RE614 Cost Approach

7/31/2019 RE614 Cost Approach

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Dr. Longhofer Real Estate Appraisal 1

The Cost Approach

Real Estate 614

Real Estate AppraisalDr. Longhofer


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The Cost Approach

Begin by estimating the cost of any improvementson the landReproduction costis the cost to construct the building

today, replicating it in exact detailReplacement costis the cost required to construct a

building of equal utility, using modern constructiontechniques, materials, and design

Subtract from this the cost of any accruedphysical, functional, or external depreciation

Add in the value of the site as raw land to get theindicated value using the cost approach


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Estimating Construction Costs

Comparative-unit MethodFor relatively standardizedstructures, the size of the building is multiplied by the per-square foot cost of that type of construction

Segregated-cost MethodThe costs of the individualcomponents in the building are used to estimate the overallreplacement cost

Quantity-survey MethodIdentifies the exact materialsrequired to reproduce the structure to estimate the cost

Index MethodAssumes that the replacement cost issimply the original construction cost times a cost index


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Categories of Accrued Depreciation

Physical deterioration is the result of wear andtear, weathering from the elements, vandalism andneglect

Functional obsolescence refers to features, design,and other elements of the building that are not upto modern standards; it also includes features inexcess 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 particulartype of depreciation (esp. econ. obsolescence)

Breakdown methodComplex 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

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

newCostLifeEconomic

ageEffectiveondepreciatiAccrued


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Modified Age/Life Method

Sometimes the age/life method is modified

by subtracting out curable physical and

functional depreciation before calculatingthe lump sum depreciation of the rest

The idea is that the owner will cure these

problems because it adds more value than itcosts


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Modified Age/Life Method Example

Reproduction cost new $245,000

Physical and functional depreciation, curable 12,500

Adjusted cost $232,500

Total economic life 55 years

Effective age 17 years

% accrued depreciation = 17/55 = 30.9%

Accrued depreciation 71,843

Depreciated value of improvements 160,657

Land value 39,000

Estimated market value $199,657


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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 $1,520,000

Less: Land value 300,000

Less: Contributing value of site improvements 150,000

Depreciated value of improvements $1,070,000

Reproduction cost of improvements $1,500,000

Less: Depreciated value of improvements 1,070,000

Accrued depreciation $430,000

Depreciation = 430,000 / 1,500,000 = 28.67%

Annual depreciation rate (20 years old) 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 areisolated and estimated separately

This is particularly important for external

obsolescence, which may vary for a propertyover time


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Categories of Depreciation

Physical deterioration

Curable (deferred maintenance)

Incurable Short-lived

Long-lived


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Functional obsolescence

Curable

Deficiencies Defects

Superadequacies

Incurable

Deficiencies Defects

Superadequacies


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External obsolescence

Locational

Economic


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Steps in Breakdown Method

1. Identify each component cost and totalcost new; classify as short- or long-lived

2. Estimate cost of deferred maintenance(curable physical deterioration)

3. Estimate cost of curable functional

obsolescence4. Estimate impact of incurable physicaldeterioration on short-lived items


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Steps in Breakdown Method

5. Estimate the impact of long-livedincurable physical deterioration

6. Estimate cost of incurable functionalobsolescence

7. Estimate the impact of external

obsolescence8. Add up total depreciation and estimateproperty value


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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 thecomponent

Make sure you subtract off the cost of deferred

maintenance from each component before youcalculate depreciation (avoid double counting)


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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 deferredmaintenance) of short-lived components


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Curable Functional Obsolescence

Deficiencies are items or features that are

missing and would be required by the

marketThe 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


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Defects are items that are present but do not

meet modern standards

The loss in value due to a defect is the cost ofthe item new less the undepreciatedcost of the

existing item (the part of the cost that has not

yet been depreciated)


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Superadequacies are features orcomponents that exceed modern standards

Excess cost adjustment methodLoss equalsthe added cost associated with the item less thedepreciation already taken

Rent loss methodLoss equals the capitalized

difference in NOI between what it would taketo 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


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Incurable External Obsolescence

This, too, is calculated using the rent lossmethod, with some modifications

Use the difference between the buildings rentand market rent for comparable properties

No need to subtract off depreciation alreadytaken because external obsolescence relates to

factors outside the propertyThe 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 obsolescenceTotal depreciation


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Add Up Total Depreciation and

Calculate Market Value

Reproduction cost new

Total depreciationDepreciated value of improvements

+ Contributing value of site improvements

+ Land valueValue indication from cost approach

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RE614 Cost Approach