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Cost Approach Example #1

Let's use a depreciation example to walk you through the Cost Approach process. We'll assume the following figures were obtained during our appraisal field work and inspection of the subject property.

Analysis Figures:
Actual Age
Effective Age
Total Economic Life

Reproduction Cost New
=
=
=

=
10 years
5 years
50 years

$ 75,000
Physical Curable:
Painting needed
Gutters needed
=
=
$ 750
450
Total Physical Curable Depreciation = $ 1,200

 

Short Lived Items:
. Cost Effective Age Useful Life % of Depreciation $ of Depreciation
Roof
Heat System
Carpets
Kitchen Appliances
$ 2,000
1,500
600
1,800
10
10
2
10
20
25
6
15
50
40
33
67
$ 1,000
600
200
1,206
Total Cost of Items: $5,900 . Actual Depreciation Cost: $3,006

There's a point to remember when estimating the Total Physical depreciation amount for the structure. That is, to use the Actual Depreciation Cost, and not the total cost new of the items, as your Short Lived Items depreciation amount. This means that the Short Lived Items are still in operating order but they have aged and won't last as long as a similar new item. For example, the roof is 10 years old but it has a life expectancy of 20 years. This gives the roof another 10 years before it will need to be replaced. If it costs $2,000 to install a new roof and it's 50% depreciated now, then the current depreciated dollar amount value of the roof is $1,000. It's similar to buying a used car. A used car may still be operating properly but you wouldn't buy it for the same price you could get a new one for, would you?

The percentage of depreciation for the value of the Long Lived items (the structure) is estimated by dividing the Effective Age by the Total Economic Life of the subject property. This is also referred to as the Age/Life Method for estimating the physical depreciation of a building. The Total Economic Life is also called the Remaining Economic Life. Therefore, in our example it would be:

Effective Age/Total Economic Life = % of Depreciation

5/50 = .10    or   10%

 

We will use the 10% depreciation figure to estimate the depreciation dollar amount for the Long Lived Items. But first we must subtract the Physical and Short Lived Items from the Reproduction Cost New, before estimating the depreciation for the Long Lived Items. We do this by taking the depreciation cost of the Physical Curable depreciation items, and then adding this amount to the total cost new of the Short Lived Items. We then subtract this amount from the Reproduction Cost New. In our example we end up with the following formula.

$75,000 - ($1,200 + $5,900) = $67,900

Therefore, $67,900 is the amount left to be depreciated by the percentage amount we derived earlier. This is needed to estimate the depreciation dollar amount for the Long Lived Items.

$67,900 x .10 = $6,790

Therefore, we are left with the following dollar amounts of depreciation:

Physical = $1,200

Short Lived Items = $3,006

Long Lived Items = $6,790

We add these to get our Total Physical Depreciation for the building.

$1,200 + $3,006 + $6,790 = $10,996

You have to remember, that you must subtract the Physical Curable depreciation and the total cost new of the Short Lived Items, from the Reproduction Cost New before estimating the depreciation for the Long Lived Items. The reason for this is that if you don't, you'll be "double dipping " when you estimate your depreciation amounts. Meaning that the depreciation amount that you subtract for the Long Lived Items, will be incorrectly increased by the inclusion of the depreciation amounts for the Physical Curable and Short Lived Items. You would then be taking out more depreciation then you should be. We'll use our example to show you the incorrect way of doing this so you can see what I mean by "double dipping."

$75,000 x .10 = $7,500

The increase would be $7,500 - $6,790 = $710. This would incorrectly increase the amount of Total Physical Depreciation for the subject property by $710.

Now we'll take an example of Functional Obsolescence. Remember that obsolescence is the same as saying depreciation. Let's say the vast majority of houses in the area that are similar to the subject property have central air-conditioning. Therefore, we can conclude that a typical buyer would expect the house to have central A/C. If the house did not have central A/C, then the buyer would pay a little bit lower purchase prices to compensate for the air-conditioning not being installed. This is considered a Functional Depreciated item, as opposed to a Physical Depreciated item. The reason for that is the central air-conditioning is not installed in the house, so there's no physical depreciation on it to account for.

We have to first estimate what the cost would be to install a central air-conditioning system "as of" the date of the appraisal. Let's say we asked a local A/C contractor, or checked the published cost manuals, and get an estimate. We'll assume that the estimate is $1,750 to correct the problem by installing the central air-conditioning. We then must estimate what it would have cost to install the central air-conditioning at the time the house was built. Our research tells us that during construction of the property it would have cost $1,500 to install central air-conditioning.

We can now conclude the Accrued Functional Depreciation for the subject property. We do this by subtracting the two figures.

$1,750 - $1,500 = $250

From our research we have found that a comparable house to the subject property would sell for an additional $2,800 if central air-conditioning was installed. We have already estimated that it would cost $1,750 to install. Therefore, the central air-conditioning is a Functional Curable Item because the value added to the subject property by installing it, is equal to or greater than the cost of installing the A/C.

Now we'll take an example of Locational Obsolescence. This is also called External or Economic Obsolescence. Let's say, there's a gas station next to the subject property. From our knowledge of the area, we conclude that the typical buyer would pay less for the house to compensate for the location next to a gas station. The typical buyer would rather have a house with only other residential properties around it and not any commercial properties in view.

You have to apply any Locational Obsolescence values separately to the building and the land of the subject property. This is because the land is not a depreciable item. However, site improvements do have depreciated values, such as, driveways, landscaping, etc. The land will be affected by a Locational Obsolescence and you have to take that into account in your site value estimate.

In order to estimate the total Locational Obsolescence depreciation amount, we need to make some evaluations. We must first decide what percentage of the value of the subject property is allocated to land, and what percentage is allocated to the building. This is called the Land Value to Building Value Ratio. This technique is also used for tax purposes. The technique is used to figure out the depreciation amount on your tax returns for real estate. Let's say our research of the area has shown that typically the estimate of value is 20% allocated to the land and 80% allocated to the building. Another way of saying this is that the Land Value to Building Value Ratio s 1:4. Meaning the ratio is one part land plus four parts building. This tells us that 1/5 (or 20%) of the value is allocated to the land.

From our research, we have found that a comparable house to the subject property would sell for an additional $4,200 if it was not located next to the gas station. We simply multiply this figure by the percentage of value allocated to the building, to get our Locational Obsolescence amount.

$4,200 x .80 = $3,360

Now we will add up all of the three depreciation amounts we have estimated. We do this to obtain the depreciated value of the Reproduction Cost New of the subject property.

Total Physical Depreciation = $10,996

Total Functional Depreciation = $250

Total Locational Depreciation = $3,360

We add these to get our Total Depreciation for the building.

$10,996 + $250 + $3,360 = $14,606

Now we simply subtract the total depreciation amount from the Reproduction Cost New.

$75,000 - $14,606 = $60,394

Therefore, the depreciated value of the Reproduction Cost New of the subject property is estimated to be $60,394.

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