Cost Approach: Principles and Application

Chapter 2: cost❓ Approach: Principles and Application

1. Introduction to the Cost Approach

   • Definition: The cost approach is a valuation method that estimates the value of a property by summing the estimated land value and the depreciated cost of the improvements. It is predicated on the economic principle of substitution, which suggests a buyer won’t pay more for a property than what it would cost to acquire a similar site and construct a substitute improvement.
   • Key Principles:
     • Substitution: A rational buyer will not pay more for an existing property than the cost to purchase land and build a new, equivalent structure.
     • Contribution: The value of any component of a property is determined by its contribution to the overall value, not necessarily its cost.
     • Highest and Best Use: The cost approach is most reliable when the existing improvements represent the highest and best use of the land as if vacant.

   • Applications: This approach is most applicable for:

     • New or relatively new properties where depreciation is minimal.
     • Special-purpose properties where there is no active market for comparable sales (e.g., schools, churches, public buildings).
     • Insurance appraisals to estimate replacement cost.
       2. Components of the Cost Approach

   • Land Value Estimation

     • Importance: Accurate land valuation is crucial.
     • Methods:
       • Sales Comparison Approach: Comparing the subject site to similar vacant land sales.
       • Extraction Method: Subtracting the depreciated cost of improvements from the overall sale price of comparable improved properties to infer land value.
       • Allocation Method: Determining the typical ratio of land value to total property value in the market and applying that ratio to the subject property.
       • Land Residual Technique: Capitalizing the net income attributable to the land. This method is less common and requires estimating the income the land could generate if put to its highest and best use.
   • Estimating the Cost of New Improvements
     • Reproduction Cost vs. Replacement Cost:
       • Reproduction Cost: The cost of creating an exact replica of the existing structure, using the same materials, design, and construction methods. This is seldom used due to obsolescence factors.
       • Replacement Cost: The cost of constructing a new improvement with similar utility to the subject property, using current materials, design, and construction techniques. This is the more common and practical approach.
     • Cost Estimation Methods:
       • Quantity Survey Method: A detailed itemization of all direct (materials and labor) and indirect costs (permits, fees, overhead, profit). This is the most accurate but also the most time-consuming method.
       • Unit-in-Place Method: Estimating the cost of each component of the building (e.g., walls, roof, flooring) based on the installed cost per unit (e.g., per square foot, per cubic foot).
       • Comparative-Unit Method: Applying a cost per square foot or cubic foot derived from recently constructed comparable buildings, adjusted for differences in quality, features, and location.
     • Direct Costs: These are directly attributable to the construction process.
       • Materials: Cost of all building materials (lumber, concrete, steel, roofing, etc.).
       • Labor: Wages, benefits, and payroll taxes for all construction workers.
     • Indirect Costs: These are expenses related to the construction project but not directly tied to physical labor or materials.
       • Architectural and engineering fees.
       • Building permits and inspection fees.
       • Construction financing costs (interest on loans).
       • Insurance and bonding costs.
       • Overhead and profit (general contractor’s markup).
     • Mathematical Representation of Cost:
       • Total Cost = Direct Costs + Indirect Costs
       • TC = ∑(Material Cost + Labor Cost) + (Architect Fees + Permits + Financing + Insurance + Overhead + Profit)

   • Accrued Depreciation Estimation

     • Definition: The loss in value of a property from any cause.
     • Types of Depreciation:
       • Physical Deterioration: Loss in value due to wear and tear, age, and deferred maintenance.
         • Curable: Repairs are economically feasible and would increase the property’s value more than the cost of the repair (e.g., painting, roof repair).
         • Incurable: Repairs are either not economically feasible or would not significantly increase the property’s value (e.g., structural damage, foundation problems).
       • Functional Obsolescence: Loss in value due to outdated design, inefficient layout, or inadequate equipment.
         • Curable: Modifications are possible and economically justifiable (e.g., adding an HVAC system).
         • Incurable: The cost to cure the deficiency is excessive or physically impossible (e.g., inadequate ceiling height in an older building).
       • External (Economic) Obsolescence: Loss in value due to factors outside the property itself, such as changes in the neighborhood, economic conditions, or zoning regulations.
         • Always incurable from the perspective of the property owner.
     • Methods of Estimating Depreciation:
       • Age-Life Method: Based on the ratio of the property’s effective age to its total economic life.
         • Depreciation = (Effective Age / Economic Life) * Replacement Cost
         • Effective Age: The age of a property based on its condition, not its actual chronological age.
         • Economic Life: The estimated period over which the property is expected to generate income or provide utility.
         • Example: A building with a replacement cost of $500,000, an effective age of 20 years, and an economic life of 50 years would have depreciation of (20/50) * $500,000 = $200,000.
       • Breakdown Method: Separately estimating depreciation for physical deterioration (curable and incurable), functional obsolescence (curable and incurable), and external obsolescence. This method is the most comprehensive but also the most complex.
       • Market Extraction Method: Comparing the sale prices of similar properties with varying levels of depreciation to infer the market’s perception of depreciation.
         • Depreciation = Replacement Cost - Market Value
     • Mathematical Representation of Value:
       • Property Value = Land Value + (Replacement Cost – Accrued Depreciation)
       • V = L + (RC – D)
         3. Entrepreneurial Incentive (Profit)

   • Definition: The amount an entrepreneur expects to receive for their expertise, coordination, and risk-taking in developing a property. It is a key component in the cost approach, particularly for new construction or development projects.

   • Inclusion: Entrepreneurial profit is added to the sum of the land value and the depreciated cost of improvements to arrive at a final value estimate.
   • Estimation: It is often expressed as a percentage of total development costs (direct costs, indirect costs, and land costs). The appropriate percentage is determined by analyzing market conditions and typical developer returns for similar projects.
   • Formula:
     • Total Value = Land Value + Depreciated Cost + Entrepreneurial Incentive
     • TV = L + DC + EI
     • Entrepreneurial Incentive = (Direct Costs + Indirect Costs + Land Value) * Profit Margin
       4. Steps in the Cost Approach
   1. Estimate the Land Value: Determine the value of the site as if vacant and available for its highest and best use.
   2. Estimate the Replacement Cost: Determine the current cost of constructing a substitute improvement.
   3. Estimate Accrued Depreciation: Quantify the total loss in value due to physical deterioration, functional obsolescence, and external obsolescence.
   4. Calculate Depreciated Cost: Subtract the accrued depreciation from the replacement cost.
   5. Add Land Value and Depreciated Cost: Sum the land value and the depreciated cost of the improvements.
   6. Add Entrepreneurial Incentive: Include a reasonable entrepreneurial incentive or profit to reflect the developer’s return.

2. Practical Applications and Experiments

   • Case Study: Applying the Cost Approach to a New Residential Construction
     • Scenario: A new single-family home is being appraised. The appraiser has determined the land value to be $100,000. Using the comparative-unit method, the replacement cost of the home is estimated at $250,000. The appraiser estimates accrued depreciation to be minimal (1%) due to the new construction. Entrepreneurial profit is estimated at 10% of total construction costs including land.
     • Calculations:
       • Replacement Cost: $250,000
       • Depreciation: 1% of $250,000 = $2,500
       • Depreciated Cost: $250,000 - $2,500 = $247,500
       • Total Cost (Direct and Indirect) is equal to the Replacement Cost = $250,000.
       • Entrepreneurial Profit = ($100,000 + $250,000) * 10% = $35,000
       • Total Value = $100,000 + $247,500 + $35,000 = $382,500
   • Experiment: Sensitivity Analysis of Depreciation Rates
     • Objective: To demonstrate the impact of different depreciation rates on the final value estimate.
     • Method: Apply varying depreciation rates (e.g., 5%, 10%, 15%) to the same property and observe the resulting change in value.
     • Expected Outcome: Higher depreciation rates will result in lower value estimates, highlighting the importance of accurate depreciation assessment.

   • Case Study: Cost Approach Application for Commercial Property (Referring to provided PDF)

     • Reconstructing the operating statement from the given data in the PDF provides insights into various cost components. The following points address the “issues for further thought and discussion” mentioned in the document as they relate to the cost approach, though indirectly, by providing the cost basis of the existing structure to compare with hypothetical new construction costs.
     • First year’s projection of income:
       • The income projection can be estimated using a “per square foot of GLA” basis, analyzing percentages, and other relevant data. In the PDF example, suite rental rates vary per sq. ft., and this rate, alongside occupancy, drives revenue estimates.
     • First year’s projection of expenses:
       • Estimates are made on a “per square foot of GLA” basis, percentages of Effective Gross Income (EGI), etc. The PDF shows expenses like utilities, management, and maintenance salaries being estimated based on these metrics.
     • First year’s projection of tenant improvements and capital expenses:
       • These are estimated on a “per square foot of GLA” basis, percentages, etc. The PDF includes expenses for new space build-out and leasing commissions.
     • Following years’ projections of income:
       • Rate of increase as a function of inflation and other items like EGI, occupancy, etc. The PDF shows income increasing due to inflation and potential rollover rates.
     • Following years’ projections of expenses:
       • Rate of increase as a function of inflation and other items like EGI, occupancy, etc. The PDF demonstrates expenses increasing at a rate of 3% per year.
     • Following years’ projections of tenant improvement expenses:
       • Rate of increase as a function of inflation and other items like EGI, occupancy, etc. The PDF includes periodic expenses for new space build-out and leasing commissions.
     • Operating expense ratios for all years:
       • The PDF calculates operating expenses per square foot, providing ratios for all years.
     • Discount rate and terminal capitalization rate estimation:
       • The PDF notes that discount rates range from 8% to 9%, and the terminal capitalization rate is 9%.
         6. Limitations of the Cost Approach

   • Difficulty in Estimating Depreciation: Depreciation is subjective and can be challenging to quantify accurately.

   • Reliance on Cost Data: Cost data may not always reflect market value. Construction costs can fluctuate, and the cost approach may not accurately reflect current market conditions.
   • inapplicability❓ to Older Properties: The cost approach is less reliable for older properties with significant depreciation.
   • Overestimation of Value: The cost approach can sometimes overstate value, especially in declining markets or for properties with significant functional or economic obsolescence.
     7. Conclusion

   The cost approach is a valuable valuation tool, particularly for new or special-purpose properties. However, it is crucial to understand its limitations and to apply it appropriately, considering all forms of depreciation and entrepreneurial incentive. When used correctly, the cost approach provides a reasonable indication of value and serves as a useful check against the other valuation methods (sales comparison and income capitalization).