The Cost Approach

Real Estate 614 Real Estate Appraisal Dr. Longhofer

Dr. Longhofer Real Estate Appraisal 1

The Cost Approach

Begin by estimating the cost of any improvements on the land
Reproduction cost is the cost to construct the building today, replicating it in exact detail Replacement cost is the cost required to construct a building of equal utility, using modern construction techniques, materials, and design

Subtract from this the cost of any accrued physical, functional, or external depreciation Add in the value of the site as raw land to get the indicated value using the cost approach
Dr. Longhofer Real Estate Appraisal 2

Estimating Construction Costs

Comparative-unit Method For relatively standardized structures, the size of the building is multiplied by the persquare foot cost of that type of construction Segregated-cost Method The costs of the individual components in the building are used to estimate the overall replacement cost Quantity-survey Method Identifies the exact materials required to reproduce the structure to estimate the cost Index Method Assumes that the replacement cost is simply the original construction cost times a cost index

Dr. Longhofer

Real Estate Appraisal

Categories of Accrued Depreciation

Physical deterioration is the result of wear and tear, weathering from the elements, vandalism and neglect Functional obsolescence refers to features, design, and other elements of the building that are not up to modern standards; it also includes features in excess of what the market can support (superadequacies) External (economic) obsolescence refers to loss of value due to influences outside the property
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Estimating Accrued Depreciation

Lump-sum age/life method
Easy to apply Does not explicitly account for each particular type of depreciation (esp. econ. obsolescence)

Breakdown method
Complex and time consuming to apply Explicitly considers each type of depreciation Helps to avoid double counting
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Age/Life Method
This method estimates depreciation as a lump sum based on assumed straight-line depreciation
Effective age Accrued depreciati on Cost new Economic Life

Economic life is estimated using rules of thumb based on past experience or published sources Effective age is usually used in place of actual age, but this varies
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Age/Life Method Example

Reproduction cost new Total economic life 55 years Effective age 20 years % accrued depreciation = 20/55 = 36.4% Accrued depreciation Depreciated value of improvements Land value Estimated market value $245,000

89,180 155,820 39,000 $194,820

Dr. Longhofer

Real Estate Appraisal

Modified Age/Life Method

Sometimes the age/life method is modified by subtracting out curable physical and functional depreciation before calculating the lump sum depreciation of the rest
The idea is that the owner will cure these problems because it adds more value than it costs

Dr. Longhofer

Real Estate Appraisal

Modified Age/Life Method Example

Reproduction cost new Physical and functional depreciation, curable Adjusted cost Total economic life 55 years Effective age 17 years % accrued depreciation = 17/55 = 30.9% Accrued depreciation Depreciated value of improvements Land value Estimated market value
Dr. Longhofer Real Estate Appraisal

$245,000 12,500 $232,500

71,843 160,657 39,000 $199,657

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Comments on Age/Life Method

The general relationship between age and depreciation varies from market to market
Use local patterns, not national ones

Although this method assumes straight line depreciation, this is not typically accurate
The amount of depreciation changes from year to year

Location of a property within a given market area does not appear to affect depreciation rates
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Comments on Age/Life Method

Effective age (based on subjective appraiser judgment) appears to be more accurate than physical age Depreciation rates of between 0.70 and 1.25 percent per year seems to be a useful benchmark for properties that are not too old Depreciation rates can be estimated from comparable sales (market extraction)
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Market Extraction Example

Sale price of property Less: Land value Less: Contributing value of site improvements Depreciated value of improvements Reproduction cost of improvements Less: Depreciated value of improvements Accrued depreciation Depreciation = 430,000 / 1,500,000 = 28.67% Annual depreciation rate (20 years old)
Dr. Longhofer Real Estate Appraisal

$1,520,000 300,000 150,000 $1,070,000 $1,500,000 1,070,000 $430,000

1.43%
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Breakdown Method
In the breakdown method, the physical, functional and external factors contributing to the loss in value of the improvements are isolated and estimated separately
This is particularly important for external obsolescence, which may vary for a property over time

Dr. Longhofer

Real Estate Appraisal

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Categories of Depreciation
Physical deterioration
Curable (deferred maintenance) Incurable
Short-lived Long-lived

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Real Estate Appraisal

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Categories of Depreciation
Functional obsolescence
Curable
Deficiencies Defects Superadequacies

Incurable
Deficiencies Defects Superadequacies
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Categories of Depreciation
External obsolescence
Locational Economic

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Real Estate Appraisal

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Steps in Breakdown Method

1. Identify each component cost and total cost new; classify as short- or long-lived 2. Estimate cost of deferred maintenance (curable physical deterioration) 3. Estimate cost of curable functional obsolescence 4. Estimate impact of incurable physical deterioration on short-lived items
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Steps in Breakdown Method

5. Estimate the impact of long-lived incurable physical deterioration 6. Estimate cost of incurable functional obsolescence 7. Estimate the impact of external obsolescence 8. Add up total depreciation and estimate property value
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Curable Physical Deterioration

The depreciation associated with deferred maintenance is simply the cost of curing the item
Generally, deferred maintenance will apply to short-lived components In some cases, long-lived components may have deferred maintenance as well; treat these the same way
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Incurable Physical Deterioration of Short-lived Components

For each component, depreciation is calculated using the age/life method based on the effective age and useful life of the component
Make sure you subtract off the cost of deferred maintenance from each component before you calculate depreciation (avoid double counting)

Dr. Longhofer

Real Estate Appraisal

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Incurable Long-lived Physical Deterioration

Use the age/life method to estimate the depreciation due to physical deterioration of the long-lived components
Begin with the total reproduction cost of the improvements Subtract off the cost of curing deferred maintenance Subtract off the adjusted cost (after curing deferred maintenance) of short-lived components

Dr. Longhofer

Real Estate Appraisal

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Curable Functional Obsolescence

Deficiencies are items or features that are missing and would be required by the market
The loss from a deficiency is the difference between the cost of installing the item today and what it would have cost to include the item when the building was constructed

Dr. Longhofer

Real Estate Appraisal

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Curable Functional Obsolescence

Defects are items that are present but do not meet modern standards
The loss in value due to a defect is the cost of the item new less the undepreciated cost of the existing item (the part of the cost that has not yet been depreciated)

Dr. Longhofer

Real Estate Appraisal

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Curable Functional Obsolescence

Superadequacies are features or components that exceed modern standards
Excess cost adjustment method Loss equals the added cost associated with the item less the depreciation already taken Rent loss method Loss equals the capitalized difference in NOI between what it would take to support the item compared to market rent, less depreciation already taken
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Incurable Functional Obsolescence

The loss associated with incurable functional obsolescence is calculated using the rent loss method

Dr. Longhofer

Real Estate Appraisal

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Incurable External Obsolescence

This, too, is calculated using the rent loss method, with some modifications
Use the difference between the buildings rent and market rent for comparable properties No need to subtract off depreciation already taken because external obsolescence relates to factors outside the property The loss is generally allocated between land and building
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Add Up Total Depreciation and Calculate Market Value

Physical deterioration + Incurable short-lived components + Incurable long-lived components + Functional obsolescence + External obsolescence Total depreciation
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Add Up Total Depreciation and Calculate Market Value

Reproduction cost new Total depreciation Depreciated value of improvements + Contributing value of site improvements + Land value Value indication from cost approach
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