I've included this article since it discusses some real life situations you will encounter in real estate and the appraisal business. This article is reprinted with permission from Ken Jones.
Appraisal Cost Approach: It DOES NOT Indicate Fee Simple Market Value!
One of the more hotly debated issues within the real property appraisal and banking industries, as well as within those tax assessing jurisdictions required to base real property assessments upon Market Value, is the topic of whether or not the Cost Approach is appropriate for use in appraisal assignments of existing building improvements, regardless of their age (including brand-new structures), when the purpose of the assignment is to estimate Market Value, as defined in the Uniform Standards of Professional Appraisal Practice (USPAP), of the Fee Simple estate.
On the one side, we have a majority of real estate appraisers who have been educated in the application of this methodology, either directly or indirectly, in accordance with the text and teachings of the Appraisal Institute which states, "the result [of the Cost Approach] is an indication of the value of the fee simple interest in the property. " (1). On the other side, we have a broad diversity of real estate professionals, including builders, developers, professional cost-estimators, contractors, real estate brokers, as well as the overwhelming majority of the buying and selling population who fail to act in accordance with those teachings. These groups, both knowingly and unknowingly, conduct their business activities consistent with fundamental economic principles, and do not regard the results from the use/application of the Cost Approach as an indication of Market Value, contrary to those teachings.
This paper is intended to 1) provide the reader with an examination of the differences between the current academic teachings and factual market activities, and 2) provide the practicing appraiser factual economic and USPAP based support with which to educate their clients to the fact that the use of the Cost Approach within Market Value appraisals of the Fee Simple or a lesser/partial estate is inappropriate.
In order to grasp the inherent problems with the common belief that the results of the Cost Approach provides an indication of the Market Value of the Fee Simple property rights, one must first know and understand that there is a substantial difference between real estate, which is the tangible aspect of the land and whatever structures are intended to be permanently affixed thereto, if any, and real property, which are the intangible, man-made rights to the use of the real estate, typically referred to as the Bundle of Rights which include the rights to own, use, occupy, rent, reversion, sell, give away, or to do none of these things. It's absolutely essential to understand the fact that, when an appraiser is given an assignment to estimate Market Value of the Fee Simple or a partial/lesser interest, the "thing" being valued is not the tangible real estate, but the intangible real property rights inherent to that specific parcel of real estate.
The next fact that must be recognized is that, when estimating either the reproduction cost-new (the estimated cost to create an exact duplicate of the subject improvements, including the exact building materials used in its construction as well as its exact design, including its functional deficiencies) OR the replacement cost-new (the estimated cost to create a new building of the same use [warehouse, office building, multi-family, single family, etc.] using the latest, most modern building materials and optimum functional design features) the result of such an estimate is merely an accounting of all of the expenses necessary to create a physical structure, hence its former name The Summation Approach. The result of this accounting procedure which is the Cost Approach, does not mean, nor should it be mistaken to mean, that the typical market participant will pay the amount of that cost estimate, or any amount relative to it in exchange for the rights to that parcel of real estate.
In order to believe that this accounting procedure indicates the Market Value of the Fee Simple property rights requires one to ignore a number of fundamental economic laws, including the 4 specific essential components which must exist simultaneously in order for anything to be considered to have value, being: 1) Utility it must serve a useful purpose, 2) Desirability; it must be desired by those to whom it has a use, 3) Scarcity; its supply must be less than its relative demand, and 4) Affordability; it must be affordable to those to whom it has utility and desirability.
Further, to believe that the Cost Approach accounting procedure can provide an indication of the Market Value of the Fee Simple, or any partial interest in those property rights, is also to ignore the Principle of Contribution which states that an item only has value to the extent that it contributes to the value of the whole, OR by the amount that the value of the whole is diminished by the absence of that item.
Let us now consider the actions of typical market participants. It doesn't matter if we were to consider typical investor types involved in sophisticated income producing properties, or the typical first home buyer; when it comes to deciding the price to pay for the property rights associated with a specific parcel of real estate their "appraisal" methodology is virtually identical in that, neither considers the Cost Approach accounting methodology.
Why not? Primarily because, in their eyes it's irrelevant! The fact that the building is already there eliminates the need to know what it would cost to build new and depreciate it to present value. The investor only cares about the amount of return from a subject property as an investment compared to returns from competitive investments, AND the home buyer only cares about the purchase price of house A relative to the purchase price of house B, plus consideration of the Contributing Value, if any, from any differences between the two houses that they, the typical buyer, may consider to be of value and in such subjective dollar amount(s), as they, the typical buyer, may attribute to such differences as the differences are perceived to contribute to the overall utility and desirability of each house. As for the typical seller, they are solely concerned with obtaining the highest price possible relative to the sales prices obtained by sellers of what they perceive to be competitive properties.
POINT OF FACT: The very premise of the Cost Approach accounting methodology is totally foreign to the typical buyer and seller of real estate which is supported by the virtual absence of such activity being undertaken in the market by those typical buyers and sellers of existing building improvements.
POINT OF FACT: In addition to their apparent recognition of the irrelevance of indications from the Cost Approach accounting procedure, the typical buyer and seller of real property haven't the technical knowledge nor the practical experience required to undertake the construction of a building in a competent, cost-effective, timely manner, thus, cannot possibly be considered capable of undertaking the development of the Cost Approach.
IT SHOULD BE OF SERIOUS CONCERN to every appraiser and every user of an appraisal report to ensure that the person providing estimates of cost-new has sufficient technical knowledge and practical experience in the disciplines of building design, construction and cost-estimating to be considered in compliance with the Competency Provision of USPAP when the use of the Cost Approach is appropriate.
Adding to the absence of economic support, thus, further undermining the credibility in the belief that the Cost Approach accounting procedure can provide an indication of the Market Value of the real property rights associated with a specific parcel of real estate is the topic of the currently taught and accepted methods by which appraisers "depreciate" cost-new estimates in order to theoretically obtain an indication of the present "value" of the already existing building and site improvements.
Most appraisers have been taught that buildings "depreciate", or lose "value" 1) by means of the aging process, 2) through changes in standards of functional utility, as well as 3) from "externalities" negative influences from outside the boundaries of a property.
Above all, "depreciation" as it is currently taught and practiced, is just another accounting procedure, which reinforces the distinct difference between the Cost Approach methodology, which is conducted in isolation from "Market Forces ", and the Sales Comparison and Income Capitalization methodologies which are solely and wholly the direct result of market activity. This is supported by the fact that there would be no need to obtain indications of "depreciation" from the other 2 true Market approaches, such as using the capitalized rent loss from the income approach; just one of many examples.
An analysis of the practice of "Physical Depreciation " due to the aging process finds the cost-new estimate is most commonly "depreciated " by either the economic or actual age/life method, both of which are based upon an accountant-like Straight-Line depreciation model developed by dividing the age (actual or effective) of the improvement by the estimate of its remaining life (physical or economic). In addition to the fact that this "depreciation" estimate is not derived from "Market " evidence, is the major problem that it assumes that all things within the structure, as well as any and all site improvements, "depreciate " at the same, constant, average annual straight-line rate. Example: A building with an actual age of 15 years and an estimated remaining life expectancy of 45 years has depreciated, according to this model, by a total of 25%, implying an average annual Straight-Line rate of 1.67% annually. Since markets simple don't work this way, this accountants methodology cannot reasonably be considered "Market " based nor "Market " related, therefore, it cannot possibly reach a conclusion nor provide an indication of "Market Value".
Another contributing problem in this accountants method of depreciation, are the typically unsupported statements of estimated actual life expectancies. It seems, according to virtually every real estate appraisal report I've ever read, there isn't a house structure in the USA that will last longer than 50-60 years, nor an industrial building that will last longer than 40-50 years, with similarly short actual life expectancies stated for all other types of building improvements.
I'm certain, as I'm sure you are, that there are vast numbers of buildings throughout the United States that exceed 80-100 years of age being put to all types of uses. In fact, there probably isn't a building structure being built today in accordance with minimal building codes that will not physically last for at least 100 years, assuming normal ongoing maintenance. And, while it may not continue to provide Contributing Value to the land/site for that long a time period, it's more likely than not that it will physically stand at least that long, again, assuming normal maintenance.
This brings us to the next major topic when discussing the applicability of the currently applied and accepted methods of "depreciation ", which is the concern that many appraisal reports fail to demonstrate a working understanding of the implications from the term "remaining economic life" which, if you're not an appraiser, is the estimated amount of time into the future that the existing improvement(s) will continue to provide Contributing Value to the Market Value of the vacant land/site.
This problem begs the obvious question, "How can an appraiser reasonably support their prediction of the amount of years that a structure is going to continue to provide Contributing Value to the Market Value of the vacant land/site? ". With the most reasonable answer being, "It probably can't be done.".
While one can argue the merits and/or demerits of various methods of measuring "depreciation " logic dictates that even the consideration of "depreciating" cost-new estimates is, by its nature, dealing solely with the physical aspect of the real estate, totally outside of and apart from the parameters required of the appraisal of Market Value of property rights.