Cost Approach: Methods and Depreciation

Cost Approach: Methods and Depreciation - Introduction

The cost approach to valuation is a critical methodology in real estate appraisal, providing an independent estimate of value predicated on the economic principle that a rational actor will pay no more for a property than the cost to acquire an equivalent substitute. This chapter, “Cost Approach: Methods and Depreciation,” offers a comprehensive and scientifically rigorous examination of the techniques employed to estimate the cost of constructing a new improvement and subsequently account for any accrued depreciation.

The scientific importance of the cost approach stems from its reliance on verifiable construction cost data and systematic depreciation analysis. It offers a framework for quantifying the individual components of value and understanding the impact of physical, functional, and external factors on property worth. By meticulously accounting for all costs associated with creating a property and subtracting the quantified loss in value from depreciation, the cost approach provides a theoretically sound and practically applicable valuation estimate. This is especially crucial when market data is scarce or unreliable, such as in the valuation of specialized or unique properties.

This chapter will delve into the following key areas:

• Cost Estimation Methods: A detailed exploration of prevalent cost estimation methods, including the square foot method, unit-in-place method, and quantity survey method, emphasizing the underlying assumptions and limitations of each technique. The process of data acquisition, encompassing both market analysis and the utilization of cost estimating manuals, will be rigorously analyzed.
• Depreciation Analysis: A comprehensive examination of depreciation theory, including the classification of depreciation into physical deterioration, functional obsolescence, and external obsolescence. The crucial distinction between curable and incurable depreciation will be explained and analyzed.
• Depreciation Estimation Techniques: A critical evaluation of various depreciation estimation methodologies, such as the economic age-life method, sales comparison method, and capitalization method. Special attention will be given to the accuracy and applicability of each technique under different market conditions and property types.

The educational goals of this chapter are to equip the student with the following capabilities:

1. Application of Cost Estimation Methods: To proficiently apply various cost estimation techniques to accurately determine the reproduction or replacement cost of an improvement.
2. Depreciation Identification and Quantification: To systematically identify and quantify the various forms of accrued depreciation (physical, functional, and external) affecting a property’s value.
3. Integration of Cost and Depreciation Data: To synthesize cost estimation and depreciation analysis results to derive a reliable value indication based on the cost approach.
4. Critical Evaluation of the Cost Approach: To understand the strengths and limitations of the cost approach relative to other valuation methodologies (sales comparison and income capitalization), enabling informed decision-making in diverse appraisal scenarios.

By mastering the principles and techniques presented in this chapter, students will gain a foundational understanding of the cost approach, a crucial component of the broader discipline of real estate valuation and essential for complying with financial institutions and real estate appraisal regulations.

Chapter 8: Cost Approach: Methods and Depreciation

I. Introduction to the Cost Approach

The cost approach is a method used in real estate appraisal to estimate the value of a property based on the cost of constructing a new replacement for it, less any accrued depreciation❓❓. It relies on the principle of substitution, which suggests that a buyer will pay no more for a property than the cost of building a substitute of equal utility. This approach is particularly useful for valuing unique or specialized properties where market data is scarce, and for new construction. The following formula is used:

Value = Cost of New Replacement - Accrued Depreciation + Land Value

II. Cost Estimation Methods

The first step in the cost approach is to estimate the cost of either reproducing or replacing the existing improvements. Reproduction cost refers to the cost of creating an exact replica of the existing structure, while replacement cost refers to the cost of creating a substitute structure with the same utility, using modern materials and construction techniques. The most common methods for estimating cost are:

A. Comparative Unit Method (Square Foot Method)

This method involves estimating the cost per square foot of a similar structure and multiplying it by the area of the subject property. It’s a relatively simple and widely used method, especially for residential properties.

1. Process:

   • Calculate the area of the building (length x width). Separate calculations can be made for different structures, i.e. living area and garage.
   • determine❓ the appropriate cost per square foot based on market analysis or cost estimating manuals.
   • Multiply the area by the cost per square foot to arrive at the estimated cost.
   • Add the value of the land and any site improvements to the value calculated above.

2. Formula:

   • Total Building Cost = Area (sq. ft.) x Cost per sq. ft.
   • Total Property Value = Total Building Cost + Land Value + Site Improvement Value

3. Sources of Unit Costs:

   • Market Analysis: Analyzing sales of comparable new homes. Subtracting the site value from the sales price and dividing the result by the square footage gives a unit cost.
     • Unit Cost = (Sales Price - Site Value) / Square Footage
   • Cost Estimating Manuals: Utilizing published cost manuals (e.g., Boeckh, Marshall & Swift, R.S. Means) that list average unit costs for different sizes and styles of construction.
   • Local builders and developers.

4. Adjustments:

   • Construction Features: Higher-quality materials or complex designs will increase the unit cost.
   • Size and Shape: Unit costs tend to be higher for smaller buildings due to fixed costs (e.g., kitchen, bathrooms) being spread over fewer square feet. Cost increases with complex design (perimeter-to-area ratio).
   • Time: Adjust for changes in construction costs since the data was published (e.g., inflation, material price fluctuations).
   • Location: Account for regional differences in labor and material costs.
   • Entrepreneurial Profit: Manual costs usually do not include entrepreneurial profit. This represents the return required to incent a developer to undertake a building project.

5. Example:

   • A new 1,500 sq. ft. rambler sold for $120,000.
   • Site value is estimated at $30,000.
   • Building value is $90,000 ($120,000 - $30,000).
   • Unit cost is $60 per sq. ft. ($90,000 / 1,500 sq. ft.).
     A cost manual indicates the average cost per square foot is $55.50.
     Adjustment made for larger structure = 8%
     Adjustment made for time (current cost) = 5%
     Adjustment made for location (local cost) 11%
     Adjustment made for exterior finishes $3.50 per sq. ft.

B. Unit-in-Place Method

This method involves estimating the cost of each individual component of the building (e.g., foundation, walls, roof) and summing them up to arrive at the total cost. It’s more detailed than the square foot method and can provide a more accurate estimate.

1. Process:

   • Identify all major building components.
   • Measure the quantity of each component (e.g., square feet of flooring, linear feet of walls).
   • Determine the unit cost for each component (e.g., cost per square foot of flooring, cost per linear foot of wall).
   • Multiply the quantity by the unit cost for each component.
   • Sum up the costs of all components to arrive at the total cost.

2. Formula:

   • Component Cost = Quantity x Unit Cost
   • Total Building Cost = Sum of all Component Costs

3. Sources of Unit Costs:

   • Local builders and developers.
   • Cost estimating manuals.

4. Adjustments:

   • Time and Location: Similar to the square foot method.
   • Indirect Costs and Entrepreneurial Profit: Ensure these are included in the total cost estimate.

5. 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
   • Interior partitions: 100 linear ft. @ $40/linear ft. = $4,000
   • Ceilings: 5,000 sq. ft. @ $4/sq. ft. = $20,000
   • Doors and windows = $5,000
   • Roof cover = $10,000
   • Plumbing lines and fixtures = $5,500
   • Electrical system = $5,000
   • Heating and cooling = $20,000
   • Hardware and all other costs = $10,000
     *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 breakdown of all costs associated with construction, including labor, materials, equipment, overhead, and profit.

1. Process:

   • Identify every single item required for construction (e.g., specific type and quantity of lumber, nails, wiring, etc.).
   • Estimate the cost of each item separately, including labor and equipment.
   • Sum up all costs to arrive at the total cost.

2. Formula:

   • Material Cost = Quantity x Unit Price
   • Labor Cost = Hours x Hourly Rate
   • Equipment Cost = Usage Time x Rental Rate
   • Total Building Cost = Sum of all Material Costs + Labor Costs + Equipment Costs + Overhead + Profit

3. Application:

   • Primarily used by contractors and builders for bidding purposes.

D. Cost Index Trending

This method uses construction cost indexes to adjust the original construction cost of a building to its current cost.

1. Process:

   • Determine the original construction cost and the year of construction.
   • Find the construction cost index for the original year and the current year.
   • Calculate the ratio of the current index to the original index.
   • Multiply the original cost by the ratio to arrive at the current cost.

2. Formula:

   • Current Cost = Original Cost x (Current Index Value / Original Index Value)

3. Limitations:

   • Least reliable method, as it assumes the original construction cost was typical and the index accurately reflects cost changes.
   • Best used as a check for other cost estimation methods.

4. Example:

   • A house was built in 1980 at a cost of $100,000.
   • Construction cost index was 150 in 1980, and is currently 200.
   • Current cost = $100,000 x (200/150) = $133,333

III. Depreciation Estimation

Depreciation is the loss in value of an improvement due to physical deterioration, functional obsolescence, and external obsolescence. It is the difference between the market value of the improvement and its cost. Accurately estimating depreciation is crucial in the cost approach.

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/Historical Age): The actual amount of time the improvement has been in existence.
3. Effective Age: The apparent or functional age of the improvement, based on its current condition and market appeal.
4. Economic Life (Useful Life): The period during which the improvement contributes to the property’s value.
5. Physical Life: The total length of time an improvement is expected to last with normal maintenance.

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

7. Relationships:

   • 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: Loss in value due to wear and tear, damage, or deferred maintenance.

   • Curable: The cost to cure is less than the resulting increase in value.
   • Incurable: The cost to cure exceeds the resulting increase in value.
   • Long-Lived Items: Components expected to last the life of the building (e.g., foundation).
   • Short-Lived Items: Components that need replacement during the building’s economic life (e.g., paint, carpeting).

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

   • Curable: The cost to cure is less than the resulting increase in value.
   • Incurable: The cost to cure exceeds the resulting increase in value.
   • Deficiencies: Features that are lacking or substandard (e.g., inadequate insulation).
   • Superadequacies: Over-improvements where the cost exceeds the contribution to value (e.g., overly expensive wall framing).

3. External (Economic) Obsolescence: Loss in value due to factors outside the property itself (e.g., proximity to a nuisance, poor economic conditions).

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

C. Methods of Estimating Depreciation

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

   • Formula:

     • Depreciation = (Effective Age / Economic Life) x Cost
     • Depreciated Value = Cost - Depreciation

   • Modification for Curable Items:

     • Adjusted Cost = Cost - Cost to Cure Curable Items
     • Incurable Depreciation = (Effective Age After Cure / Economic Life) x Adjusted Cost
     • Total Depreciation = Incurable Depreciation + Cost to Cure Curable Items
     • Depreciated Value = Cost - Total Depreciation

   • Limitations: Not reliable for functional or external obsolescence.

   • Example:

     • Reproduction cost: $220,000
     • Economic life: 60 years
     • Effective age: 15 years
     • Depreciation rate: 15/60 = 0.25 (25%)
     • Depreciation: 0.25 x $220,000 = $55,000
     • Depreciated value: $220,000 - $55,000 = $165,000
       Curable physical and functional defects = $5,000
       After cure effective age = 12
       Economic Life = 60
       Cost adjusted = $220,000 - $5,000 = $215,000
       depreciation rate: 12/60 = 0.20 (20%)
       incurable depreciation = 0.20 x $215,000 = $43,000
       Total depreciation = $43,000 + $5,000 = $48,000
       depreciated value = $220,000 - $48,000 = $172,000

2. Sales Comparison Method: Identifies comparable properties with and without the same defect to determine the market’s perception of the depreciation.

   • Process:

     • Find comparable sales with the defect.
     • Find comparable sales without the defect.
     • The difference in selling prices indicates the amount of depreciation.

   • Example:

     • Houses with a poor floor plan sell for $110,000.
     • Houses with a functional floor plan sell for $120,000.
     • Depreciation due to poor floor plan: $120,000 - $110,000 = $10,000

3. Capitalization Method: Similar to the sales comparison method, but uses rental income instead of sales prices.

   • Process:

     • Identify comparable rental properties with and without the defect.
     • Calculate the difference in income between the two sets of properties.
     • Capitalize the income difference to arrive at the depreciation amount.

   • Formula:

     • Annual Income Difference = Monthly Rent Difference x 12
     • Depreciation = Annual Income Difference / Capitalization Rate

Example
Subject property located near a busy airport
Comparable properties rent for $800.00 per month
Comparables in a more favorable location rent for $900.00 per month
$100.00 per month difference
$100.00 x 12 = $1,200 per year difference
*$1,200 / .08 = $15,000

4. Cost to Cure Method: The depreciation due to curable items is equivalent to the cost of curing the defects.

   • Process:
     • Identify curable physical deterioration and functional obsolescence.
     • Estimate the cost to cure each defect.
     • The sum of these costs represents the depreciation.

5. Observed Condition Method (Breakdown Method): Estimates each type of depreciation separately, using a combination of straight-line, sales comparison, capitalization, and cost to cure techniques. This technique is seldom used in residential real estate appraisals.

IV. Uniform Residential Appraisal Report (URAR) and the Cost Approach

The URAR form includes a section dedicated to the cost approach, requiring the appraiser to provide:

• Estimated Site Value
• Estimated Reproduction or Replacement Cost New
• Depreciated Cost of Improvements
• “As-is” Value of Site Improvements
• The form also allows for comments regarding the source of cost estimates, site valuation, and remaining economic life.

V. Conclusion

The cost approach is a valuable tool for real estate appraisers, particularly when market data is limited or when valuing unique properties. By carefully estimating the cost of new construction and accounting for depreciation, appraisers can arrive at a credible indication of value.