Cost Approach to Value: Site Valuation and Depreciation

Chapter 7: Cost Approach to Value: Site Valuation and depreciation❓❓

Introduction

As part of the training course “Real Estate Income Analysis: Mastering Direct Capitalization,” this chapter provides an in-depth examination of the Cost Approach to Value, with a specific focus on Site Valuation and Depreciation. The cost approach is crucial for accurately assessing property value by considering the cost of replacing or reproducing the improvements and the value of the underlying land. This chapter connects to the course description by enhancing your ability to reconstruct operating statements and calculate pre-tax cash flow, ultimately empowering you to make sound financial decisions in the dynamic world of real estate.

7.1 Overview of the Cost Approach

The Cost Approach operates on the principle of substitution. This principle posits that a prudent buyer will not pay more for a property than the cost of acquiring a comparable site and constructing a similar improvement. The cost approach is particularly relevant in appraisals where income-generating properties are concerned, since a rational economic actor must consider that the income of a property cannot exceed the construction cost. This ties the cost approach to the INCOME generating properties targeted by the course description.

7.1.1 Formula

The basic formula for the Cost Approach is:

Property Value = Site Value + (Reproduction Cost New - Accrued Depreciation)

Where:

• Site Value: The estimated value of the land as if vacant and available for its highest and best use.
• Reproduction Cost New (RCN): The estimated cost to construct an exact replica of the existing improvement, using the same materials, design, and construction methods.
• Accrued Depreciation: The total loss in value of the improvement due to physical deterioration, functional obsolescence, and external obsolescence.

7.2 Site Valuation

A separate site valuation is a sine qua non for the cost approach.

7.2.1 Importance of Site Valuation

• Provides a basis for the cost approach calculation. The accuracy of the property value is directly related to the accuracy of the site valuation.
• Supports highest and best use analysis. A properly valued site estimate reflects the market’s perception of the land’s potential.
• Required by law in some jurisdictions, particularly for property tax assessment and condemnation proceedings.

7.2.2 Methods of Site Valuation

Several methods exist for estimating site value. We’ll explore the most common ones, highlighting their applications and scientific principles:

7.2.2.1 Sales Comparison Method

• Description: The most reliable method, it involves comparing the subject site to similar vacant sites that have recently sold. Accurate identification of true market “comparables” is key. Adjustments are then made to the sales prices of the comparables to account for differences between them and the subject site. This is directly relevant to understanding income estimation using comparable properties for direct capitalization.
• Scientific Principles: This method is rooted in the principle of substitution. The market provides evidence of value through transactions involving comparable assets. Effective use requires statistical rigor.

• Elements of Comparison: Adjustments are made for differences in:

  • Real Property Rights Conveyed (fee simple, leasehold, etc.)
  • Financing Terms
  • Conditions of Sale (arm’s length transaction, motivated seller, etc.)
  • Market Conditions (time adjustment)
  • Location (neighborhood amenities, access, zoning)
  • Physical Characteristics (size, shape, topography, soil conditions)
  • Economic Characteristics (development potential, allowed uses)
  • Formula:

  Subject Site Value = Comparable Sale Price +/- Adjustments
  * Practical Application: An appraiser is estimating the value of a 1-acre commercial site in a developing area. They find three recent sales of similar sites:

  • Comparable 1: 1.1 acres, sold for $150,000, located on a less busy street (adjustment +$10,000).
  • Comparable 2: 0.9 acres, sold for $130,000, sold six months ago (market conditions +$5,000)
  • Comparable 3: 1 acre, sold for $140,000, poorer soil (adjustment -$15,000)

  Based on these adjustments, the appraiser can determine a reasonable value range for the subject site and reconcile to a single indicated value.
  * Related Experiment: Conduct a sensitivity analysis. Vary the adjustments within a reasonable range (e.g., +/- 10% for location, +/- 5% for time). Observe how these variations affect the final indicated value. This helps assess the robustness of the valuation.

7.2.2.2 Allocation Method

• Description: This method relies on market-derived ratios of land value to total property value in the area. This relies on market trends in a localized area, in line with the course description. It assumes that a consistent proportion of value is attributable to the land component for similar properties.
• Scientific Principles: Relies on statistical averages and market observations. Less precise than sales comparison but can be useful as a check or in areas with limited vacant land sales data.

• Formula:

  Site Value = Total Property Value x (Land Value Percentage)

  Where the “Land Value Percentage” is derived from market data of similar properties.
  * Practical Application: An appraiser is valuing an apartment complex. Market data suggests that land values typically constitute 20% of the total property value. If a comparable apartment complex recently sold for $1,000,000, the indicated land value for the subject would be $200,000.

7.2.2.3 Extraction Method

• Description: This involves estimating the depreciated cost of the improvements and subtracting that amount from the total sale price of the property. The residual represents the implied land value.
• Scientific Principles: This method relies on a sound understanding of depreciation principles (covered in Section 7.3). Accuracy hinges on the reliability of the depreciation estimate.

• Formula:

  Site Value = Sale Price of Improved Property - Depreciated Cost of Improvements
  * Practical Application: A small retail building recently sold for $300,000. The appraiser estimates the reproduction cost new of the building to be $250,000 and total depreciation to be $80,000. The extracted site value is: $300,000 - ($250,000 - $80,000) = $130,000.

7.2.2.4 Development Method (Subdivision Analysis)

• Description: Used for valuing large, undeveloped parcels suitable for subdivision. The appraiser projects the revenues from the sale of finished lots, subtracts all development costs (including profit and overhead), and discounts the resulting cash flow back to present value.
• Scientific Principles: This is a sophisticated discounted cash flow (DCF) analysis, relying on the Principle of Anticipation, which is that value is related to the discounted present value of future revenues. Accuracy depends heavily on the reliability of projections and the selection of an appropriate discount rate. This application involves advanced capital budgeting techniques.

• Formula: Requires a complex spreadsheet model, incorporating:

  • Projected Lot Sales (price, quantity, timing)
  • Development Costs (infrastructure, marketing, legal, etc.)
  • Discount Rate (reflecting risk and opportunity cost)
  • Present Value Calculation
  • Practical Application: An appraiser is valuing a 20-acre parcel proposed for a residential subdivision. The development plan calls for 50 lots, which are projected to sell for an average of $50,000 each over a 5-year period. Total development costs are estimated at $800,000. Using a discount rate of 12%, the present value of the land can be calculated using a DCF model.

7.2.2.5 Land Residual Method

• Description: Similar to the subdivision method, it is more frequently used to identify the value of a site for potential development, and how much the construction costs will impact the ability of the finished property to achieve the value it needs. This is done by allocating a portion of the total income generated by an improved property to the land and then capitalizing that income stream into a value indication.
• Scientific Principles: Involves the Principle of Anticipation, as value is determined by discounting projected net income from the property;
• Formula::
  • Net Operating Income - (Value of Building Improvements * Capitalization Rate) = Land Income
  • Land Income / Land Capitalization Rate = Land Value
• Practical Application:: A developer plans to develop a commercial property and can calculate the total NO income based on the land and what it is expected to generate. The developer will perform an analysis by allocating the proper percentage of what must be done to construction and then determine the land value by capitalization of the income.

7.2.2.6 Ground Rent Capitalization Method

• Description: This method is used when the land is leased and generates income through ground rent.
• Scientific Principles: Again, it involves the Principle of Anticipation, with value linked to anticipated ground rent payments;
• Formula::
  • Ground Rent Income / Cap Rate = Land Value
• Practical Application: A property is leased at a ground rent of $10,000 per year. The estimated capitalization rate for similar leased properties is 10%. The land value would then be: $10,000/.10 = $100,000.

7.2.3 Reconciling Site Valuation Indicators

After applying multiple methods, the appraiser must reconcile the resulting value indications. The Sales Comparison Method typically receives the greatest weight, especially when sufficient comparable sales data are available. Other methods serve as supporting evidence and a check on the reasonableness of the sales comparison result. This is directly related to the course, since the Sales Comparison approach often relies on estimating the INCOME generated from “comp” property, which is critical to DIRECT CAPITALIZATION.

7.3 Depreciation

Depreciation is the reduction in value of an asset over time, usually due to wear and tear. However, in appraisal practice, depreciation refers to any loss in value from any cause.

7.3.1 Types of Depreciation

There are three primary types of depreciation:

• Physical Deterioration: Loss in value due to wear and tear, age, or physical damage.
• Functional Obsolescence: Loss in value due to inadequacies in the property’s design or utility. This could be due to changing tastes or standards.
• External (Economic) Obsolescence: Loss in value due to factors external to the property itself, such as neighborhood decline, zoning changes, or environmental issues.

7.3.2 Methods of Estimating Depreciation

Accurately estimating depreciation is crucial for the cost approach. The following are widely accepted methods:

7.3.2.1 Age-Life Method

• Description: Assumes depreciation is a function of the property’s age relative to its total economic life.
• Scientific Principles: Simplistic but widely used. Relies on estimations of effective age and total economic life.

• Formula:

  Depreciation = (Effective Age / Total Economic Life) x Reproduction Cost New

  Where:

  • Effective Age: The age of the property based on its condition, not necessarily its chronological age.
  • Total Economic Life: The estimated period over which the improvement is expected to contribute economically to the property.
  • Practical Application: A building has a reproduction cost new of $200,000. Its effective age is estimated to be 20 years, and its total economic life is estimated to be 50 years. The estimated depreciation is:

  Depreciation = (20 years / 50 years) x $200,000 = $80,000
  * Related Experiment: Create a spreadsheet and vary the effective age and total economic life within reasonable ranges. Observe the resulting impact on depreciation. This demonstrates the sensitivity of the method to changes in these key assumptions.

7.3.2.2 Cost-to-Cure Method

• Description: Estimates depreciation based on the cost to remedy specific items of physical deterioration or functional obsolescence.
• Scientific Principles: More precise than the age-life method, but requires a detailed inspection and cost estimating.

• Practical Application:

  • The appraiser identifies a leaky roof requiring replacement. The cost to replace the roof is estimated to be $10,000. Therefore, the physical deterioration component of depreciation is $10,000.

7.3.2.3 Market Extraction Method (Sales Analysis)

• Description: This method relies on analyzing sales of comparable properties to extract the market’s perception of depreciation.
• Scientific Principles: This relies on market data. The appraiser identifies sales that differ primarily in age and condition. By analyzing price differences, an estimate of depreciation can be extracted.
• Formula:
  • Sale Price of New Property - Sale Price of Used Property = Depreciation
• Practical Application: A new commercial property of identical size and usage has a fair market value of $300,000, while an older property is valued at $240,000. The amount of depreciation can then be calculated as: $300,000-$240,000 = $60,000.

7.3.3 Depreciation and Income Estimation

Accurately estimating depreciation is especially important for income-producing properties. Depreciation directly affects the Net Operating Income (NOI), which, as covered in the course description, is a key determinant of property value using the Direct Capitalization method. Overstated depreciation reduces NOI, understating the property’s value, and vice versa. Understanding depreciation is also related to Reconstructing Operating Statements, which is another topic in the course description.

7.4 Reconciliation and Final Value Estimate

After estimating site value and depreciation, the appraiser reconciles all the data to arrive at a final value indication using the Cost Approach. The reliability of this final value is contingent upon:

• The accuracy of the site valuation.
• The reliability of the cost data used to estimate reproduction cost new.
• The thoroughness and accuracy of the depreciation estimate.

The Cost Approach should be reconciled with value indications from other approaches, such as the Sales Comparison Approach and the Income Approach (covered in later chapters), to arrive at a final, supported opinion of value.

Conclusion

This chapter provided a detailed examination of the Cost Approach to Value, highlighting the importance of both site valuation and depreciation. By mastering the techniques presented, you will be better equipped to reconstruct operating statements and calculate pre-tax cash flow, ultimately improving your ability to make sound financial decisions in the world of real estate. This is directly related to the course description.