Real Estate Appraiser Guidelines - Part 6 COST APPROACH The Cost Approach views value as the combination of: > the value of the land as if vacant; and
> the cost to reconstruct the appraised building as new on the date of value, less the accrued depreciation the building suffers in comparison with a new building.
The principle of substitution applies: i.e., value tends to be set by the price of an equivalent substitute. In the Cost Approach, the substitute is the cost of reconstructing the present building on a vacant site.
The total cost of the land as if vacant, plus the reconstruction cost new of the building with all direct and indirect expenses and profit, and before deduction of depreciation, will tend to set the upper limit of value. In this view, the cost new can be used as a benchmark for measuring the other approaches.
The Procedure in Brief
> Estimate the value of the land as though vacant and available for development to its highest and best use.
> Estimate the replacement or reproduction cost of the existing improvements as of the appraisal date.
> Estimate the amount of accrued depreciation to the improvements from all causes (physical deterioration and/or functional or external obsolescence).
> Deduct the amount of the accrued depreciation from the replacement cost new to find the estimate of the depreciated value of the improvements.
> Add the estimated present depreciated value for the improvements to the value of the land. The result is an indication of the value for the subject property.
Cost New Bases
The Cost Approach views the value of the building at its cost of reconstruction as new on date of value. There are three bases of reconstruction cost as new: > Historic Cost indexed to Cost New;
> Reproduction Cost New; and
> Replacement Cost New.
Each basis has value to a cost-as-new study, but terms should not be confused.
Historic cost indexed to cost new. Historic Cost is the actual cost of the building when originally constructed, yesterday or fifty years ago. By use of price indices from building or engineering cost services, or from the original building contractor, Historic Cost can be “indexed” to Cost New on date of value. Indexed Historic Cost can be very useful if the building is fairly new and/or it is so unique that it is the only reliable value base. The advantage of Indexed Historic Cost is the accuracy of employing actual building costs. The disadvantage is that the older the costs are the less reliably they can be indexed. When considering Indexed Historic Costs, the appraiser should be certain that historic costs were normal costs at time of construction and that historic costs, as indexed, will accurately reflect Cost New on date of value. Reproduction cost new is the cost, on date of value, of constructing a replica of the appraised building. This is a replica in actual design and materials. In this method, the cost-as-new estimate is made as if looking at plans of an exact duplicate of the present building. The advantage of Reproduction Cost New is the greater accuracy of duplicating the building in actual design and materials. The disadvantage is that advances in building construction and methods, materials and design make cost estimates of obsolete building construction very difficult and wildly distorted for materials no longer reasonably available or requiring large amounts of hand labor. Reproduction Cost New is most useful for study of refined methods of depreciation, unique construction, and occasional legal requirements for court testimony.
Replacement cost new views the building as if reconstructed with modern methods, design and materials that would most closely replace the use of the appraised building. For example, an older brick warehouse would be constructed today with concrete block or tilt-up cast slab construction. The advantage of Replacement Cost New is the ready availability of accurate current costs, and a better understanding by all parties of modern methods, design and materials. The disadvantage is the subjective decisions of proper current replacement materials and design for older construction. In actual practice, the Replacement Cost New is the most frequently used Cost Approach base.
Steps in the Cost Approach
A. An estimate is made as to the land’s current market value, assumed vacant and available for improvement to its highest and best use. Land value is usually based on a market approach utilizing comparable market data of similar sites in the area. B. An estimate is made of the cost new of reconstructing the buildings and other improvements.
1. The appraiser selects the proper cost new base:
a. Historic Cost of appraised building indexed to cost new on date of value.
b. Reproduction Cost of duplicating the replica of the appraised building using original materials and design on date of value.
c. Replacement Cost of replacing the use and facility of the appraised building using modern materials, methods, and design on date of value.
2. The appraiser completes property inspection, description, measurement, inventory, and plot plan of appraised building improvements and equipment, with notes regarding type, style, quality, and condition of building materials, workmanship and condition.
3. The appraiser selects appropriate method of cost new estimating.
a. The Square-Foot Method is the most common method used by appraisers on the West Coast to estimate the cost of construction. The property being appraised is compared with similar structures where costs are known, and which have been reduced to units per square foot of floor area. Standard type buildings whose costs are known are broken down to a cost per square foot of floor area. The building being appraised is compared with the most comparable standard building and its cost per square foot is used for the subject property. Adjustments must be made for size of building, and various exterior and interior features. Though adjustments cannot be made for many variables, this method, in most instances, is accurate enough for the real estate appraiser. The square-foot method can be used and applied faster than any other estimate.
b. The Cubic-Foot Method is similar to the square-foot method, except the cubic contents of buildings are compared instead of the square footage of the floor area. This method is most popular in the Eastern United States. If used properly, it is more accurate than the square foot method, since the height as well as area of the building is taken into consideration. This method is most often used for industrial or warehouse buildings.
c. The Quantity Survey Method involves a detailed estimate of all labor and materials for each component of the building. Items such as overhead, insurance, and contractor’s profit must be added to direct costs. This is a very accurate but time-consuming method to arrive at costs. Because of the detail and time required, this method is seldom used, except by building contractors and professional cost estimators.
d. The Unit-in-Place Cost Method entails calculation of the cost of units of the building as installed. The total costs of walls in place, heating units, roof, etc. are obtained on a square foot basis, including labor, overhead, and profit. This is a detailed, accurate method generally used for checking on new construction units. It is seldom used by appraisers because specialized knowledge is necessary to gather all elements of unit costs.
4. The appraiser investigates cost sources and estimates cost-as-new of all buildings and improvements. Costs must be measured accurately. They are classified as direct (hard) costs and indirect (soft) costs. Indirect costs are usually associated with the administration of the project while direct costs are expenditures for labor, equipment and materials, overhead and profit.
a. Cost sources:
(l) Costs of comparable buildings under construction.
(2) Owners, builders, and/or contractors of comparable buildings.
(3) The contractor of original building, if available.
(4) Published cost services (usually handbooks providing current comprehensive cost data, by local areas and general construction types).
(5) Professional cost estimators.
b. The appraiser completes the cost estimate to include all:
(l) Direct expenses of construction such as labor, materials and equipment and engineering for the building, site preparation, street and utility work, landscaping, etc.
(2) Indirect expenses such as legal, title, appraisal and feasibility study fees, licenses, permits, ad valorem taxes during construction, demolition and removal costs, inspections, insurance during construction, financing charges, accounting, etc.
(3) Developers’ overhead, supervision, and profit; for planning, construction, and sale of the project to “turnkey” condition (that is, completely ready for a new purchaser/occupant) and selling costs. C. The appraiser estimates the accrued depreciation and deducts from cost-as-new estimate. This amount must be deducted from the cost-as-new to determine the present value of the improvements. The difficulties of correctly estimating depreciation tend to increase with the age of the improvement. Experience and good judgment are among the necessary qualifications for making a realistic estimate of proper depreciation. There is no justification in assuming that improvements necessarily depreciate at a rate corresponding to their age.
D. The appraiser adds the land value to depreciated value of improvements for indicated value by Cost Approach.
DEPRECIATION
In connection with the appraisal of real property, depreciation is defined as “loss in value from any cause.” It is customarily measured by estimating the difference between the current replacement or reproduction cost new and the estimated value of the property as of the date the property was appraised. Contrasting with depreciation is appreciation of value from inflation or special supply and demand forces relating to the specific property. Appreciation may reduce or offset entirely a normally anticipated decrease of value due to depreciation.
Depreciation includes all of the influences that reduce the value of a property below its cost new. The principal influences are often grouped under three general headings and subdivided as follows: 1. Physical deterioration resulting from:
a. Wear and tear from use;
b. Negligent care (sometimes termed “deferred maintenance”);
c. Damage by dry rot, termites, etc.; or
d. Severe changes in temperature.
2. Functional obsolescence resulting from:
a. Poor architectural design and style;
b. Lack of modern facilities;
c. Out-of-date equipment;
d. Changes in styles of construction;
e. Construction methods and materials obsolete by current standards; or
f. Changes in utility demand such as desire for master bath or more garage space.
3. External obsolescence resulting from adverse environmental and economic influences outside the property itself, such as:
a. Misplacement of improvement (not typical for neighborhood);
b. Zoning and/or legislative restrictions;
c. Detrimental influence of supply and demand; or
d. Change of locational demand.
The first two categories of accrued depreciation are considered to be inherent within the property and may be curable or incurable. The third category is caused by factors external to the property and is almost always incurable.
Appraisal and Income Tax Views - “Book” vs. Actual Depreciation It is important to understand that “depreciation” is a word with two meanings: one for the appraiser and another for the owner concerned with tax position. Book depreciation. Depreciation, for the owner’s income tax position, is “book” depreciation, a mathematical calculation of steady depreciation from owner’s original purchase price or cost basis. This “book” depreciation allows the owner to recover the cost of the investment over the “useful life” of the improvement. It accrues annually and is an income tax deduction. In this sense, the owner’s accountant sees depreciation as a deduction from gross income. Frequently, “book” depreciation results in negative gross income, at least on paper. The building seems to be losing value faster than the income replaces it. This gives the owner a “paper loss” that can be offset against other income. This “paper loss” or “tax shelter” is a motivating factor for purchase or exchange of many income properties. “Book” depreciation is: > an allowable deduction from cost for accounting or income tax purposes; > determined by owner’s policy and to meet IRS requirements; and > deducted from owner’s original (historic) cost.
“Book value” is the current value for accounting purposes of an asset expressed as original cost plus capital additions minus accumulated depreciation, based on the method used for the computation of depreciation over the useful life of the asset for income tax purposes. Depreciation is allowed on improvements only, not land. The book value of the property may be ascertained at any given time by adding the depreciated value of the improvement to the allocated value of the land.
Actual depreciation. The “book” depreciation from owner’s original cost is not the depreciation normally considered by the appraiser. The appraiser looks not to owner’s original cost, but cost new on date of value. From this current cost new, the appraiser deducts the estimate of accrued "actual" (not book) depreciation. Depreciation (loss in value) is estimated only for improvements. "Actual" depreciation used by appraisers is: > loss in value;
> determined by market data, observed condition, etc.; and
> deducted from current reconstruction cost new.
Because accountants and appraisers select rates of depreciation for different purposes, accruals for book and actual depreciation vary considerably. While both estimators may use the same period as to the remaining economic life of the property and may also use the same method, additional considerations may affect the resultant rate. Whereas the accountant may be restricted because of accounting conventions, the appraiser is under no such restrictions.
The real estate agent who is determining values should understand the necessity for following proper appraisal procedures and should not rely on book values either to estimate accrued depreciation or for future depreciation accruals.
Methods of Calculating Accrued Depreciation
Accrued depreciation is depreciation which has already occurred up to the date of value. Remainder depreciation is depreciation which will occur in the future. Accrued depreciation may be classified either as curable or incurable. The measure between curable and incurable is economic feasibility. It is possible to physically restore or cure most depreciation such as by expensive restoration of old homes. However, in most circumstances, cure of deficiencies is measured by the economic gain (increased rents) compared with the cost of the cure. Three methods of estimating accrued depreciation are discussed next.
Straight line or age-life method is depreciation which occurs annually, proportional to the improvement’s total estimated life.
For example, an improvement with an estimated total life of 50 years would be said to depreciate at an equal rate of 2 percent per year. (2 percent x 50 years equals 100 percent depreciation.)
The effective age of the building is generally used instead of the actual age. Effective age is the age of a similar and typical improvement of equal usefulness, condition and future life expectancy. For example, if a building is actually 25 years of age but is as well maintained and would sell for as much as adjoining 20-year-old properties, it would be said to have an effective age of 20 years.
The straight line method is: easy to calculate; used by the Internal Revenue Service; and easily understood by the lay person.
However, in actuality, buildings do not depreciate in a straight line at a stated percentage each year, but will vary according to maintenance and demand for the type of structure.
The cost-to-cure or observed condition method (breakdown method) involves: > Observing deficiencies within and without the structure and calculating their costs to cure. The cost to cure is the amount of accrued depreciation which has taken place.
> Computing an amount for physical deterioration or deferred maintenance for needed repairs and replacements.
> Determining and assigning a dollar value to functional obsolescence due to outmoded plumbing fixtures, lighting fixtures, kitchen equipment, etc.
> Measuring functional obsolescence which cannot economically be cured (e.g., poor room arrangements and outdated construction materials) and calculating the loss in rental value due to this condition.
> Calculating external obsolescence (i.e., caused by conditions outside the property) and determining the loss of rental value of the property as compared with a similar property in an economically stable neighborhood. The capitalized rental loss is distributed between the land and the building.
This is the most refined method of examining complex causes and cures of depreciation. However, it can be difficult to calculate minor or obscure depreciation accurately. Also, measurement by rental loss is sometimes difficult to substantiate.
A combination of the straight line and cost-to-cure methods may be used to: > determine the normal depreciation as if the property is not suffering from undue depreciation; and,
> add any excess deterioration and obsolescence
For example: a house is 20 years old and has a remaining life estimated at 40 years for a total life of 60 years, thus depreciating at a rate of 1.67 percent a year. Effective age due to condition estimated at 15 years. | Cost New | $105,000 | | 1. Normal deterioration: 1.67 percent x 15 years = 25 percent 25 percent x $105,000 = | $26,250 | | 2. Excessive physical deterioration: New roof, exterior painting | $5,000 | | 3. Functional obsolescence, curable: Modernize bathroom | $3,900 | | 4. Functional obsolescence, incurable: Poor room arrangement results in rental loss of $40 per month when compared to normal house. Monthly gross multiplier 100. $100 x $40 a month = | $4,000 | | 5. External obsolescence: Estimated monthly rent of subject if located in ideal neighborhood (after curing physical and functional deficiencies) . | $1,000 | | Estimated rental loss due to external causes | $50 | | Yearly rental loss is 12 x $50 = $600 Capitalization rate applicable to properties in ideal neighborhood (ratio of annual rent to value) = 10.5 percent Capitalized rental loss: $600 ÷ 10.5 percent = $5,700 Ratio of land to building value: in ideal neighborhood, land 30 percent, building 70 percent. | | | Economic obsolescence: 70 percent x $5,700 | $3,990 | | | | | TOTAL ESTIMATED DEPRECIATION | $43,140 | | DEPRECIATED VALUE OF HOUSE | $61,860 |
Reproduction or replacement cost method. The subject property is improved with a duplex, two detached garages, a covered porch for each unit and common driveway and walk.
Measurements and current cost replacement figures for the improvements are as follows: > Each unit of duplex is 25’ x 35’ @ $55.00 per sq. ft.
> Each detached garage is 21’ x 25’ @ $20.00 per sq. ft.
> Each covered porch is 6’ x 10’ @ $14.00 per sq. ft.
> Driveway is 20’ x 100’ @ $2.40 per sq. ft.
> Walk is 3’ x 40’ @ $2.40 per sq. ft. The improvements are now 12 years old and it is determined that such improvements have a remaining economic life of 38 years. The current lot value, by comparison, is $45,000.00. Depreciation computations are based on the use of the straight line method. | What is the replacement cost new and, using the cost approach method, what is the present value of this property? | | Each duplex unit (25’ x 35’ x $55.00) x 2 | $96,250.00 | | Each detached garage (21’ x 25’ x $20.00) x 2 | 21,000.00 | | Each covered porch (6’ x 10’ x $14.00) x 2 | 1,680.00 | | Driveway (20’ x 100’ x $2.40) | 4,800.00 | | Walk 3’ x 40’ x $2.40 | 288.00 | | Improvements – Total Replacement Cost New | 124,018.00 | | | | | Depreciation: | | | 12 yrs. + 38 yrs. = 50 yrs. life of improvements when new 100 ÷ 50 = 2 percent annual depreciation rate, or recapture rate. 12 yrs. x 2 percent = 24 percent total depreciation to date. 124,018 x 24 percent = Total depreciation in value to date | 29,764.00 | | Total value of improvements less depreciation | $94,254.00 | | Plus lot value | 45,000.00 | | Total Current Value by Replacement Cost Approach | $139,254.00 |
Market data method. A comparative method is frequently used in residential appraisals where the property being appraised can be compared with market data of buildings of similar type and condition. 1. From the sales price of a comparable residential property, deduct an estimate of land value.
2. From the resulting total comparable improvement value, deduct the estimated contributory value of secondary improvements and landscaping.
3. The result is the value of the comparable main residence at its total depreciated value in place.
4. Divide this main residence value by the residence square footage. This yields depreciated unit value.
5. By multiplying the appraised building square footage by the unit value of the comparable residence, the total indicated depreciated value is found for the appraised residence. | Sales price of comparable property | $180,000 | | Less estimated land value | - 55,000 | | Improvement Value | 125,000 | | Less estimated value of secondary improvements and landscaping | - 23,000 | | Value of comparable residence | 102,000 | | Divide by area of comparable residence | ÷ 2,900 sq. ft. | | Depreciated unit value of comparable residence | $35.17/sq. ft. | | Multiply by size of appraised residence | x 2,850 sq. ft. | | Indicated depreciated value in place of appraised residence | $100,234 |
Advantage of the Market Data Method: This method is the most accurate measure of depreciation from the market. Disadvantage of the method: It is sometimes difficult to obtain truly comparable market data and occasionally difficult to accurately estimate land value and secondary improvement value for deductions for main residence value indication.
Age-life method using effective age. House has an actual physical age of 25 years with a remaining life of 25 years, thus depreciating at the rate of 2 percent a year. It is the opinion of the appraiser that the subject house is of the same condition and utility as similar houses that are only 20 years of age. Therefore, the house has been assigned an effective age of 20 years. The accrued depreciation would thus be 20 years times 2 percent or 40 percent. | Calculated cost new | $120,000 | | Accrued depreciation (40 percent x $120,000) | 48,000 | | Depreciated value of improvement | 72,000 | | Plus land value | 50,000 | | Indicated value by cost approach | $122,000 |
Measuring physical deterioration. A store building has a remaining useful life of 30 years and an effective age of 20 years. Present reproduction cost for the structure is $230,000. The roof is 75% deteriorated. A new roof will cost $10,000. The air conditioning and heating systems are 40% depreciated. Their installed cost new is $8,000. What is the total amount of physical deterioration?
The building, under the straight-line or age-life method, is 40% depreciated (100% ÷ 50 = 2% x 20 years effective age = 40%). This 40% depreciation to the building is to be applied to the amount of the building’s reproduction cost less the depreciation already taken on the other components.
| Depreciation to roof (.75 x $10,000) | $7,500 | | Depreciation to air conditioning and heater (.40 x $8,000) | $3,200 | | Depreciation to rest of building (.40 x $212,000) | $84,800 | | Total physical deterioration | $95,500 |
Income approach - future depreciation. Future depreciation is loss in value which has not yet occurred but will come in the future and is of significance in the capitalization of income method, which will be discussed next. In the income approach to valuation, depreciation is based on the remaining economic or useful life, during which time provision is made for the recapture of the value of improvements. It is the return “of” the investment, as differentiated from the return (interest and profits) “on” the invested capital.
Under the income approach, this depreciation is usually measured by one of two methods: straight-line or sinking fund. In straight-line depreciation, a definite sum is deducted from the income each year during the total estimated economic life of a building to replace the capital investment. If the appraiser estimates that a building will have a remaining life of 25 years, this method provides that 1/25 or 4 percent of the building’s value be returned annually as a deduction from net income. The sinking fund method also includes a fixed annual depreciation deduction from income, but with yearly reserves from such funds deposited into a sinking fund which, with compound interest, will offset the depreciated value of the structure and be collectible at the end of the building’s useful life. Accruals for future depreciation to replace the capital investment are in addition to and essentially different from both maintenance charges and reserves for periodic replacement of curable depreciation. Should there be any estimated salvage value to the improvement at the end of its economic life, this amount need not be returned through the annual depreciation charge under either the straight-line or the sinking-fund method. |
