THE COST APPROACH

Types of cost appraised

Depreciation

Steps in the approach

The cost approach is most often used for recently built properties where the actual costs of development and construction are known. It is also used for special-purpose buildings which cannot be valued by the other methods because of lack of comparable sales or income data.

The strengths of the cost approach are that it:

  • provides an upper limit for the subject’s value based on the undepreciated cost of reproducing the improvements
  • is very accurate for a property with new improvements which are the highest and best use of the property.

The limitations of the cost approach are that:

  • the cost to create improvements is not necessarily the same as market value
  • depreciation is difficult to measure, especially for older buildings

Types of cost appraised                    

The cost approach generally aims to estimate either the reproduction cost or the replacement cost of the subject property.

Reproduction cost is the cost of constructing, at current prices, a precise duplicate of the subject improvements. Replacement cost is the cost of constructing, at current prices and using current materials and methods, a functional equivalent of the subject improvements.

Replacement cost is used primarily for appraising older structures, since it is impractical to consider reproducing outmoded features and materials. However, reproduction cost is preferable whenever possible because it facilitates the calculation of depreciation on a structure.

Depreciation                 

A cornerstone of the cost approach is the concept of depreciation. Depreciation is the loss of value in an improvement over time. Since land is assumed to retain its value indefinitely, depreciation only applies to the improved portion of real property. The loss of an improvement’s value can come from any cause, such as deterioration, obsolescence, or changes in the neighborhood. The sum of depreciation from all causes is accrued depreciation.

An appraiser considers depreciation as having three causes: physical deterioration, functional obsolescence, and economic obsolescence.

Physical deterioration. Physical deterioration is wear and tear from use, decay, and structural deterioration. Such deterioration may be either curable or incurable.

Curable deterioration occurs when the costs of repair of the item are less than or equal to the resulting increase in the property’s value. For example, if a paint job costs $6,000, and the resulting value increase is $8,000, the deterioration is considered curable. Incurable deterioration is the opposite: the repair will cost more than can be recovered by its contribution to the value of the building. For example, if the foregoing paint job cost $10,000, the deterioration would be considered incurable.

Functional obsolescence. Functional obsolescence occurs when a property has outmoded physical or design features which are no longer desirable to current users. If the obsolescence is curable, the cost of replacing or redesigning the outmoded feature would be offset by the contribution to overall value, for example, a lack of central air conditioning. If the functional obsolescence is incurable, the cost of the cure would exceed the contribution to overall value, for example, a floor layout with a bad traffic pattern that would cost three times as much as the ending contribution to value.

Economic obsolescence. Economic (or external) obsolescence is the loss of value due to adverse changes in the surroundings of the subject property that make the subject less desirable. Since such changes are usually beyond the control of the property owner, economic obsolescence is considered an incurable value loss. Examples of economic obsolescence include a deteriorating neighborhood, a rezoning of adjacent properties, or the bankruptcy of a large employer.

Steps in the approach     

The cost approach consists of estimating the value of the land “as if vacant;” estimating the cost of improvements; estimating and deducting accrued depreciation; and adding the estimated land value to the estimated depreciated cost of the improvements.

Estimate land value. To estimate land value, the appraiser uses the sales comparison method: find properties which are comparable to the subject property in terms of land and adjust the sale prices of the comparables to account for competitive differences with the subject property. Common adjustments concern location, physical characteristics, and time of sale. The indicated values of the comparable properties are used to estimate the land value of the subject. The implicit assumption is that the subject land is vacant (unimproved) and available for the highest and best use.

Estimate reproduction or replacement cost of improvements. There are several methods for estimating the reproduction or replacement cost of improvements. These are as follows.

  • Unit comparison method (square-foot method)

The appraiser examines one or more new structures that are similar to the subject’s improvements, determines a cost per unit for the benchmark structures, and multiplies this cost per unit times the number of units in the subject. The unit of measurement is most commonly denominated in square feet.

  • Unit-in-place method

The appraiser uses materials cost manuals and estimates of labor costs, overhead, and builder’s profit to estimate the cost of constructing separate components of the subject. The overall cost estimate is the sum of the estimated costs of individual components.

  • Quantity survey method

The appraiser considers in detail all materials, labor, supplies, overhead and profit to get an accurate estimate of the actual cost to build the improvement. More thorough than the unit-in-place method, this method is used less by appraisers than it is by engineers and architects.

  • Cost indexing method

The original cost of constructing the improvement is updated by applying a percentage increase factor to account for increases in nominal costs over time.

Estimate accrued depreciation. Accrued depreciation is often estimated by the straight-line method, also called the economic age-life method. This method assumes that depreciation occurs at a steady rate over the economic life of the structure. Therefore, a property suffers the same incremental loss of value each year.

The economic life is the period during which the structure is expected to remain useful in its original use. The cost of the structure is divided by the number of years of economic life to determine an annual amount for depreciation. The straight-line method is primarily relevant to depreciation from physical deterioration.

Subtract accrued depreciation from reproduction or replacement cost. The sum of accrued depreciation from all sources is subtracted from the estimated cost of reproducing or replacing the structure. This produces an estimate of the current value of the improvements.

Add land value to depreciated reproduction or replacement cost. To complete the cost approach, the estimated value of the land “as if vacant” is added to the estimated value of the depreciated reproduction or replacement cost of the improvements. This yields the final value estimate for the property by the cost approach.