Chapter 5 Cost Approach - Cost Estimating

Entrepreneurial profit

"A market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and risk; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur's compensation for the risk and expertise associated with development. An entrepreneur is motivated by the prospect of future value enhancement (i.e., the entrepreneurial incentive). An entrepreneur who successfully creates value through new development, expansion, renovation, or an innovative change of use is rewarded by entrepreneurial profit. Entrepreneurs may also fail and suffer losses."

Direct Costs

"Expenditures for the labor and materials used in the construction of improvements; also called hard costs."

Indirect Costs

"Expenditures or allowances for items other than labor and materials that are necessary for construction, but are not typically part of the construction contract. Indirect costs may include administrative costs; professional fees; financing costs and the interest paid on construction loans; taxes and the builder's or developer's all-risk insurance during construction; and marketing, sales, and lease-up costs incurred to achieve occupancy or sale. Also called soft costs."

Entrepreneurial Incentive definition

"The amount an entrepreneur expects to receive for his or her contribution to a project. Entrepreneurial incentive may be distinguished from entrepreneurial profit (often called developer's profit) in that it is the expectation of future profit as opposed to the profit actually earned on a development or improvement. The amount of entrepreneurial incentive required for a project represents the economic reward sufficient to motivate an entrepreneur to accept the risk of the project and to invest the time and money necessary in seeing the project through to completion."

Replacement Cost is defined as

"The estimated cost to construct, at current prices as of the effective appraisal date, a building with utility equivalent to the building being appraised, using modern materials and current standards, design and layout." Replacement cost is defined in the IVS Glossary as: "The estimated cost to construct, at current prices as of a specific date, a substitute for a building or other improvements, using modern materials and current standards, design, and layout."

Reproduction cost is defined as

"The estimated cost to construct, at current prices as of the effective date of the appraisal, an exact duplicate or replica of the building being appraised, using the same materials, construction standards, design, layout, and quality of workmanship and embodying all the deficiencies, superadequacies, and obsolescence of the subject building." A similar definition for reproduction cost exists in the IVS Glossary, that states: "The cost to create a virtual replica of the existing structure, employing the same design and similar building materials. The current cost of an identical new item."

Marshall and Swift Quarterly Multiplier

**See picture Here is a sample page from Marshall & Swift. Please note that the multipliers vary by the type of house and the quality level. For example, look in the left column (in Section A) and note the difference between Single Family, Detached and Town Houses. So first make sure you are in the right category and then look for the right district, according to where you are in the country (see the map below). One further distinction is made, depending on whether the house is of frame or masonry construction.

A lack of market activity precludes the use of the sales comparison approach

A lack of market activity precludes the use of the sales comparison approach Sometimes this happens. You can't do the sales comparison approach without a reasonable amount of reliable sales data. There are times and there are certain areas where this is just not possible. It may also not be possible when you have unusual property types. Generally, you can do the sales comparison approach for any kind of property. It works great with houses if you have a reasonable quantity and quality of data. If I am appraising a gas station and can find sales of comparable gas stations, I certainly will develop the approach. The same goes for bowling alleys or golf courses. But if I don't have sales, I may have to forget the sales comparison approach. The cost approach may be an alternative.

Comparative - Unit Method - Cost Service

A unit cost figure may be developed from cost services, such as Marshall & Swift. The same process applies, with adjustments made for differences from the benchmark structure and modifications for time and location of the subject. Indirect costs that are not included in the cost service need to be added. Also, we need to add in entrepreneurial incentive. We will work our way through a case study of a residence utilizing the Marshall & Swift Handbook. First, on the next few pages we will examine how we can make adjustments for time and location.

Appraiser's Files

Appraiser's Files This goes along with examining construction contracts. Every time you do an appraisal for a proposed construction, try to get a hold of and keep a copy of the construction contract. Over time this will build into a nice database. It would be more advantageous to cross-reference these files and establish a separate file containing just the costs. In other words, extract the pertinent cost figures from a construction contract and create a running file containing cost figures. It's not always possible to get the actual contract, but every time you appraise a newer proposed construction, you have to create your own cost estimates. Therefore, that will be another source for you. You can keep a spreadsheet or matrix that tracks the construction costs that you estimated or that you obtained from actual sales contracts. Pertinent information can also be gained from additions or renovations. You may be asked to appraise a property that is proposing to add a new deck or new garage. You may be privy to written estimates from contractors, and you can easily translate that into what each are expected to cost on a per square foot basis. Once you keep track of that, you'll be better prepared to estimate costs for the deck or garage part of a new construction estimate.

Building additions or renovations are being considered

Building additions or renovations are being considered Let's suppose you are asked to appraise a 30-year-old ranch house with a proposed addition that will include 800 square feet, three rooms, a full bath, and a fireplace. You may not be able to find sales of comparable properties that include an older house with a large, new addition. That eliminates the sales comparison approach. Assume the house will still be of single-family orientation and there would not be a market for such property as an investment. Therefore, we probably cannot perform an income capitalization approach. We should be able to estimate the cost of the addition. There should be a cost estimate from the contractor available. There should be little, if any, depreciation. Therefore, the projected cost of the proposed addition added to the present value of the property should be a pretty good indication of the value of the property upon completion. Of course, we know that cost and value are not the same. We cannot blithely assume that if you add the new addition cost of $50,000 to an existing $100,000 property that the resultant value will automatically equal $150,000. We have to be alert to the possibility of overimprovement for a neighborhood (i.e., a superadequacy). However, the cost approach will be useful in our analysis and may very well present the best and the most authoritative information available.

Construction Contracts for Similar Properties

Construction Contracts for Similar Properties This certainly is a prime source if you can get your hands on such contracts. After all, what we are trying to accomplish is to figure out what typical building contractors are charging for properties similar to our subject in the local area. You may be able to obtain such documents from real estate agents, lenders, or other appraisers. The most common unit of construction costs, particularly in residential construction, is the cost per square foot (SF). If you examine a construction contract to build a 2,000 square foot house and the total cost is $200,000, then a quick division tells you that the cost per square foot will be $100.

Cost Estimating Services

Cost Estimating Services Cost estimating services are not always 100% reliable, but they are probably the most commonly-utilized source of cost data for appraisers. There are several national cost estimating services. They produce and periodically update compendiums of building costs for all types of structures and appurtenant site improvements. These cost services are available for both residential and commercial or industrial properties. They appear both in book or manual printed format and in computer software applications. The major cost estimating services are: Marshall & Swift www.marshallswift.com RS Means Company, Inc. www.rsmeans.com You can go on any of their websites and poke around for information and examples of their products. You can check their computer programs and current pricing.

Cost Index Trending

Cost manuals and computerized estimating services contain cost index tables that reflect the changes in the cost of construction over time. These cost indices can convert known costs from a past time into a current cost estimate. Example: The contract cost for constructing a house in January 1996 was $324,500. The index for January 1996 was 212.6 and the current index is 306.4. 306.4 / 212.6 = 1.441. This converts to a percentage as 144.1%. Subtracting the 100% from the 144.1%, leaves 44.1% increase. This means the costs have increased 44.1%. $324,500 X 1.441 = $467,605

Data is scarce or lacking to estimate the amount of entrepreneurial profit

Data is scarce or lacking to estimate the amount of entrepreneurial profit Entrepreneurial profit is another topic that we have not explored in depth yet; however, it is one of the vital ingredients of estimating the cost new of a structure. Investors must be motivated. The same caveat applies here. If we are unsure of any of the components of the cost approach we must question its reliability and its ultimate applicability.

Data is scarce or lacking to estimate the land value

Data is scarce or lacking to estimate the land value We can have the most elaborate and accurate cost estimates possible, but that is just one of the components in the cost approach. As we discussed in earlier chapters estimating land value is sometimes a difficult issue. If we are in one of those problem areas we referred to earlier, where there have not been vacant land sales in a long period of time, then we have to fall back on one of the alternative approaches to site valuation. Usually they are not as reliable as the sales comparison method. There are three legs supporting the value estimate by the cost approach: cost, depreciation, and land value. A tripod is a stable mechanism because it has three solid legs to stand on. If any of the three is weak, the lack of support could prove disastrous.

Depreciation

Depreciation is defined as 1. In appraising, a loss in property value from any cause; the difference between the cost of an improvement on the effective date of the appraisal and the market value of the improvement on the same date. 2. In accounting, an allocation of the original cost of an asset, amortizing the cost of the asset's life; calculated using a variety of standard techniques." Again there is a similar definition found in the IVS Glossary that defines depreciation as: "In the context of asset valuation, depreciation refers to the adjustments made to the cost of reproducing or replacing the asset to reflect physical deterioration and functional (technical) and economic (external) obsolescence in order to estimate the value of the asset in a hypothetical exchange in the market when there is no direct sales evidence available. In financial reporting, depreciation refers to the charge made against income to reflect the systematic allocation of the depreciable amount of an asset over its useful life to the entity. It is specific to the particular entity and its utilization of the asset, and is not necessarily affected by the market."

Entrepreneurial Incentive

Entrepreneurial incentive is defined as "The amount an entrepreneur expects to receive for his or her contribution to a project. Entrepreneurial incentive may be distinguished from entrepreneurial profit (often called developer's profit) in that it is the expectation of future profit as opposed to the profit actually earned on a development or improvement. The amount of entrepreneurial incentive required for a project represents the economic reward sufficient to motivate an entrepreneur to accept the risk of the project and to invest the time and money necessary in seeing the project through to completion." This is a somewhat technical concept that we will also study later. Suffice it to say at this point that it is a real part of the cost of construction that is sometimes overlooked by appraisers. Builders, developers and investors do expect to make a profit on a project - and it must be accounted for in the cost estimates. It's the pot of gold at the end of the rainbow!

Estimating the use value of special purpose properties

Estimating the use value of special purpose properties Special-purpose properties are sometimes called no-market properties. They represent things that are not normally bought and sold in the marketplace. They include properties such as churches and schools, for example. That's not to say that churches and schools are not occasionally sold. Usually, however, you would be hard-pressed to find a bunch of good comps in your MLS book. For example, if you are appraising a church building, and you can't find a substantial number of sales of churches, and they are not normally bought for investment purposes, then that rules out the sales comparison approach and the income capitalization approach as possibilities. At that point, you only have one approach left. So even though we say the cost approach has applicability in estimating the value of special-purpose properties, sometimes it's really the only way to go, by default. I have appraised several churches. I could not find comparable sales, but I could do a cost approach. I looked in my cost manual and found cost figures for that type of construction along with what it would cost to add such specialty items as stained-glass windows, steeples, and pews. Then I subtracted depreciation and added in land value. I was able to estimate value by the cost approach and that was my final opinion of value. I have successfully used the cost approach as my one and only indicator of value on such special purpose properties as schools, an oil storage tank facility, a brick manufacturing plant, and quite a few special-purpose industrial properties, such as an asphalt rendering plant and a bottling plant. When nothing else works, the cost approach often will!

In the unit-in-place method, typical components would include:

Excavation Foundation Floor construction Framing Interior walls Ceilings Exterior walls Roof framing Roof covering Plumbing Heating system Plumbing system Electrical system Special items

Fee Simple Interest

Fee simple interest is defined as "Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat." The definition of cost approach on the previous page stated that the cost approach is used to estimate the value of a fee simple interest, and it can also be used for other types of ownership interests if appropriate adjustments are made. As we may remember from Basic Appraisal Principles, a fee simple interest is still subject to the normal public limitations on ownership. For example, you may own a property free and clear of all encumbrances, no mortgage and with a warranty deed - however, if you fail to pay your taxes, the property can be taken by the taxing municipality.

Cost Approach Applicability (situations)

Here is a summary of when the cost approach generally is most applicable. Then we will look at each point in more detail. The cost approach is most applicable when: A lack of market activity precludes the use of the sales comparison approach The property is not typically income-producing and the income capitalization approach is not pertinent The building improvements are new or relatively new The land value is well supported The improvements represent the highest and best use of the land as though vacant Estimating the use value of special purpose properties Building additions or renovations are being considered The appraisal requires that land and improvements be valued separately, such as for insurance or accounting purposes Land value is a significant portion of the overall value, as with agricultural properties

Comparative - Unit Method - Market Derivation example

Here's a quick example. You find a comparable sale of a new house similar to the one you are appraising. It just sold for $320,000. You estimate the value of the site at $75,000 and the cost of the site improvements at $15,000. $320,000 - $75,000 -$15,000 = $230,000. The house has 2,550 square feet (SF) of gross living area (GLA). What is the unit cost of the structure? All you have to do is divide $230,000 by 2,550 and the answer is $90.20. That is a market-derived comparative unit cost. If your subject property has 2,475 SF, what should it cost to build? 2,475 x $90.20 = $223,245. That works well when the houses are about the same size. We will see later that the costs vary according to the size of the structure. Okay, let's do a quick cost approach for our subject property. Your research shows the land is worth $65,000 and you project the site improvements will cost $12,000. When completed, it will be brand new with no depreciation. Cost new - Depreciation + Land Value + Site Improvements = Value by Cost Approach $223,245 - 0 + $65,000 + $12,000 = $300,245, rounded to $300,000.

The depreciation is a type that is difficult to estimate

I know we haven't gotten to depreciation yet, other than to define it as a loss in value from any cause. Depreciation is a difficult topic and it comes in many forms. We'll spend considerable time addressing it later in the course. However, depreciation is one of the three basic elements of the cost approach. If it is of a type that is difficult to estimate accurately, there's a good chance that the final estimate of value will be difficult to support. Of course, this should spur us on to take extra effort when estimating that depreciation. As before, this is not to say that it would rule out the cost approach but just that we would have to temper the results in the final reconciliation if we are not well-grounded in our depreciation estimate.

Replacement Cost

If we were to take that same Victorian subject property and instead do a replacement cost estimate, there would be many differences. Remember that the definition of replacement cost talks about constructing a building with similar utility. However, we would be using modern materials and current standards, design and layout. Would we bother putting on a slate roof? No. The purpose of the roof is to keep off the rain and snow, and the typical fiberglass shingle roof would do the trick nicely. Would we try to replicate the gorgeous curving staircase? No. The purpose of a staircase is to transport people from one floor to another. A nice straight, stock builder's staircase will work just as well. Would we employ 12-foot ceilings? Probably not. They are not as energy-efficient and cost more than eight-foot ceilings. Although, it is true that higher ceilings have a lot of eye appeal and are being utilized by many builders today on high-end houses. When we were done with our replacement cost estimate of this Victorian home, it supposedly would offer similar utility. In other words, it might contain 2,400 square feet, have two floors and eight rooms as does the subject dwelling, but it sure would look different! The photos on the next page will demonstrate what I'm talking about.

Current Cost Multipliers

In Marshall & Swift, and other cost services, building costs are continuously being monitored to try to keep abreast of changing costs. For example, the cost of plywood varies according to supply and demand, along with other factors. There was a large surge in demand after Katrina and the other 2005 hurricanes. Labor costs also are dynamic. In some areas they are cyclical and change with the seasons. When pages are printed in the Handbook, they soon grow out of date. Marshall & Swift issues multipliers every quarter to update the costs in the Handbook. They are similar to what we just did in the last problem. We calculate the cost according to the Handbook, and then we apply a multiplier to adjust the cost figures to the present. NOTE: In this course we will concentrate on the Residential Cost Handbook pages. They are clear and you can see how the steps are logical. Some people enjoy working with a hard copy in their hands. Marshall & Swift also has the same information available online that you may display the pages on your computer screen. They also have several software programs that are interactive and will do a lot of the calculations for you. You enter the basic facts about the property you are costing and the program will do the math and apply the correct current multiplier.

Quantity Survey Method

In the quantity survey method, the quantity and quality of all materials used and all categories of labor required are estimated, and unit cost figures are applied. It is the most comprehensive and accurate method, but requires extensive knowledge and ample time to complete. It is more likely to be applied by a contractor or professional cost estimator than an appraiser. Most appraisers would not have the expertise. It gets right down to how many pounds of nails and sheets of plywood are required, the cost of each and the cost of labor to install each item. It would perhaps be utilized in a situation where a builder plans to put up 200 houses, consisting of three different models; a ranch, a split level and a 2-story colonial. The builder might order a quantity survey cost workup of each model. He would be keenly interested in knowing the exact costs for labor and materials. Then, perhaps, some cost cutting measures could be applied. This could make a big difference in the overall profit picture of the project. It is not possible to create a quantity survey cost estimation using a cost manual. With Marshall & Swift, you can accomplish the two less detailed costing methods (comparative unit and unit-in-place), but not the quantity survey.

Cost Approach Applicability

It is important that you know when to apply the cost approach and when not to. If the approach is pertinent we should develop it. To not do so would be shirking our responsibilities. USPAP gives clear direction in this area. Standards Rule 1-1 (a) says an appraiser must "be aware of, understand, and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal." 1 Standards Rule 1-4 (b) says "when a cost approach is necessary for credible results, an appraiser must: (i) develop an opinion of site value by an appropriate appraisal method or technique; (ii) analyze such comparable cost data as are available to estimate the cost new of the improvements (if any); and (iii) analyze such comparable data as are available to estimate the difference between the cost new and the present worth of the improvements (accrued depreciation)." 2 Standards Rule 1-2 (h) says you must "determine the scope of work necessary to produce credible assignment results in accordance with the SCOPE OF WORK RULE." 3

Comparative-Unit Method - Market Derivation

It is possible to derive unit costs from the market. We can just follow these steps: Select sales of recently constructed buildings that are similar to the subject property and represent the highest and best use of the site Subtract the value of the site and site improvements from the sales price to arrive at the cost new of the improvements (including entrepreneurial incentive) Make adjustments for physical differences between the subject and the sale properties Divide the adjusted cost new by the desired unit of area or volume to arrive at the cost per unit Adjust the unit cost for market conditions, if necessary Apply the unit costs to the subject property This all sounds very complicated, but it's not hard to do (particularly with residential properties). It becomes more difficult with commercial or industrial properties.

Land value is a significant portion of the overall value; such as with agricultural properties

Land value is a significant portion of the overall value; such as with agricultural properties You may be faced with appraising four or five hundred acres of valuable farmland whose only improvements are a rickety old farmhouse and several sagging outbuildings. Again, finding comparable sales may be a problem. Even if you do find sales of similar improved properties, making appropriate adjustments could be problematic. In doing a cost approach on this type of property you could do a rigorous sales comparison approach of vacant land sales to nail down the value of the land component. This might reveal that the building improvements contribute little or no value.

Cost Approach Formula

Let's begin with the basic formula for the cost approach: Reproduction or Replacement Cost New - Accrued Depreciation + Site Value = Property Value We start with some type of cost new. That will be the subject of this chapter. Then we subtract accrued depreciation. That will be studied in later chapters. After that, we add in the site value. That was the subject of an earlier chapter. The result will be the value indicated by the cost approach. (This entire process will be covered in-depth in another course called Residential Site Valuation and Cost Approach.) A very simplistic example would be as follows. A house cost $200,000 to build new. It is 10 years old and has sustained a total of 15% depreciation. It sits on a lot worth $40,000. What is its value by the cost approach? Cost New $200,000 - Accrued Depreciation ($200,000x.15) - $30,000 $170,000 + Site Value + $ 40,000 Indicated Value by Cost Approach $210,000 Again, the math is deceptively simple. Once you have those three numbers (cost new, depreciation, and site value) anybody can process the results by adding and subtracting. Where you will earn your stripes as an appraiser is in researching, analyzing and reconciling your way to the right three numbers. Now we will concentrate on some definitions that set the stage for all that follows.

Replacement Cost versus Reproduction Cost

Let's get right to the big issue. The first step in the cost approach formula is to estimate what it would cost to build the subject building improvements brand new today. There are two basic ways we can do this. Let's review these two definitions. Reproduction Cost "The estimated cost to construct, at current prices as of the effective date of the appraisal, an exact duplicate or replica of the building being appraised, using the same materials, construction standards, design, layout, and quality of workmanship and embodying all the deficiencies, superadequacies, and obsolescences of the subject building." Replacement Cost "The estimated cost to construct, at current prices as of a specific date, a substitute for a building or other improvements, using modern materials and current standards, design, and layout."

Unit-in-Place Method:

Let's turn our attention away from the square foot method of estimating cost new, for now. Next, we will look at the unit-in-place method. In this method, total building cost is estimated by adding together the unit costs for the various building components. Sometimes it is called the segregated cost method. Costs are computed based on the quantity of materials used plus the labor involved in assembly. For example, costs could be estimated per square foot of floor area or lineal foot of wall area. For example, we might determine that the cost per lineal foot of exterior wall is $106.28. Lineal foot means running along the ground. If a house has this layout or footprint, how many lineal feet of exterior wall are there? To total the lineal feet, you add up all the lengths of the walls around the perimeter. 24 + 28 + 8 + 26 + 22 + 26 + 10 + 28 = 172 lineal feet.

Local Building Contractors

Local Building Contractors This is called getting it from the horse's mouth! If we want to know building costs, let's go ask a builder. They should be a prime source. We need to cultivate relationships with these founts of information. Get to know some of the local contractors. Drop by a building site and introduce yourself. Let them know you are active in the local market and are desirous of keeping up with the latest trends. Leave your business card. You might invite them out for lunch. You might want to attend some meetings of the local builder's association. Find out when and where they meet. However, be careful how you ask questions of a building contractor. Don't throw out a broad question such as, "What does it cost to build a house today?" If so, you'll deserve the undoubtedly broad answer that you'll receive. To cover all eventualities, the contractor probably will just throw out a nice round, optimistic statement such as, "Oh, I can't build anything today for less than $150 per square foot." You might get a better result if instead you had posed a question such as, "What do you think it costs to build a three-bedroom, two-bath, 1,400 square foot ranch on a full basement?" If nothing else, it will cause the contractor to pause and think about it and then tailor the response to your more specific request. If you really want the right number, you might have to submit a complete set of plans and specifications to the builder and then ask for, and perhaps pay for, a firm quote.

Marshall & Swift

Marshall & Swift Marshall and Swift is the most popular cost service among residential appraisers. We will look at illustrations from their Residential Cost Handbook, with their kind permission, as we work some sample problems in this course. They do also have as well a publication for costing commercial and industrial buildings, entitled the Marshall Valuation Service. Marshall & Swift has been in business for more than 70 years and have research teams constantly monitoring the costs of labor and materials throughout the United States and Canada.

Shape Consideration

Remember back in Chapter 3 when we had three different lots that were all one acre - but they were three different shapes? I indicated they might have different values. Well, the same reasoning applies here. You might have a house containing 1,600 SF of area, but the cost to construct might vary according to the shape. The easiest shape is one that is square and has four corners. A rectangle also has four corners but is strung out more and may have more perimeter wall area, as well as more roof area and foundation area. The more corners you have, the more expensive it becomes in terms of framing and construction difficulties. It will also use more materials for bracing and cost more in labor. Marshall & Swift has identified multipliers that you can use to adjust your cost figures according to the shape of your subject building. Please look at the next page. It shows three separate houses. Each contains 1,600 SF, but look at the differences in perimeter, wall area, floor area, and costs to construct.

Local Multipliers

Okay, so we looked in the Handbook and applied the Current Cost Multiplier to bring our cost figures up to date. But don't building costs vary from area to area? You bet they do! It costs a lot more to build a house in Anchorage, Alaska than it does in Mobile, Alabama. There are many reasons. Let's start with the geography and the climate. It gets a lot colder in Anchorage. They need to excavate to place footings below the frost line, which runs about 10 feet there. Buildings need to be well insulated and have roofs capable of supporting a heavy snow load. None of that is necessary in Mobile, but they have more concerns about air conditioning and termite protection (as well as hurricane engineering). The materials cost more in Anchorage because everything has to be transported a longer way. Labor wages are considerably higher in Anchorage due to the higher cost of living. Marshall & Swift has pages of Local Multipliers that are also updated every quarter. They adjust the basic cost figures found in the Handbook to your particular locale. Each state has various locations listed on these pages with multipliers attached to each. If your city is not listed, please use the multiplier from the one closest to you. See a sample on the next page. NOTE: The Cost Multipliers are not infallible. They are based on averages and may not be 100% accurate for your particular jurisdiction. I hear from appraisers who say "Marshall & Swift doesn't work in my area. The figures I look up are always 10% too low!" That may very well be the case. However, they will probably be consistently 10% low. You may be in a pocket with particular costs because of some local factors. Fine - then make an adjustment of 10% and explain it in the report! There is no substitute for local knowledge.

Then we need to add in the costs of the other components, such as the roof, heating system, foundation, etc.

On the last page, we added up the lengths of all the exterior walls and determined there are a total of 172 lineal feet. We also said that the cost per lineal foot was $106.28 in this structure. 172 x $106.28 = $18,280. That would be the cost for the exterior wall. Then we need to add in the costs of the other components, such as the roof, heating system, foundation, etc. That cost for the exterior walls would include all the components necessary for a finished product. That lineal foot (costing $106.28) might include an eight-foot-high wall. In the costs of that 1 foot wide and 8 foot tall wall would be the proportionate cost of the studs, sheetrock and paint on the inside, insulation in the wall, and the costs of the exterior sheathing and siding. Some cost services include contractor's overhead and profit in their unit-in-place costs and some do not.

Professional Cost Estimators

Professional Cost Estimators There are people who do this for a living. They may be contractors who do consulting on the side or full-time professional estimators who work for construction firms or architects. You will have to pay for their advice. But if you are embarking on a large appraisal assignment involving a complex property, it may be very worthwhile. It may even be a necessity. Remember the COMPETENCY RULE of USPAP. If the cost approach would be a pertinent part of your appraisal assignment, then you would have to decide prior to accepting the assignment if you are competent to perform a cost approach. If you do not have the appropriate and sufficient background in construction cost estimating, you would not be able to accept the assignment on your own. You would have to decline the assignment or affiliate yourself with someone who does have the requisite knowledge.

So which type of cost estimate are we going to use?

So which type of cost estimate are we going to use? That will depend on the type of property and the intended use of the appraisal. If the property is older or exhibits unusual construction, then perhaps the more accurate method would be to use reproduction cost. Or if the subject property exhibits a large or unusual amount of depreciation, it can be more accurately measured through the use of reproduction cost. When replacement cost is used, it eliminates any functional obsolescence that may be present in the structure and replaces it with functional utility that is acceptable in the marketplace today. If the purpose or intended use of an appraisal is to provide an accurate measurement of loss, then reproduction cost should prove to be more accurate. Be aware, however, that most fire and casualty insurance is written to pay an amount equal to the replacement cost of the structure. That is an eye-opener to many people. Certainly the majority of the appraisals performed today reflect the use of replacement cost if the cost approach is developed. As we will see later, when you use a cost manual (e.g., Marshall & Swift) the estimate will be based on replacement cost.

Other Adjustment Factors

Specific step-by-step instructions on how to use Marshall & Swift are beyond the scope of this course. Nevertheless, let's take a quick look at some of the other features available in the Marshall & Swift Residential Cost Handbook. First, it features some pages with photos of older houses. You aren't always appraising new houses or proposed construction. What if you are appraising a bungalow or a Craftsman style house built in the early 1900s? If you wanted to estimate replacement cost new for one of these structures, you should go to the Old Residence pages. Look at the page below. It says under the first photo, if your house looks like this "Use Average Quality, One and a Half Story Cost Tables."

Underlying Principle

The basic principle underlying the cost approach is the principle of substitution. This principle is defined as: "The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. This is the primary principle upon which the cost and sales comparison approaches are based." The principle of substitution really underlies all three approaches to value. In the sales comparison approach, it asks the question, "Why should I pay more than $200,000 for your property, when I can buy another one just as good for $200,000?" In the income approach it begs the question, "Why should I pay more than $200,000 for your property, when I can buy another one for $200,000 that has an economic return just as good?" The principle of substitution triggers this question in the cost approach, "Why should I pay more than $200,000 for your property, when I can build another one just as good for $200,000?" Buyers do shop around and compare properties. Some sellers correlate cost with value. It is an easy concept to understand; even though they don't always get it right from an appraisal standpoint. "Gee, a new house just went up in my neighborhood for $275,000. I guess mine must be worth about the same as that one."

The building improvements are new or relatively new

The building improvements are new or relatively new The cost approach has good applicability when the improvements we are appraising are new or relatively new. The first step in the cost approach is to estimate the cost new of the building improvements. If it was recently built, it most likely was constructed of modern materials, utilizing modern construction techniques. If it was recently built, you may be able to ascertain the contract cost. Maybe you can interview the builder, or perhaps the plans and costs are on file with the local building department. You might be able to interview the lender or contact the person who appraised that property. As a building gets older, and older, it will be more difficult to arrive at an estimate of what it would cost to construct that building brand new today. Maybe some of the materials used in that construction are no longer available. Perhaps there are not skilled artisans available who could do a particular type of craftsmanlike finish. There are not a lot of people out there now who work with slate roofs or who mill "gingerbread" eaves. So the difficulties inherent in estimating costs new of older structures include both material costs and labor costs. Besides some of these older structures are lacking in utility to the extent that no one would pay to reproduce them today.

Comparative-Unit Method

The comparative-unit method is the first of the three traditional methods. It is the simplest, quickest, least complicated, and least accurate method of estimating costs. It is the one that is used primarily by appraisers. Costs are expressed in terms of dollars per unit of area or volume. The usual measure of area for residential appraisers is cost per square foot. Volume is less common and would be used more by commercial or industrial appraisers. For example, an important value factor in warehouses is the ceiling height. A warehouse with a 24-foot ceiling should be worth more and cost more than one with a 16-foot ceiling - you can pile stuff up higher and accommodate more stock. Costs then should be calculated according to cubic volume - length x width x height. The costs can be derived from the local market or from cost services. It is based on known costs of similar structures and then the costs are adjusted for physical differences, time and location. Unit costs vary with size, and adjustments may have to be made if comparing different sized structures.

Approaches to Value

The cost approach has been around for a while. It is the oldest of the three traditional approaches that appraisers use. If you were an appraiser back in 1940, all you would have used was a cost approach. As time went on, the sales comparison approach was introduced along with the income approach and its many variations. The fortunes of each approach changed over time as well. Many participants in the residential mortgage market today feel that the sales comparison approach is the only way to go. The 2005 revisions of the Fannie Mae/Freddie Mac forms stress that the cost approach and the income approach are not required by them. Some appraisers denigrate the cost approach, while others appreciate its capabilities. Within the appraisal profession, there has been an ongoing debate about the applicability of the cost approach in varying situations. There is unanimity in the thought that the cost approach has diminishing applicability as a property ages. However, there is no consensus as to where to draw the line. In other words, how old is too old to have the cost approach work adequately?

The improvements represent the highest and best use of the land as though vacant

The improvements represent the highest and best use of the land as though vacant The ideal situation for developing a cost approach is where the current building improvements truly do represent the highest and best use of the land as though vacant. Any time we stray away from that ideal, there is potential for errors. Some properties are mis-improved right from the start. The builder or the property owner is not sufficiently cognizant of the desires and dictates of the local market area. They may construct a dwelling that is larger or smaller than the norm or has unusual styling or layout. A two-unit property may be developed in an area where a four-unit property would be more appropriate. A small industrial property may be developed in an area that would be better suited to retail development. Even if a property is initially the highest and best use of the land, this can change over time. Markets are dynamic and subject to change. Typically this is a reflection of external market forces that are a combination of many factors. Some of these factors may be social, some may be economic, and some may be governmental or physical in nature. As a matter of fact, it would be unusual to find a property with building improvements fifty to a hundred years old that still represents the highest and best use of a site.

Cost Approach

The cost approach is defined as: "A set of procedures through which a value indication is derived for the fee simple estate by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including an entrepreneurial incentive or profit, deducting depreciation from the total cost, and adding the estimated land value. Adjustments may then be made to the indicated value of the fee simple estate in the subject property to reflect the value of the property interest being appraised." A companion definition that is found in the IVS (International Valuation Standards) Glossary says: "One of the approaches to value commonly applied in Market Value estimates and many other valuation situations. A comparative approach to the value of property or another asset that considers, as a substitute for the purchase of a given property, the possibility of constructing another property that is an equivalent to the original or one that could furnish equal utility with no undue cost resulting from delay. The Valuer's estimate is based on the reproduction or replacement cost of the subject property or asset, less total (accrued) depreciation. The cost approach establishes the value of a real property by estimating the cost of acquiring land and building a new property with equal utility or adapting an old property to the same use with no undue cost due to delay. An estimate of entrepreneurial incentive or developer's profit/loss is commonly added to land and construction costs. For older properties, the cost approach develops an estimate of depreciation including items of physical deterioration and functional obsolescence." Next, we will define some of the terms that are inherent in the basic definition of the cost approach.

Here are the situations in which the cost approach is least applicable:

The depreciation is a type that is difficult to estimate Data is scarce or lacking to estimate the amount of entrepreneurial profit Data is scarce or lacking to estimate the land value The interest valued is anything other than fee simple - adjustments must be made

The interest valued is anything other than fee simple

The interest valued is anything other than fee simple We said at the beginning that the cost approach should result in an indication of fee simple value. If we are appraising any unusual interests such as a leased fee, a life estate, a leasehold estate, partial interests, trusts, etc., the value may be better reflected by the use of the sales comparison approach or the income capitalization approach. If we are appraising a leasehold estate and we value it by comparing it to sales of other leasehold properties, then we take that factor out of play. It is possible to do a cost approach of that type of property, but then we have to make adjustments for that difference in property rights as a lump sum adjustment at the end. The appropriate adjustment factor may be difficult to obtain.

The land value is well supported

The land value is well supported Another step in the cost approach is the value of the land or site. If it's a standard lot and there are adequate sales in the marketplace, it becomes a relatively easy and straightforward task to arrive at that value. If the land is unusual in any aspect such as size, shape, topography, utilities, then the difficulty is compounded. If it turns out that the land value is not well supported, a non-credible value might be developed which can throw off the results of the cost approach. Have you ever tried to find comps for a 100-acre site in a suburban area where virtually all the properties are two acres or less in size? If we have difficulty supporting the land value, that does not mean that we cannot do a cost approach, but we have to realize that the results may be suspect.

The property is not typically income-producing and the income capitalization approach is not pertinent.

The property is not typically income-producing and the income capitalization approach is not pertinent. You can't do an income capitalization approach unless the property is income-producing or has the potential to produce income. The income approach is best applied when the typical purchaser would be an investor who is buying the property for investment purposes. However, you can virtually always do a cost approach! I don't care how old it is, what type of property it is, or what the market activity is. I can research a property, estimate its cost new, subtract apparent depreciation, and add site value. It is the one universal approach that can be applied to any kind of improved real property. In some cases, it may not be the best approach or the most supportable opinion of value - but one can always do a cost approach. NOTE: This explanation assumes that the property is improved with building and site improvements. A parcel of unimproved land would, obviously, not be appraised using a cost approach as there is nothing to "cost estimate" on the subject.

Cost Estimating Methods

There are three traditional cost estimating methods. They vary in degree of difficulty and accuracy. They include the following: Comparative-unit method Unit-in-place method Quantity survey method We will investigate each in depth shortly. However, there is one other simplistic method that I want to mention first, the index method. It is only available in limited situations. If you know what the original cost of construction was for a building at some time in the past, it is possible through the use of special pages in cost services to apply a multiplier to bring it up to a present cost. It is akin to a cost of living index. For example, using an index, you can calculate that a quart of milk that cost 10 cents at the time when it was delivered to your door now costs $1.48 from a store. Well, you can also use the same principle to find out what a house that cost $125,000 to construct in 1980 would cost today.

Entrepreneurial Incentive/Profit in Residences

There is an ongoing debate in the appraisal community as to whether or not entrepreneurial incentive or profit is a real factor in estimating the cost of a single residence. If it is part of a large project, then there may be some entrepreneurial profit that was accounted for in the land value as the lot was sold to the contractor. If the subject property or comparable sales is just a single unit residence that was constructed on an odd lot that was purchased or previously owned, then entrepreneurial incentive may not have a place. If the land was already owned and the property owner contracts with a builder to erect a house on the site that he or she intends to live in, then there probably would not be any entrepreneurial profit incentive. The normal contractor's profit would be realized and included in the direct costs. If a property owner builds a house on speculation and intends to try to sell it for a profit, then entrepreneurial incentive is back in the picture; on top of the contractor's profit. You have to make your own decisions as to whether or not entrepreneurial incentive or profit is a factor in your local marketplace, for that type of property. Be aware, however, that if you use a cost service such as Marshall and Swift - it will not be included. Cost services include direct and indirect costs in their cost figures - but NOT entrepreneurial profits or incentives!

Indirect Cost examples

These are sometimes intangible items, or soft costs, that are less capable of direct measurement. They will vary from project to project, and some may not be present at all in some construction projects. Some of these costs would be typical in properties more complex than a single family house. The last item in the list, waiting for stabilized occupancy, would be applicable if you were constructing an apartment building or shopping mall. Indirect costs include: Architectural and engineering fees Appraisal, accounting and legal fees Cost of carrying the investment (e.g., construction loans) Property insurance and taxes during construction Marketing, sales and lease-up costs and commissions Administrative expenses of the developer Costs of title changes Cost of carrying the investment after construction until stabilized occupancy is achieved

Direct Cost examples

These are tangible items, or hard costs, that are the nuts and bolts of any construction project. They include the unavoidable costs of labor and materials. These are items that will be billed and must be paid. They are generally possible to estimate with a good deal of precision. Direct costs include: Building permits Materials used to construct buildings Labor used to construct buildings Equipment used in construction Security during construction Contractor's shack and temporary fencing Material storage facilities Installation of power line Contractor's overhead and profit Worker's compensation and liability insurance

Entrepreneurial incentive is what a contractor or developer hopes to get; entrepreneurial profit is what they actually get.

This is calculated as the difference between the market value of a property after completion and its total cost of development. There may or may not be any profit. As a matter of fact, it may be zero or there may be a loss. Entrepreneurial incentive/profit is conceptually sound, but in reality may be received only when the property is ultimately sold, or never. However, it needs to be included along with the direct and indirect costs. Depending on local custom, it may be estimated as a percentage of: Direct costs only Direct and indirect costs Direct and indirect costs plus site value The value of the completed project If an investor/developer undertakes to develop a large tract into 100 home sites, it will require a substantial investment over a long period of time and entail considerable risk and unknowns. It may require a lot of those things we listed under indirect costs: architectural fees, engineering fees, appraisal fees, accounting fees, legal fees, marketing and advertising fees. Much of that will have to be paid up front, before a single lot is sold. The site approval and permitting process may go on for years. Much of the ultimate profit will come from site sales, but the entrepreneur wants an additional bonus for having the foresight to plan such a project and the ability to consummate the concept. The investor/developer may also serve as the general contractor or just sell out the lots to builders. In either event, the actual contractor of each house will expect the typical builder's profit - which is part of the normal direct costs.

Region/Climate Map

To accommodate the regional differences in climate (remember the comparison between Anchorage and Mobile), Marshall & Swift has employed a map. When you are building up a cost estimate, you can tailor it according to the location of the house. That will adjust for such things as insulation, footing depth, roof load, etc. You can look at the map and determine if you are in what they call a mild, moderate, or extreme climate.

."The amount an entrepreneur expects to receive."

We defined this third cost item as ..."The amount an entrepreneur expects to receive." It is the motive for taking on a project. There will be some investment involved and a certain risk. This incentive is what makes it all worthwhile.

USPAP Obligations

What approach or approaches to value are required by USPAP? Simply put, appraisers are required to develop whatever approaches are necessary to produce credible assignment results. Even if an approach may not be necessary for credible assignment results in a particular assignment, the appraiser may still choose to develop the approach. This becomes our choice under the SCOPE OF WORK RULE. We have to analyze the type of property and make our own decision as to which approaches should be developed. Fannie Mae may say the cost approach is not required - by them. But, if the property is new, or reasonably new, and of standard construction; the cost approach might be necessary for credible results. If the approach is necessary for credible results, it is therefore required by USPAP. Fannie Mae says you don't have to complete the cost approach - they don't say you cannot complete the cost approach.

Cost Estimates

Whatever the source of the cost data, all cost estimates to be used in the cost approach need to include three basic ingredients: Direct costs Indirect costs Entrepreneurial incentive

Cost Data Sources

Where does this cost data come from? Cost data may be obtained from: Construction contracts for similar properties Appraiser's files Local building contractors Professional cost estimators Cost estimating services

Here is an example of one of the pages from the Segregated Costs section of the Marshall & Swift Residential Cost Handbook.

You can get an idea of the amount of detail that is indicated. You can tailor a cost precisely to the type of construction components you observe. Of course, when you get done and add up the costs of the individual components, then you would as usual apply the applicable time and location multipliers. **See picture