Cost Approach: Methods, Depreciation, and URAR

Chapter 8: Cost Approach: Methods, Depreciation, and URAR

This chapter delves into the scientific underpinnings and practical application of the Cost Approach in real estate appraisal. We will examine the methodologies used to estimate construction costs, explore the concept of depreciation from a scientific perspective, and demonstrate how these principles are applied within the framework of the Uniform Residential Appraisal Report (URAR).

I. Cost Approach: Fundamental Principles

The Cost Approach estimates value by summing the land’s value with the depreciated cost of the improvements. The underlying principle is the Principle of Substitution, stating that a rational buyer will not pay more for a property than the cost to acquire a similar substitute.

Equation:

• Property Value = Land Value + Depreciated Cost of Improvements

This approach relies on the following assumptions:

• Accurate Land Valuation: A reliable land value estimate is crucial.
• Cost Estimation Accuracy: Construction costs can be reasonably estimated.
• Depreciation Measurability: Depreciation, representing loss in value, can be quantified.

II. Cost Estimation Methods: A Scientific Breakdown

We explore various methods for estimating the cost of constructing a replica or replacement for the subject property.

A. Comparative Unit Method (Square Foot Method)

This method estimates cost based on the cost per square foot of similar buildings.

1. Methodology:

• Determine the building area (square footage).
• Research the current cost per square foot for similar construction.
• Multiply the area by the unit cost.

Equation:

• Total Cost = Area (sq ft) × Cost per sq ft

2. Scientific Principles:

• This method relies on the Law of Averages. It averages construction costs over the entire building area.
• Accuracy depends on selecting comparables with similar characteristics and construction quality.

3. Deriving Unit Costs:

• Market Analysis: Analyze sales of comparable new homes. Subtract the site value from the sales price and divide by the building area.
  • Unit Cost = (Sales Price - Site Value) / Building Area
• Cost Estimating Manuals: Utilize published cost manuals (Boeckh, Marshall & Swift, R.S. Means).

4. Adjustments:

Unit costs must be adjusted for:

• Construction Features: Adjust for differences in materials, finishes, and features.
• Size and Shape: Smaller buildings often have higher unit costs due to fixed costs being distributed over fewer square feet (e.g., kitchen costs). Building shape impacts perimeter wall length and thus cost.
• Time (Current Cost): Use cost indexes to adjust for changes in construction costs over time.
• Location (Local Cost): Adjust for regional variations in labor and material costs.

Example (Based on provided document):

A house has a living area of 1280 sq ft and a garage of 576 sq ft. Cost per sq ft is $60 for the living area and $25 for the garage.

• Cost of Living Area = 1280 sq ft × $60/sq ft = $76,800
• Cost of 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 Approach Value = $91,200 + $8,500 + $35,000 = $134,700

Experiment: Construct a spreadsheet model that allows users to input building dimensions, unit costs, and adjustment factors (location, features). Vary these inputs to see how they affect the final cost estimate.

B. Unit-in-Place Method

This method estimates cost by summing the costs of individual building components (foundation, walls, roof, etc.).

1. Methodology:

• Identify and quantify each building component (e.g., square feet of flooring, linear feet of walls).
• Determine the unit cost for each component (including labor, materials, overhead).
• Multiply the quantity by the unit cost for each component.
• Sum the costs of all components.

Equation:

• Total Cost = ∑ (Quantity of Component × Unit Cost of Component)

2. Scientific Principles:

• This method breaks down the construction process into smaller, more manageable units.
• Accuracy relies on detailed measurements and accurate unit cost data.

3. Data Sources:

• Cost manuals, local builders, and costing services.

4. Measurements and Units:

• Ensure consistency between the measurement units and the unit costs (e.g., linear feet of wall vs. square feet of wall surface).

5. Adjustments:

• Time (Current Cost)
• Location (Local Cost)
• Indirect Costs & Entrepreneurial Profit (If not included in unit costs)

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

• …and so on.

• Total Direct and Indirect Costs = $249,500

Experiment: Develop a database of unit-in-place costs for different building components. Research cost variations based on materials (e.g., wood vs. concrete walls).

C. quantity survey method❓❓

This is the most detailed method, estimating the cost of all labor, materials, equipment, and overhead separately.

1. Methodology:

• Quantify every item required for construction (e.g., number of bricks, board feet of lumber, hours of labor).
• Determine the unit cost for each item.
• Multiply the quantity by the unit cost.
• Sum the costs of all items.

Equation:

• Total Cost = ∑ (Quantity of Material A × Unit Cost of Material A) + ∑ (Hours of Labor Type B × Hourly Wage of Labor Type B) + …

2. Scientific Principles:

• This method provides the highest level of accuracy by accounting for all cost elements individually.
• Requires extensive knowledge of construction practices and cost accounting.

3. Application:

• Primarily used by contractors and builders for bidding on projects.

4. Subcontractor Bids:

• Specialty subcontractors (plumbing, electrical, carpentry) typically provide estimates for their sections. The general contractor then combines these sub-estimates.

Experiment: Select a small building element (e.g., a section of drywall) and perform a detailed quantity survey. Research current material prices and labor rates to calculate the total cost.

D. Cost Index Trending

Estimates the reproduction cost of a building based on its original construction cost and changes in construction cost indexes.

1. Methodology:

• Determine the original construction cost.
• Identify the cost index value at the time of construction and the current cost index value.
• Calculate the cost index ratio.
• Multiply the original cost by the cost index ratio.

Equation:

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

2. Scientific Principles:

• This method relies on the assumption that changes in the cost index accurately reflect changes in construction costs.

3. Limitations:

• Not considered very reliable, as it assumes the original construction cost was typical and that the index accurately tracks cost changes for the specific type of building.

Example:

A house was built in 1980 for $100,000. The cost index was 150 in 1980 and is currently 200.

• Cost Index Ratio = 200 / 150 = 1.33
• Current Cost = $100,000 × 1.33 = $133,000

Experiment: Track historical construction cost indexes (e.g., Engineering News-Record Construction Cost Index). Compare the index-adjusted costs to actual sales prices of older buildings to assess the method’s accuracy.

III. Estimating Depreciation: Understanding Value Loss

Depreciation is the loss in value of an improvement compared to its cost. It reflects the difference between the market value and the reproduction/replacement cost. Accrued depreciation is the total depreciation from the time the improvement was built to the effective date of the appraisal.

A. Depreciation Terminology

• Actual Age (Chronological Age): The actual time the improvement has been in existence.
• Effective Age: The apparent or functional age based on its condition and market conditions. It may be less than, equal to, or greater than the actual age.
• Economic Life (Useful Life): The period during which the improvement contributes to the property’s value.
• Physical Life: The total time the improvement is expected to last with normal maintenance (often longer than economic life).
• Remaining Economic Life: The time from the effective date of the appraisal until the end of the improvement’s economic life.

Equations:

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

Example:

A house built in 1980 has an estimated economic life of 50 years. Appraised in 1994 (actual age 14 years). Because it is well maintained, the appraiser estimates the remaining economic life at 40 years.

• Effective Age = 50 years - 40 years = 10 years

B. Types of Depreciation: A Causal Classification

Depreciation is categorized based on its cause and whether it can be remedied.

1. Physical Deterioration:

• Caused by wear and tear or damage to physical components (broken windows, leaky roofs, peeling paint).
• Curable: If the cost to correct is less than the resulting increase in value (e.g., repainting).
• Incurable: If the cost to correct exceeds the resulting increase in value (e.g., cracked foundation).
• Long-Lived Items: Expected to last as long as the building (e.g., foundation).
• Short-Lived Items: Need replacement during the building’s economic life (e.g., paint, carpeting).

2. Functional Obsolescence:

• “Built-in” obsolescence due to design defects or outdated features.
• Deficiency: Something lacking (e.g., inadequate insulation).
• Superadequacy: Over-improvement (e.g., excessively thick wall framing that adds little value).
• Curable: If the defect can be remedied at a cost less than the value increase (e.g., adding insulation).
• Incurable: If the cost to remedy is prohibitive (e.g., raising ceiling heights).

3. External (Economic) Obsolescence:

• Loss in value due to factors outside the property (e.g., negative influences from surrounding properties, poor local economic conditions).
• Generally considered incurable, as the property owner has no control over external factors.

C. Methods of Estimating Depreciation

Estimating depreciation is the most challenging aspect of the Cost Approach.

1. Economic Age-Life Method (Straight-Line Method):

• Assumes an improvement loses value at a constant rate over its economic life.

Equation:

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

Example:

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 years / 60 years = 0.25 (25%)
• Depreciation = 0.25 × $220,000 = $55,000
• Depreciated Value = $220,000 - $55,000 = $165,000

Variations: Account for curable defects by subtracting the cost to cure them from the cost before applying the age-life ratio.

2. Sales Comparison Method:

• Identifies comparable properties with and without the defect. The price difference represents the amount of depreciation.
  • Depreciation = Sales Price (without defect) - Sales Price (with defect)

3. Capitalization Method:

• Identifies comparable rental properties with and without the defect. The income difference is capitalized to estimate the depreciation.
  • Depreciation = Annual Income Difference / Capitalization Rate

4. Cost to Cure Method:

• Depreciation due to curable items is equal to the cost of curing the defects.

5. Observed Condition Method (Breakdown Method):

• Estimates each type of depreciation separately, using various techniques (straight-line, sales comparison, capitalization, cost to cure).

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

The URAR includes a section for the Cost Approach, requiring:

• Estimated Site Value
• Estimated Reproduction or Replacement Cost New (based on square footage)
• Depreciated Cost of Improvements
• “As-is” Value of Site Improvements

The URAR provides space for comments on the cost estimate, site valuation, square foot calculation, and estimated remaining economic life. Addendums may be necessary for detailed explanations.

V. Chapter Summary

The Cost Approach involves estimating the value of a property by summing the land value with the depreciated cost of improvements. Accurate cost estimation and depreciation assessment are crucial. Different cost estimation methods (Comparative Unit, Unit-in-Place, Quantity Survey, Cost Index Trending) offer varying levels of detail and accuracy. Depreciation is categorized as physical deterioration, functional obsolescence, and external obsolescence. Several methods are used to estimate depreciation (Economic Age-Life, Sales Comparison, Capitalization, Cost to Cure, Observed Condition), each with its own assumptions and limitations. The URAR requires specific data related to the Cost Approach. The Cost approach, while less emphasized than the Sales Comparison Approach, provides critical information in determining a property’s value.