market value of the land as if vacant and available for its highest and best use.

II. Cost Estimation Methods

Several methods are used to estimate the cost of reproduction or replacement new. The choice of method depends on the complexity of the property, the availability of data, and the appraiser’s experience.

A. Comparative Unit Method (Square Foot Method)

This is the simplest and most widely used cost estimation method, particularly 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:
   • Calculate the area of the building. This typically involves measuring the exterior dimensions of the building. Example (from provided content): A house has a living area of 1280 sq ft (32 ft x 40 ft) and an attached garage of 576 sq ft (24 ft x 24 ft).
   • Determine the appropriate unit cost. Unit costs can be derived from:
     • Market Analysis: By analyzing the sales prices of comparable new properties, subtracting the site value, and dividing the result by the building area. Example (from provided content): A 1,500 sq ft new rambler sold for $120,000. If the site value is $30,000, the building value is $90,000. The unit cost is $90,000 / 1,500 sq ft = $60 per sq ft.
     • Cost Estimating Manuals or Services: Publications like Boeckh, Marshall & Swift, or R.S. Means provide average unit costs for different types of construction. Example (from provided content): A cost manual indicates an average cost of $55.50 per sq ft for a one-story house of average quality.
   • Multiply the area by the unit cost. Apply different unit costs to different components of the building if necessary (e.g., living area vs. garage). Example (from provided content): Cost of living area = 1280 sq ft x $60/sq ft = $76,800. Cost of garage = 576 sq ft x $25/sq ft = $14,400.
   • Estimate the value of site improvements (e.g., landscaping, driveways) separately. Example (from provided content): Site improvements are valued at $8,500.
   • Sum the costs of the building and site improvements. Example (from provided content): Total cost of improvements = $76,800 + $14,400 + $8,500 = $99,700.
   • Add the site value to arrive at the total property value. Example (from provided content): Property Value = $99,700 + $35,000 = $134,700.

2. Formula:

   Total Improvement Cost = (Area Living Area * Cost/sq ft Living Area) + (Area Garage * Cost/sq ft Garage) + Site Improvements

   Total Property Value = Total Improvement Cost + Site Value

3. Considerations:

   • Building Shape: More complex shapes (e.g., L-shaped) generally have higher unit costs due to increased perimeter wall length compared to the square footage.
   • Size: Smaller buildings generally have higher unit costs per square foot because certain fixed costs (e.g., kitchen, plumbing) are spread over fewer square feet.
   • Adjustments: Unit costs from manuals must be adjusted for local market conditions, specific building features, and the time elapsed since the manual’s publication. Example (from provided content): Adjustments are made for location (construction costs are 11% higher), above-average exterior finishes ($3.50 per sq ft), larger size (8% reduction), economic slowdown (5% reduction), and entrepreneurial profit (10%).
4. Formula for adjusted cost:

   Adjusted Cost = Original Cost \* (1 + Sum of Percentage Adjustments) + Sum of Fixed Cost Adjustments
   

B. Unit-in-Place Method

This method involves estimating the cost of each individual component of the building (e.g., foundation, walls, roof, floors) and summing these costs to arrive at the total cost.

1. Process:
   • Identify all the major building components.
   • Determine the quantity of each component. For example, measure the area of the floors, the linear feet of walls, etc.
   • Obtain unit costs for each component. These costs represent the total cost to install the item, including materials, labor, equipment, and overhead. Sources include cost manuals, local builders, and developers.
   • Multiply the quantity of each component by its unit cost.
   • Sum the costs of all components to arrive at the total cost.
   • Adjust for any indirect costs (e.g., architectural fees, permits, financing costs) and entrepreneurial profit not included in the unit costs.
   • Adjust costs for time and location.

2. Formula:

   Total Cost = (Quantity Component 1 * Unit Cost Component 1) + (Quantity Component 2 * Unit Cost Component 2) + … + Indirect Costs + Entrepreneurial Profit

3. Considerations:

   • Ensure that the measurements used for the different building components are consistent with the way the costs are stated (e.g., cost per linear foot of wall framing vs. cost per square foot of wall surface).
   • Adjustments for differences in construction features, size, and complexity are generally not required because the procedure takes these differences into account through the detailed component breakdown.
4. 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
   • …
   • Total Direct and Indirect Costs = $249,500

C. Quantity Survey Method

This is the most detailed and accurate cost estimation method. It involves a complete itemization of all costs, including labor, materials, equipment, overhead, and profit.

1. Process:
   • Determine the quantities of all materials needed (e.g., board feet of lumber, square feet of sheathing, number of nails).
   • Estimate the labor hours required for each task and the associated labor rates.
   • Estimate the equipment costs.
   • Add up all material, labor, and equipment costs.
   • Add indirect costs (e.g., permits, insurance) and entrepreneurial profit.
2. Considerations:
   • Often performed by contractors or builders.
   • Different sections of the estimate (foundation, plumbing, carpentry, electrical, etc.) are typically prepared by specialty subcontractors.
3. Example:
   • Unit-in-place method: uses a single unit cost to calculate exterior wall framing including lumber, sheathing, carpentry labor, scaffolding, etc.
   • Quantity Survey Method: estimates the quantities of each item separately and multiplies each by its own unit cost (cost per board foot of framing lumber, cost per square foot of sheathing, cost per hour of carpentry labor, etc.).

D. Cost Index Trending

This method is used to estimate the current cost of a building when the original construction cost is known, using a construction cost index.

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.
   • Divide the current index value by the original index value.
   • Multiply the result by the original construction cost.

2. Formula:

   Current Cost = Original Cost * (Current Index Value / Original Index Value)

3. Considerations:

   • This method is quick and convenient but not very reliable.
   • Assumes that the original construction cost was typical for similar improvements built at the same time.
   • Most appropriate as a double-check for other cost estimating procedures.
4. Example (from provided content):
   • A house built in 1980 cost $100,000.
   • The construction cost index was 150 in 1980 and is currently 200.
   • Current Cost = $100,000 * (200 / 150) = $133,000

III. Estimating Depreciation

Depreciation is the loss in value of an improvement from all causes. Accurately estimating depreciation is the most challenging part of the cost approach, especially for older properties.

A. Depreciation Terminology

1. Depreciation: The difference between the market value of an improvement and its cost. Note (from provided content): does not refer to book depreciation, only accrued depreciation.
2. Accrued Depreciation: The total depreciation that has occurred between the time the improvement was built and the effective date of the appraisal.
3. Actual Age (Chronological or Historical Age): The actual amount of time the improvement has been in existence.
4. Effective Age: The apparent or functional age of the improvement, based on its current condition and the conditions in the market. It can be the same as, greater than, or less than the actual age.
5. Economic Life (Useful Life): The length of time during which the improvement will contribute to the value of the property.
6. Physical Life: The length of time that an improvement would be expected to last with normal maintenance.
7. Remaining Economic Life: The amount of time from the effective date of the appraisal until the end of the improvement’s economic life.

B. Age and Economic Life Relationships

The relationship between economic life, remaining economic life, and effective age is:

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

Example (from provided content): A house built in 1980 has an estimated economic life of 50 years. In 1994 (actual age 14 years), it’s appraised and estimated to have a remaining economic life of 40 years. The effective age is 50 - 40 = 10 years.

IV. Types of Depreciation

Depreciation is categorized by its cause and whether it’s curable or incurable.

1. Causes of Depreciation:
   • Physical Deterioration
   • Functional Obsolescence
   • External (Economic) Obsolescence
2. Curability:
   • Curable Depreciation: Can be remedied; the cost to correct the defect is less than the resulting increase in value.
   • Incurable Depreciation: Cannot be remedied, or the cost of the remedy exceeds the resulting increase in value.

A. Physical Deterioration

Depreciation caused by wear and tear or damage to the physical components of the improvement (e.g., broken windows, leaky roofs, peeling paint).

1. Curable Physical Deterioration: The cost to correct the deterioration is less than the added value. Example (from provided content): Repainting is usually curable.
2. Incurable Physical Deterioration: The cost to correct the deterioration exceeds the added value. Example (from provided content): Repairing a cracked foundation.
3. Long-Lived Items: Components expected to last as long as the building itself (e.g., foundation).
4. Short-Lived Items: Components expected to need replacement during the improvement’s economic life (e.g., paint, carpeting).

B. Functional Obsolescence

Depreciation caused by design defects, either from the beginning or due to changes in standards over time. It can be either deficiencies or superadequacies.

1. Deficiencies: Lacking a necessary feature. Example (from provided content): Houses built without bedroom closets.
2. Superadequacies: Over-improvements; features whose costs are greater than their contribution to value. Example (from provided content): A house built with 2’ x 12’ wall framing when 2’ x 4’ or 2’ x 6’ is standard.
3. Curable Functional Obsolescence: The defect can be remedied at a cost that is less than the resulting increase in value. Example (from provided content): Inadequate ceiling insulation.
4. Incurable Functional Obsolescence: The defect cannot be remedied cost-effectively. Example (from provided content): Substandard ceiling heights.

C. External (Economic) Obsolescence

Depreciation caused by factors outside the property itself (e.g., negative influences from surrounding properties, poor local economic conditions).

1. Generally considered incurable because the property owner has no control over external factors. Example (from provided content): A residence located in an industrial area, or a community’s sole employer closing down.

V. Methods of Estimating Depreciation

Several methods are used to estimate depreciation.

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

This method assumes that an improvement loses value at a steady rate over its economic life.

1. Process:

   • Estimate the effective age and the 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 to determine the amount of depreciation: Depreciation = Accrued Depreciation Rate * Cost
   • Subtract depreciation from the cost to estimate the depreciated value.

2. Formula:

   Depreciation = (Effective Age / Economic Life) * Cost
   

   • Depreciated Value = Cost - Depreciation

3. Considerations:

   • Simple to use but may not accurately reflect the actual depreciation pattern.
   • Most appropriate for measuring depreciation due to physical deterioration. Not reliable for functional or external obsolescence.

Example (from provided content): A home has a reproduction cost of $220,000, an economic life of 60 years, and an effective age of 15 years.

Accrued Depreciation Rate = 15 / 60 = 0.25 (25%)
Depreciation = 0.25 * $220,000 = $55,000
Depreciated Value = $220,000 - $55,000 = $165,000

Alternate version example (from provided content): It costs $5,000 to remedy curable physical and functional defects, and curing them would result in the house having an effective age of 12 years.

Cost adjusted for curable items = $220,000 - $5,000 = $215,000
Accrued depreciation rate = 12 / 60 = 0.20 (20%)
Incurable Depreciation = 0.20 * $215,000 = $43,000
Total Depreciation = $43,000 + $5,000 = $48,000
Depreciated Value = $220,000 - $48,000 = $172,000

B. Sales Comparison Method

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

1. Process:
   • Identify comparable properties with the same defect as the subject property and other comparable properties that do not have the defect.
   • The difference in selling prices between the two sets of comparables represents the amount of depreciation.
2. Considerations:
   • Relies on the availability of adequate data.
   • Can be used to calculate any type of depreciation when data is available.
3. Example (from provided content): Comparable houses with a poor floor plan sell for $110,000, while those with functional floor plans sell for $120,000. The depreciation due to functional obsolescence is $10,000.

C. Capitalization Method

This method capitalizes the income loss due to depreciation.

1. Process:
   • Identify comparable rental properties with and without the defect.
   • Determine the difference in income between the two sets of properties.
   • Capitalize the income difference to arrive at a figure for the amount of depreciation.

2. Formula:

   Depreciation = Income Difference / Capitalization Rate
   

3. Considerations:

   • Requires identifying appropriate capitalization rates.
4. Example (from provided content): Properties near a busy airport rent for $800/month, while comparable properties in better locations rent for $900/month. Assuming an 8% capitalization rate, the depreciation equals the locational difference of $100/month * 12 / .08 = $15,000.

D. Cost to Cure Method

This method assumes that the amount of depreciation due to curable items is equal to the cost of curing the defects.

1. Process:
   • Identify all curable items of physical deterioration and functional obsolescence.
   • Estimate the cost to cure each item.
   • Sum the costs to cure.
2. Considerations:
   • Verify that the items are truly curable (physically and legally possible, and cost does not exceed the resulting increase in value).

E. Observed Condition Method (Breakdown Method)

This method involves estimating each type of depreciation separately.

1. Process:
   • Estimate the amount of physical deterioration, functional obsolescence, and external obsolescence individually.
   • Use various techniques (straight-line, sales comparison, capitalization, cost to cure) to estimate each type of depreciation.

VI. Uniform Residential Appraisal Report (URAR)

The URAR includes a section for the cost approach.

1. Required Information:
   • Estimated Site Value
   • Estimated Reproduction or Replacement Cost New
   • Depreciated Cost of Improvements
   • “As-is” Value of Site Improvements

VII. Chapter Summary

• The cost approach estimates value by adding the site value to the depreciated cost of the improvements.
• Cost is estimated as the cost to build a new substitute improvement at current prices.
• Reproduction cost is the cost of an exact replica, while replacement cost is the cost of equivalent utility.
• Cost estimation methods include the comparative unit method (square foot method), unit-in-place method, quantity survey method, and cost index trending.
• Depreciation is the difference between value and cost, representing the loss in value from all causes: physical deterioration, functional obsolescence, and external obsolescence.
• Depreciation can be curable or incurable.
• Methods of estimating depreciation include the economic age-life (straight-line) method, sales comparison method, capitalization method, cost to cure method, and observed condition method.

VIII. Chapter Quiz

1. Which of the following cost estimating techniques would include an estimate of 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 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.