Real Estate Appraisal: Chapter 8 Cost Approach to Value
Actual age
(Chronological Age) (Historical Age) The amount of time that an improvement has been in existence.
*Estimating Cost
-Reproduction Cost and Replacement Cost -Types of Costs -Cost Estimating Techniques
Hard Costs
(Direct Costs) The cost of labor, materials, and equipment used in the construction.
Economic Age-Life Ratio
(Straight Line Method) A technique for estimating depreciation, based on the assumption that an improvement loses value at a steady rate over the course of its economic life.
Breakdown Method Step 3B
All physical deterioration that hasn't already been dealt with in either Step 2 (curable) or Step 3 (short-lived incurable) is treated as long-lived incurable physical deterioration. To calculate this, the appraiser starts with the total cost estimate for the improvement, the subtracts the cost to cure of the items included in Step 2 and the replacement cost of the short-lived items included in Step 3A. The remainder is then multiplied by the economic age-life ratio for the whole improvement. Ex. $200,000 Total estimated replacement cost of improvement -$12,000 less Replacement cost of short-lived items -$1,700 less Cost to cure of curable items (siding & roof) =$186,300 Subtotal Effective age of improvement: 5-years Economic life of improvement: 50-years x 0.10 Economic age-life ratio (5 ÷ 50 = 0.10) =$18,630 Total incurable physical deterioration for long-lived items
Deferred Maintenance
Curable physical deterioration.
Functional Obsolescence
Depreciation caused by defects in design.
Incurable
Depreciation that can not be remedied possible or practical.
Economic Obsolescence
External obsolescence caused by economic conditions or factors.
Locational Obsolescence
External obsolescence caused by surrounding properties.
Principle of Substitution
A property's value can't be greater than the cost of acquiring (buying or building) a substitute property of equal utility. In the cost approach, cost is related to value by the formula: Value = Cost - Depreciation
Short-Lived
Normally the same as its physical life. The physical life of a long-lived improvement is usually longer than its economic life: Buildings are usually torn down before they fall down.
Remaining Economic Life
Remaining Economic Life = Economic Life - Effective Age
Superadequacies
Reproduction cost must include the cost of reproducing any features that are excessive in quality or design.
Cost
The actual amount of expenditure necessary to acquire or produce something.
Book Depreciation
The amount of an asset's capital value that has been written off for accounting or tax purposes. Book depreciation is not relevant to an appraisal.
Accrued Depreciation Rate
The amount of depreciation that has occurred between the time an improvement was built and the effective date of its appraisal.
Entrepreneurial Profit
The amount of profit that an owner/developer would expect to make from improving the property.
Market Extraction Method
When adequate sales data are available, the market extraction method can be used to estimate depreciation. To apply the market extraction method, the appraiser begins by identifying suitable comparable sales. The comparable properties should be in the same market as the subject property, and they should be similar to the subject in terms of age, utility, and physical characteristics. They should also be affected by similar types and amounts of depreciation. The appraiser goes through the following steps for each of the chosen comparables. 1. The appraiser adjusts the comparable's sales price to reflect differences from a potential sale of the subject property in terms of financing, conditions of sale, the property interest conveyed, and other factors. The appraiser wants to estimate the comparable's replacement cost and depreciation at the time of sale, so adjustments aren't made for differences in market conditions. 2. The appraiser's next step is to subtract the estimated value of the comparable's land at the time of sale from the adjusted sales price. The remainder is the contributory value of the improvements -- the portion of the adjusted price that can be attributed to the improvements. Ex. Comparable #1 sold for $579,000. The appraiser makes the appropriate adjustments and arrives at an adjusted price of $587,000. The estimated value of the comparable's land is $207,000. By subtracting the land value from the adjusted price, the appraiser calculates the contributory value of the improvements. $587,000 - $207,000 = $380,000 contributory value of improvements 3. The appraiser estimates the replacement cost of the comparable's improvements at the time of sale. 4. The appraiser subtracts the contributory value of the improvements from their replacement cost. The result is the total depreciation at the time of sale. This may be referred to as the extracted depreciation; in effect, this depreciation figure has been extracted from the comparable's sales price. Ex. Continuing with the previous example, the appraiser estimates the replacement cost of Comparable #1's improvements at $434,000. She subtracts the contributory value of the improvements ($380,000) from the replacement cost to calculate the extracted depreciation. $434,000 - $380,000 = $54,000 extracted depreciation 5. Now the appraiser divides the extracted depreciation by the comparable's replacement cost. The result shows what percentage of the cost the depreciation represents. This is called the total depreciation percentage. Ex. The appraiser divides Comparable #1's extracted depreciation ($54,000) by the replacement cost ($326,000) to find the total depreciation percentage $54,000 ÷ $326,000 = 16.56% total depreciation percentage for Comparable #1 After calculating a depreciation percentage for each of the comparables, the appraiser uses those percentages to decide on an appropriate depreciation percentage for the subject property. The appraiser will then multiply the subject's replacement cost by the percentage to arrive at an estimate of the subject's total depreciation from all causes. Ex. Following the same steps she used for Comparable #1, the appraiser calculates total depreciation percentages of 16.15% and 16.87% for Comparables #2 and #3. Based on the comparables' percentages, evaluated in light of all of the data, the appraiser settles on 16.42% as the total depreciation percentage for the subject property. The subject's estimated replacement cost is $339,000. The appraiser multiplies the replacement cost by the total depreciation percentage to arrive at an estimate of the total depreciation affecting the subject property's value. $339,000 x 0.1642 = $55,664 estimated total depreciation for subject property The total depreciation percentages for the comparables in the example above are quite close together, which makes it relatively easy to choose an appropriate percentage for the subject. When an appraiser's calculations result in a wider range of depreciation percentages for the comparables, it may be worthwhile to convert them to annual rates. To do this, the appraiser generally divides each comparable depreciation percentage by its actual age. Ex. An appraiser has calculated total depreciation percentages for the comparables he's working with. Now he decides to calculate their annual depreciation rates. Comparable A is 7-years old and has a depreciation percentage of 10%. B is 18-years old and has a depreciation percentage of 31%. C is 12-years old,with a depreciation percentage of 19%. A: 10% ÷ 7-years= 1.43% average annual depreciation rate B: 31% ÷ 18-years= 1.72% average annual depreciation rate C: 19% ÷ 12-years= 1.58% average annual depreciation rate Based on these figures, the appraiser decides to use 1.65% as a depreciation rate for the subject property, which is 14-years old. By multiplying 1.65% by 14 years, the appraiser arrives at a total depreciation percentage of 23.1% for the subject property (1.65% x 14 = 23.1%). The subject's estimated replacement cost is $412,000, so the estimated total depreciation using the market extraction method is $95,172 ($412,000 x 23.1% = $95,172). When there's plenty of good comparable data and the appraiser's cost and land value estimates are sound, the market extraction method should result in a more accurate depreciation estimate than the simpler economic age-life method. A limitation of both methods is that they provide only an estimate of total depreciation. If an appraisal assignment requires those, it's necessary to use the breakdown method of estimating depreciation.
Breakdown Method Step 4B
Curable functional obsolescence caused by superadequacies doesn't need to be estimated when the basis of the cost estimate is replacement cost, since replacement cost estimates don't include the costs of reproducing superadequacies. If the cost estimate is based on reproduction cost, the procedure for this step is the same as for Step 4A(2).
Curable
Depreciation that can be remedied.
External Obsolescence
Depreciation that results from causes arising outside of the property itself. It may be economic or locational.
*Estimating Depreciation
Estimating the replacement or reproduction cost of an improvement is only the first step in the cost approach to value. In the second step, the appraiser must estimate the amount of depreciation that the subject improvement has suffered. By deducting the total depreciation from the estimated cost, the appraiser can estimate the value of the improvement.
Accrued Depreciation
The amount of depreciation that has occurred between the time an improvement was built and the effective date of its appraisal.
Breakdown Method Step 1
The appraiser begins by estimating the replacement cost of each component of the improvement. A detailed cost estimate is required, because the amount of depreciation calculated for each item will depend on the item's estimated cost.
Breakdown Method Step 6
The appraiser generally uses paired data analysis to measure depreciation caused by external obsolescence (both economic and locational).
Breakdown Method Step 7
The depreciation amounts calculated is Steps 2 through 6 are added together to find the total depreciation from all causes. This amount is then subtracted from the estimated cost (from Step 1) to find the depreciated value of the improvement. Value of Improvements = Replacement Cost New - Depreciation
Breakdown Method Step 5B
When incurable functional obsolescence s due to a superadequacy, the appraiser estimates the present value of any ongoing costs associated with the superadequacy (such as higher property taxes, insurance premiums, or utility costs). Any value contribution due to the superadequacy is then deducted. If the cost estimate (in Step 1) is for reproduction cost, the extra cost of the superadequate item (less any physical depreciation already charged) is also added to the depreciation due to incurable functional obsolescence.
Physical Deterioration
(Deferred Maintenance) Depreciation caused by wear or damage to the physical components of the improvement. Curable physical deterioration is called deferred maintenance.
Soft Costs
(Indirect Costs) Indirect costs such as architects' fees, construction loan interest, property taxes during the development period, and real estate sales commissions.
Breakdown Method
(Observed Condition Method) With the breakdown method the appraiser separately estimates the amount of each of the 5-types of depreciation: 1. Curable Physical Deterioration 2. Incurable Physical Deterioration 3. Curable Functional Obsolescence 4. Incurable Functional Obsolescence 5. External Obsolescence To do this, the appraiser may use a number of different techniques, including: 1. Cost-to-Cure 2. Age-Life Ratios 3. Paired Data Analysis The breakdown method is seldom used in residential appraisals, but it's good illustration of the theory of depreciation as it applies to appraisal. The process required by the breakdown method is summarized by the following outline, then explained in more detail. 1. Estimate replacement cost for each component of the improvement 2. Estimate curable physical deterioration 3. Estimate incurable physical deterioration A. Short-lived items B. Long-lived items 4.Estimate curable functional obsolescence A. Deficiencies 1. Curable by addition 2. Curable by modification B. Superadequacies 5. Estimate incurable functional obsolescence A. Deficiencies B. Superadequacies 6. Estimate external obsolescence A. Economic obsolescence B. Locational obsolescence 7. Calculate total depreciation and depreciated value of the improvement
Economic Age-Life Method
(Straight Line Method) The economic age-life method of estimating depreciation is based on the assumption that an improvement loses value at a steady rate over the course of its economic life. According to this assumption, a graph of the depreciated value of an improvement versus its age would appear as a straight line. The economic age-life method is sometimes called the straight line method. To use the economic age-life method, the appraiser must first estimate the effective age and the economic life of the improvement. (These estimates are based on data concerning similar improvements in the same market as the subject property.) The ratio of effective age to economic life - called the economic age-life ratio or the accrued depreciation rate -- is then multiplied by the estimated cost (Appraisers follow the same steps for estimating depreciation regardless of whether replacement cost or reproduction cost will be the basis for the value estimate. For simplicity's sake in this discussion, we usually refer to replacement cost, but keep in mind that an appraiser might use reproduction cost instead.) in order to determine the amount of depreciation. Depreciation = (Effective Age ÷ Economic Life) x Cost Ex. An appraiser estimates the replacement cost of a house at $220,000. The house has an economic life of 60-years and an effective age of 15-years. Under the economic age-life method, depreciation would be calculated as follows: 15 ÷ 60 = 0.25 (25%) economic age-life ratio 0.25 x $220,000 = $55,000 accrued depreciation $220,000 - $55,000 = $165,000 depreciated value of improvement In an alternative version of the economic age-life method, depreciation that is caused by curable physical deterioration and curable functional obsolescence is assumed to be equal to the cost of curing the defects. The cost to cure is deducted from the total estimated replacement cost, and the ratio of effective age to economic life is then applied to the remainder of the cost. When estimating effective age, the appraiser takes into account any change in effective age that would result from curing the curable physical and functional defects. Ex. Using the same figures as in the example above, assume that it would cost $5,000 to remedy the curable physical and functional defects in the house, and that curing these defects would result in the house having an effective age of only 12 years. The calculation of depreciation in this case is as follows: $220,000 - $5,000 = $215,000 Cost (adjusted for curable items) 12 ÷ 60 = 0.20 (20%) economic age-life ratio 0.20 x $215,000= $43,000 incurable depreciation $43,000 + $5,000 = $48,000 total depreciation $220,000 - $48,000 = $172,000 depreciated value of improvement The economic age-life method is the simplest method of estimating depreciation, but in many cases the other methods yield more accurate results.
Calculating Depreciation -> Functional Obsolescence ->
->Curable->Caused by Deficiency->Requiring Addition ->Curable->Caused by Deficiency->Requiring Substitution ->Curable->Caused by Superadequacy ->Incurable->Caused by Deficiency ->Incurable->Caused by Superadequacy
Calculating Depreciation -> Physical Deterioration ->
->Curable->Deferred Maintenance ->Incurable->Short-lived items ->Incurable->Long-lived items
Calculating Depreciation -> External Obsolescence ->
->Economic ->Locational
Types of Costs
An appraiser who is estimating reproduction cost or replacement cost must account for all of the types of costs necessary to construct the improvements. This include hard costs (also called direct costs), such as the cost of labor, materials, and equipment used in the construction. There are also soft costs, which are indirect costs such as architects' fees, construction loan interest, property taxes during the development period, and real estate sales commissions. The appraiser must also account for the cost of entrepreneurial profit, which is the amount of profit that the owner/developer would expect to make from improving the property. Entrepreneurial profit isn't the same thing as the actual profit or loss on a project. It is the amount (usually a percentage) that an investor would expect to earn when deciding to undertake a similar type of project. Ex. An appraiser estimates that total hard and soft costs for an office building at current prices would be $176,000. Developers of office property in the current market desire a 12% return on their developments. So 12% of the total cost will be allocated to entrepreneurial profit, and the remaining 88% is the hard and soft costs. The total cost can be calculated as: $176,000 ÷ 0.88(88%) = $200,000 total cost $200,000 total cost - $176,000 hard and soft costs = $24,000 entrepreneurial profit
Cost Estimating Techniques
Cost estimating can be quite complex in practice, but in theory it's a very simple concept. The appraiser measures some feature of the improvement (such as square footage of a building area, or number of doors) and multiplies it by the estimated unit cost for the feature. This procedure can be summarized with this formula: Cost = Number of Units x Cost per Unit The most common cost estimating techniques all apply this same procedure. The primary difference between the techniques is in the level of detail: the simpler cost estimating techniques apply unit costs to broad-scale features such as building square footage, while the more detailed techniques apply unit costs to individual features of the construction and then add them up to find the total cost. The choice of technique is determined by the scope of the appraisal; the more detailed methods generally provide a more reliable cost estimate.
Types of Depreciation
Depreciation is categorized according to the cause of the decrease in value, and also according to whether the decrease can be remedied. The 3 causes of depreciation are physical deterioration, functional obsolescence, and external obsolescence (which may be further categorized as either economic obsolescence or locational obsolescence). Depreciation that can be remedied is said to be curable; if a remedy is not possible or practical, the depreciation is incurable.
Age and Economic Life
Depreciation is related to the age of an improvement. Improvements have an actual age and an effective age. Actual age (also called chronological or historical age) is the actual amount of time that the improvement has been in existence. Ex. A house built in 1998 would have an actual age of 20-years in 2018. Effective age is the apparent or functional age of the improvement, based on its current condition and utility and on current conditions in the market. An improvement's effective age may be the same as, greater than, or less than its actual age. Effective age is related to remaining economic life, as described below. An improvement also has a physical life, a useful life, and an economic life. The physical life is the length of time the improvement can be expected to physical exist, with normal maintenance. The useful life is how long the improvement can be expected to perform the function it was originally designed for. The economic life is how long the improvement will contribute to the value of the property. The economic life of an improvement comes to an end when it no longer represents the highest and best use of the property as improved. Remaining economic life is the amount of time from the effective date of the appraisal until the end of the improvement's economic life. The relation between economic life, remaining economic life, and effective age can be expressed as follows: Economic Life = Effective Age + Remaining Economic Life or Effective Age = Economic Life - Remaining Economic Life or Remaining Economic Life = Economic Life - Effective Age Ex.Sam's house, when built, had an estimated economic life of 50-years. His house is appraised 14-years later. Because the house has been well maintained, and its design and layout are still popular in the market, the appraiser estimates that it has a remaining economic life of 40-years. In this case, the effective age of the house would be 10-years (50 - 40 = 10), as compared to the actual age of 14-years.
Using Paired Data Analysis
For certain steps in the breakdown method, the appraiser often uses a technique called paired data analysis to estimate the depreciation caused by a particular defect. To do this, the appraiser must be able to identify comparables that have the same defect as the subject property, and other comparables that don't have that defect. Ex. The subject property suffers from functional obsolescence due to a poor floor plan. Market analysis reveals that comparable houses with similar floor plans sell for $310,000, while comparable houses with more functional floor plans sell for $330,000. This indicates that the functional obsolescence due to the poor floor plan causes $20,000 in depreciation ($330,000 - $310,000 = $20,000).
Terminology
For purposes of appraisal, the term depreciation refers to a loss in the value of an improvement (as compared to its cost) due to any reason whatsoever. Depreciation is the difference between the market value of the improvement and its cost. The amount of depreciation that has occurred between the time the improvement was built and the effective date of the appraisal is called the accrued depreciation. The term depreciation is also widely used to refer to the amount of an asset's capital value that has been "written off" for accounting or tax purposes. This kind of depreciation, sometimes called book depreciation, has no significance from an appraisal standpoint.
Functional Obsolescence
In addition to physical deterioration, an improvement can suffer from depreciation that is caused by design defects. This form of depreciation is called functional obsolescence. Whether the design is defective from the start or simply becomes outdated with the passage of time, the resulting loss in value is treated as functional obsolescence. Ex. Today's market prefers energy-efficient housing, which includes insulation with a high R-value. Older housing that doesn't meet this standard may suffer a loss in value due to functional obsolescence, even though its insulation was considered standard at the time it was built. A newer house with inadequate insulation would also suffer from functional obsolescence. Design defects that cause functional obsolescence can be either deficiencies (such as inadequate insulation) or superadequacie. A superadequacy is a form of overimprovement; it's a design feature whose cost is greater than its contribution to value. Ex. Most modern housing uses 2x4 or 2x6 framing for wall construction. A house that was built with 2x12 wall framing would probably suffer from functional obsolescence due to a superadequacy. The cost of the superadequate wall framing would more than likely exceed any resulting value increase. Like physical deterioration, functional obsolescence is either curable or incurable. The same test applies: if the defect can be remedied at a cost that is less than the resulting increasing in value, then it's curable; otherwise, it's incurable. Ex. Inadequate insulation in the ceiling of a house is usually a curable form of functional obsolescence, because additional insulation can be installed at a reasonable cost. A house with substandard ceiling heights, on the other hand, probably suffers from incurable functional obsolescence, since it would be prohibitively expensive to increase the height of the walls.
Cost to Cure
It's deducted from the total estimated replacement cost, and the ratio of effective age to economic life is then applied to the remainder of the cost.
Reproduction Cost and Replacement Cost
It's important to distinguish reproduction cost from replacement cost. Reproduction cost is the cost of creating an exact replica of the improvements, using the same materials, design, layout, and level of craftsmanship. Replacement cost is the cost of building an improvement of equal utility, but using modern materials, techniques, layout, and design. Replacement cost estimates are nearly always lower than reproduction cost estimates, because it usually costs less to build a structure using modern materials and techniques. Reproduction cost must include the cost of reproducing any features that are excessive in quality or design, known as superadequacies. Replacement cost takes into account only the cost needed to create equal utility, so superadequacies are ignored. The choice of either reproduction cost or replacement cost can affect the calculation of depreciation. When reproduction cost is the basis of the cost estimate, the appraiser must estimate depreciation from all causes. When replacement cost is used, some forms of depreciation (such as functional obsolescence due to superadequacies) are accounted for in the cost estimation step, and so they aren't included in the depreciation estimate.
Cost Index Trending
Least accurate. Cost index trending is a method of estimating the reproduction cost of a building whose original construction cost is known. Most people are familiar with indexes such as the cost-of-living index or the consumer price index, which track the relative change in different categories of costs. Construction cost indexes work in the same way. To find the current cost of the construction, simply divide the current index value by the index value at the time of construction, then multiply the result by the original cost. Ex. A house was built in 2,000 at a cost of $150,000. The construction cost index was at 150 in 2000, and it's currently at 200. The current cost of building the house would be calculated as follows: Current Construction Cost = Original Construction Cost × Index Factor 200 ÷ 150 = 1.33 1.33 x $150,000 (original cost) = $199,500 current cost Step 1: Find the ratio between the cost index today and the old cost index. Step 2: Multiply the original construction cost by the ratio. Cost index trending is a quick and convenient way to estimate current cost, but it's not considered very reliable. Even when the original construction cost of an improvement is known, there is no guarantee that the actual cost was typical for similar improvements that were built at the same time. This method is most appropriate for double-checking the results of some other, more reliable, cost estimating procedure.
Quantity Survey Method
Most reliable. The most detailed and most reliable method for estimating construction costs. It's similar to the unit-in-place method, in that the cost of each construction component is estimated separately, and the component costs are then added together to find the total cost. However, in the quantity survey method, the cost of labor, materials, equipment, and overhead are each calculated separately. Also, the level of detail in a quantity survey estimate is greater than in a unit-in-place estimate. Ex. In the unit-in-place method, a single unit cost is used to calculate the cost of exterior wall framing, including the cost for the framing lumber, sheathing, carpentry labor, scaffolding, etc. In the quantity survey method, the quantities of each of these items would be estimated separately, and each would be multiplied by its own unit cost (cost per board foot of framing lumber, cost per square foot of sheathing, cost per hour of carpentry labor, etc.). Quantity survey estimates are used most often by contractors or builders. In practice, different sections of the estimate (like foundation, plumbing, carpentry, and electrical) are actually prepared by the different specialty subcontractors who are bidding for the job. The general contractor then combines the sub-estimates or bids into an estimate of total cost to complete the project.
Breakdown Method Step 5A
Next, the appraiser considers incurable functional obsolescence. The procedure for this step depends on whether or not the cost of the deficient item is included in the appraiser's cost estimate (in Step 1). If it is, the appraiser estimates the item's contribution to value (usually using paired data analysis) and deducts that amount from the item's cost. (To avoid duplication, the cost is first adjusted to reflect any physical depreciation that has already been calculated for the item.) Ex. A house has outdated bathroom fixtures, which contribute only $1,500 to its value. Their cost was estimated as $3,000, and their physical depreciation as $300. The incurable functional obsolescence due to the outdated fixtures would be calculated as $3,000 (cost new) - $300 (physical depreciation) - $1,500 (value contribution of existing item) = $1,200. If the cost of the item isn't included in the cost estimate, the appraiser must estimate its value contribution (again with paired data analysis) and subtract what it would have cost if included in the estimate of cost new. Ex. A house with 7-foot-high ceilings has a value that's $2,000 less than that of comparables houses with standard 8-foot ceilings, so adding an extra fool of wall height would add $2,000 to the value of the improvement. If it would have cost an extra $400 to build 8-foot walls in the first place, the amount of incurable depreciation for this item would be calculated as $2,000 (value contribution) - $400 (cost not included in cost estimate) = $1,600.
Physical Deterioration
Physical deterioration is depreciation that is caused by wear and tear on, or damage to, the physical components of the improvement. Broken windows, leaky roofs, peeling paint, termite damage, or worn carpeting are all examples of physical deterioration. Physical deterioration can be curable or incurable. If the cost of correcting the deterioration is less than the added value that would result from the correction, then it's curable; otherwise, it's incurable. Curable physical deterioration is often referred to as deferred maintenance. Ex. Since a fresh coat of paint often adds more to the value of a house than the cost of the painting, the need for repainting is usually curable physical deterioration, or deferred maintenance. On the other hand, the cost of repairing a cracked foundation may far exceed any increasing in value that would result from the repairs; in this case, the cracked foundation would be considered incurable physical deterioration. When analyzing the physical deterioration of an improvement, a distinction is sometimes made between long-lived items and short-lived items. A long-lived item is a component of the improvement that is expected to need replacement during the improvement's economic life. An example of a long-lived item is the foundation, which normally lasts for the life of the building. Paint and carpeting are short-lived items, which require periodic replacement. The economic life of a short-lived improvement is normally the same as its physical life. The physical life of a long-lived improvement is usually longer than its economic life: Buildings are usually torn down before they fall down. Effective Age ÷ Economic Life x Replacement cost new
*Methods of Estimating Depreciation
Properly estimating depreciation is the most difficult part of the cost approach. This is particularly true of older properties, which may suffer from several types and causes of depreciation. Simpler methods of estimating depreciation tend to rely on assumption that don't necessarily apply in every case, while more complex methods require market data that often are not available. This is one reason why the cost approach to value is considered less reliable than the sales comparison approach or the income approach. The three main methods appraisers use to estimate depreciation: the economic age-life method, the market extraction method, and the breakdown method.
Square Foot Method
Residential cost estimates using this technique almost always use square footage, so it's often referred to as the square foot method. Square footage is calculated by measuring and multiplying the outside dimensions of the building. The square footage is then multiplied by the estimated cost per square foot. Different costs per square foot are applied to different areas of the structure. Ex. A new 1-story house that doesn't suffer from any depreciation. The living area is 1,280 sq. ft. (32x40=1,280) and there is a 576 sq. ft. attached garage (24x24=576). The appraiser has determined that current construction costs for similar buildings are $60 per sq.ft. for living area and $25 per sq.ft. for garage space. The site has been valued at $35,000, and the appraiser estimates the value of site improvements (driveway, landscaping, etc.) to be $8,500. The value of the property can be estimated by the cost approach using the sq. ft. method as follows: *Cost of Living Area = 1,280 sq. ft. x $60/sq. ft. =$76,800 *Cost of Garage = 576 sq. ft. x $25/sq. ft. = $14,400 *Total cost of building = $76,800 (living area) + $14,400 (garage) = $91,200 *Total cost of improvements = $91,200 (building) + $8,500 (other improvements) = $99,700 *Indicated property value = $99,700 (improvement cost) + $35,000 (site value) = $134,700 Calculating the building areas for the square foot method is a fairly simple process. The hard part is determining the appropriate unit cost per square foot.
*Basics of the Cost Approach
The cost approach is based on the principle of substitution, which states that a property's value can't be greater than the cost of acquiring (buying or building) a substitute property of equal utility. In the cost approach, cost is related to value by the formula: Value = Cost - Depreciation Cost refers to the cost of reproducing or replacing the property's improvements. Depreciation is the difference between cost and value, from any cause. This basic formula applies only to the value of the improvements. The value of the land or site is determined separately (Ex. By using the sales comparison method), and then added to the estimated value of the improvements to reach the total value of the property. The process of the cost approach to value can be summarized by the formula: Property Value = Reproduction or Replacement Cost of Improvements - Depreciation of Improvements + Land Value This formula requires 3 separate steps. 1. Estimating the reproduction or replacement cost of the improvements. 2. Estimating depreciation 3. Estimating the value of the land
Replacement Cost
The cost of building an improvement of equal utility, but using modern materials, techniques, layout, and design. Replacement cost estimates are nearly always lower than reproduction cost estimates, because it usually costs less to build a structure using modern materials and techniques. Replacement cost takes into account only the cost needed to create equal utility, so superadequacies are ignored.
Reproduction Cost
The cost of creating an exact replica of the improvements, using the same materials, design, layout, and level of craftsmanship. Reproduction cost must include the cost of reproducing any features that are excessive in quality or design, known as superadequacies.
Depreciation
The difference between cost and value, from whatever cause.
Straight Line Method
The economic age-life method of estimating depreciation is based on the assumption that an improvement loses value at a steady rate over the course of its economic life. According to this assumption, a graph of the depreciated value of an improvement versus its age would appear as a straight line. The economic age-life method is sometimes called the straight line method. To use the economic age-life method, the appraiser must first estimate the effective age and the economic life of the improvement.
Final Value Estimate with the Cost Approach
The estimate of the depreciated cost of the improvement (the building) is the main focus of the cost approach. In order to obtain a value indication for the property as a whole, the appraiser must also estimate the value of the site and any site improvements. Ideally, the site value is established by the sales comparison vacant land may make it necessary for the appraiser to apply one of the other methods for estimating site value, such as allocation or extraction. The value of site improvements such as fences, driveways, patios, or landscaping must also be estimated, an must be included in the figure for total property value. The value of such improvements may be estimated by means of one or more of the 3 approaches to value: 1. Sales comparison 2. Cost 3. Income capitalization Ex. The value of a fence may be estimated by calculating its depreciated cost (cost approach), or by comparing the sales prices (sales comparison approach) or net incomes (income capitalization approach) of comparable properties that have, and do not have, fencing. The final value indicator for the property is determined by adding together the depreciated cost of the building, the estimated value of the site improvements, and the estimated site value. The resulting figure indicates the value of the fee simple interest in the property according to the cost approach. Additional adjustments are required if the property interest that is the subject of the appraisal is not a fee simple interest.
Physical Life
The length of time an improvement would be expected to last with normal maintenance.
Economic Life
The length of time during which an improvement will contribute to the value of a property. Economic life ends when the improvement no longer represents the highest and best use of the property. Economic Life = Effective Age + Remaining Economic Life This formula can be rearranged.
External Obsolescence
The third form of depreciation is external obsolescence, which is a loss in value resulting from causes arising outside of the property itself. External obsolescence may be either economic or locational. Economic obsolescence occurs when external factors or economic conditions reduce the property's profitability or value. Locational obsolescence occurs as a result of negative influences from surrounding properties. Ex. A home located in an industrial area will suffer a loss in value due to its poor location; this is an example of locational obsolescence. The home will also suffer a loss in value if the community's primary employer goes out of business, devastating the local economy; this is an example of economic obsolescence. Because it arises from causes outside the property itself, external obsolescence is almost always incurable. It may be temporary in nature, as in the case of a temporary slump in local market conditions.
Unit-In-Place Method
The unit-in-place method requires the appraiser to measure the quantities of various building components, such as the foundation, floor, walls, roof, doors, and windows. The quantity of each item is then multiplied by its appropriate unit cost, and the subtotals for the building components are added together to get the total cost. Unit costs for the unit-in-place method may be obtained from local builders and developers and be referring to cost manuals or costing services. The appraiser must be sure that the measurements used for the different building components are the same as the measurements for which the costs are stated. Ex. Wall framing costs may be stated as so much per lineal foot of wall, while the cost of painting the walls may be quoted as a cost per square foot of wall surface. Other costs, such as unit costs for plumbing or electrical systems, may be given as costs per square foot of building area. The appraiser must be sure to measure framing in terms of lineal foot of wall, painting in terms of square foot of wall surface, and plumbing and electrical systems in terms of square yards of wall surface instead of square feet, she will not be able to apply the unit cost without making the appropriate adjustments. As with the square foot method, the cost calculated by the unit-in-place method must be adjusted to account for differences in time (current cost) and location (local cost), and also for any cost items that are not included in the unit cost figures (such as indirect costs and entrepreneurial profit). Adjustments for differences in construction features, size, and complexity are generally not required in the unit-in-place method, since the procedure takes these differences into account. Ex. The amount of exterior wall framing can vary depending on the shape of the building, even in buildings with the same square footage. The square foot method must make an adjustment to account for this variation. In the unit-in-place method the actual amount of exterior wall framing is calculated (and then multiplied by its unit cost), so no adjustment is necessary. The unit-in-place method gets its name from the fact that the unit costs for each construction item represents the total cost of installing or building the item, including the cost of materials, labor, equipment, and overhead.
Paired Data Analysis
To estimate the depreciation caused by a particular defect. To do this, the appraiser must be able to identify comparables that have the same defect as the subject property, and other comparables that don't have that defect.
Calculating Depreciation
Total Depreciation Estimate -> ->Physical Deterioration ->Functional Obsolescence ->External Obsolescence
Breakdown Method Step 4A(2)
When functional obsolescence can be cured by modifying a design deficiency, the appraiser starts with the estimated cost of the deficient item from Step 1. Any physical depreciation calculated for this item in Step 2 or 3 is subtracted from that value to avoid duplication. Then the cost of replacing the item is added. Note that this replacement cost must also include the cost of removing the deficient item. Finally, if the removed item has any salvage value, that is deducted to arrive at the functional obsolescence estimate. Ex. If the style of carpeting in the improvement is out of fashion, the depreciation due to this functional obsolescence will be calculated as follows: $2,000 Estimated cost of existing carpeting -1,000 less Physical depreciation for existing carpeting +2,600 plus Cost of installing new carpeting +100 plus Cost of removing existing carpeting - 0 less Salvage value of existing carpeting =$3,700 Functional obsolescence for this item
Long-Lived
A component of the improvement that is expected to need replacement during the improvement's economic life.
Comparative-Unit Method
In the comparative-unit method, cost is estimated on the basis of the square footage of building area, or the cubic footage of building volume. This is the method mandated by Fannie Mae 1004 Form appraisals. Residential cost estimates using this technique almost always use square footage, so it's often referred to as the square foot method. Square footage is calculated by measuring and multiplying the outside dimensions of the building. The square footage is then multiplied by the estimated cost per square foot. How does an appraiser determine the cost per square foot of new construction? *Published cost-estimating manuals or services -Marshall & Swift -F.W. Dodge -R.S. Means -Bluebook International *Developers and builders *Market analysis Appraiser examines data on the sales of comparable properties. Sales price of comparable - Site value of comparable - Site improvements of comparable = Cost of improvements ÷ Square footage = Cost per square foot of improvements Different costs per square foot are applied to different areas of the structure. Ex. One figure is applied to the living area another is applied to the garage. The cost of site improvements such as landscaping is also estimated separately. Ex. A new 1-story house that doesn't suffer from any depreciation. The living area is 1,280 sq. ft. (32x40=1,280) and there is a 576 sq. ft. attached garage (24x24=576). The appraiser has determined that current construction costs for similar buildings are $60 per sq.ft. for living area and $25 per sq.ft. for garage space. The site has been valued at $35,000, and the appraiser estimates the value of site improvements (driveway, landscaping, etc.) to be $8,500. The value of the property can be estimated by the cost approach using the sq. ft. method as follows: *Cost of Living Area = 1,280 sq. ft. x $60/sq. ft. =$76,800 *Cost of Garage = 576 sq. ft. x $25/sq. ft. = $14,400 *Total cost of building = $76,800 (living area) + $14,400 (garage) = $91,200 *Total cost of improvements = $91,200 (building) + $8,500 (other improvements) = $99,700 *Indicated property value = $99,700 (improvement cost) + $35,000 (site value) = $134,700 Calculating the building areas for the square foot method is a fairly simple process. The hard part is determining the appropriate unit cost per square foot. Unit costs may be derived in two ways: 1. By market analysis 2. By use of cost estimating manuals or services To establish unit cost by market analysis, the appraiser gathers data on sales of comparable new homes. The comparables must be similar to the subject property in both size and quality and quality of construction, and the appraiser must be able to determine the site values for the comparables. For each comparable, the appraiser subtracts the site value from the sales price, and then divides the result by the square footage of the comparable. The result is the unit cost. Ex. A new 1,500-sq.-ft. rambler sold recently for $420,000. Market data support an estimated site value of $285,000 and the value of site improvements (landscaping, etc.) is estimated at $15,000. Accordingly, the value of the building is $120,000 ($420,000 sales price - $300,000 value of site and site improvements). Assuming the home doesn't suffer from any depreciation, it value should be equivalent to its costs. So the appraiser take $120,000 (the building value or cost) and divides that by 1,500 (the size in square feet). The result, $80 per sq. ft., becomes the unit cost. Choosing comparables similar in size to the subject property is important. Many types of construction costs don't vary in direct proportion to the size of the building. The unit costs per square foot will be higher for a smaller building than they will be for a larger building of the same quality and style. Ex. A 1,000-sq.-ft. house and a 1,800-sq.-ft. house each have only one kitchen. The plumbing, electrical work, cabinetry, countertops, and built-in appliances required for a kitchen are relatively expensive in relation to the rest of a house, and these costs will be about the same for both houses. Therefore, the unit cost of the 1,000 square foot house will be higher than the unit cost of the 1,800-sq.-ft. house, because the kitchen costs are divided between fewer square feet in the smaller house. Cost per square foot is also influenced by the complexity of the building design. The square building with a perimeter of 20x20 has 80 lineal feet of perimeter wall for 400 sq. ft. of area. The L-shaped building with the same area has a larger amount of perimeter wall, so the unit cost per sq. ft. is higher. Instead of estimating the unit cost, an appraiser may consult local builders and developers, as well as published costs manuals and professional costing services, to find the unit cost. Cost manuals are published periodically (usually quarterly) and list the average unit cost for different sizes and styles of construction. Unit cost figures must be adjusted to account for differences in construction features, size and shape, time, and location. The appraiser must have a clear understanding of what the unit cost figures include, and must make additional adjustments for any cost items that are not included in the published cost figures. Ex. According to a cost manual, the average cost per square foot for an average quality 1-story house of 1,500 sq. ft. with a 160 lineal ft. perimeter is $65.50. The manual also indicates that construction costs in the area where the subject property is located are 11% higher than average. The subject property has above-average exterior finishes, which add $3.50 per square foot to its cost. It also has 2,000 square feet of living area, which the appraiser estimates should reduce the unit cost by 8%. Since the date of publication of the manual, construction costs have declined by 5% due to a slowdown in the economy. A review of the cost manual indicates that its figures don't include entrepreneurial profit, which the appraiser has determined should be 10% for this type of property. $ 65.50 Published cost per square foot + 3.50 Adjustment for exterior finishes =$69.00 Subtotal x 0.92 Adjustment for larger size (100% - 8% = 92%) =$63.48 Subtotal x 0.95 Adjustment for time (current cost) (100% - 5% = 95%) =$60.31 Subtotal x 1.11 Adjustment for location (local cost) (100% + 11% = 111%) =$66.94 Subtotal ÷ 0.90 Adjustment for entrepreneurial profit =$74.38 Total cost per square foot $74.38 x 2,000 sq. ft. = $148,760 estimated cost of improvement (building)
Breakdown Method Step 3A
Incurable physical deterioration is estimated using age-life ratios, with separate estimates for short-lived and long-lived components of the improvement. Accrued depreciation of components that don't need to be replaced immediately, but will eventually have to be, is categorized as short-lived incurable physical deterioration. An age-life ratio is calculated for each short-lived item using actual age and useful life expectancy. Ex. Item - Age - Useful Life - Ratio - Cost to Replace - Depreciation Roofing - 5 ÷ 25 = 0.20 x $4,000 = $800 Carpets - 5 ÷ 10 = 0.50 x $2,000 = $1,000 Fixtures - 5 ÷ 20 = 0.25 x $6,000 = $1,500 =Total incurable physical deterioration for short-lived items $3,300
Breakdown Method Step 2
The amount of curable physical deterioration (deferred maintenance) for each item in the cost estimate is estimated using the cost to cure. (The appraiser must first determine whether the defects are in fact curable -- whether a cure is possible and whether the value added by the cure will be greater than the cost involved). Ex. Item - Estimated Cost - Cost to Cure Siding - $5,000 - $500 Paint - $1,200 - $1,200 =Total curable physical deterioration $1,700
Effective Age
The apparent or functional age of an improvement, based on its current condition and the current conditions in the market.
Breakdown Method Step 4A(1)
The procedure for calculating depreciation due to curable functional obsolescence depends on the nature of the particular design defect. If the defect can be cured by adding a feature to the improvement, the amount of depreciation is the difference between what it would cost to add the feature to the existing improvement and what it would have cost to include the feature in the first place. (The appraiser must first determine whether the defects are in fact curable -- whether a cure is possible and whether the value added by the cure will be greater than the cost involved). Ex. An improvement suffers from curable functional obsolescence due to the lack of a second bath. The cost of remodeling to add a second bath is $5,000. But if the house were being completely rebuilt, the cost of including a second bath in the design would be only $4,500. The depreciation due to lack of a second bath is $500 ($5,000 - $4,500).
