The Cost Approach

1. The Cost Approach An introduction Wayne Foss, MBA, MAI Wayne Foss Appraisals, Inc. Email: wfoss@fossconsult.com

2. Premise • Value is related to the cost to create • Value is the sum of the cost to create all parts of the property • Cost is the money required to assemble and own: • given materials • on a given site • as of a specified date

3. 3 Major Parts of the Cost Approach • Site Value - estimated by appraiser • Total Cost of all improvements • including all direct and indirect costs, • including developer incentive, or profit • Depreciation and Obsolescence • Physical Deterioration • Functional Obsolescence • External Obsolescence

4. Key Points • Always analyzes improvements as of the date of valuation, not original construction date • All parts of the cost approach come from the market if market value is to be estimated

5. Cost of Improvements includes • Direct Costs • labor and materials used in building by the contractor • power, utilities, equipment needed for construction • Contractor’s profit and overhead

6. Cost also includes . . . • Indirect Costs include the developer’s: • Architectural and engineering fees, surveys • Consulting, Accounting, Legal, Appraisal • Construction period holding costs, interest, taxes, insurance • marketing, sales, and leasing costs • developer’s administrative expenses

7. And Cost Includes • Developer Profit or Incentive • also called entrepreneurial profit • represents the amount the entrepreneur or developer would require and expect to receive for providing: • coordination and management • expertise, and • assumption of risk

8. Developer Profit / Incentive • May be included as • Lump-sum money amount • percent of total site and improvements cost • percent of total improvements cost • percent of equity investment required • which to use depends on how profit incentive was derived from the market.

9. Contractors Subcontractors their profit is included in their bids to the developer their profit is included in the cost factors Developer is in the role of entrepreneur, coordinator, manager brings all the parts together provides management expertise, and has the risk - profit is sometimes negative! The market decides. The parties or “profit centers” involved in “cost”

10. Methods of Cost Estimating • Comparative Unit • I.e. - Square Foot or Cubic Foot • Unit-In-Place • Quantity Survey

11. Comparative Unit • A cost estimate in terms of amount per unit of improvement area by using adjusted known costs of similar structures • indirect costs may be included or computed separately depending on whether included in source data • developer profit normally added separately

12. Unit-in-place • Also called “segregated cost’ method • uses cost estimates for various building components as installed • for example: foundation, exterior walls, roof, plumbing system, electrical system, etc. • indirect costs may be included or computed separately depending on whether included in source data • developer profit added separately

13. Quantity Survey • Most detailed, comprehensive, and potentially ‘accurate’ method • includes quantity and quality of all materials and labor, contingencies, and contractor’s profit • includes all direct and indirect costs • developer profit added separately • expensive and time consuming to do

14. Reproduction Cost is the cost to produce an exact duplicate or replica Replacement Cost is the cost to produce improvements of equal utility Types of Cost Factors • Know which one you need to use. • Know which one the cost service provides • Note: Replacement costs automatically cures some types of functional obsolescence

15. Layout of Cost Approach Improvements Cost (include direct & indirect costs and entrepreneurial incentive) is “Cost as though New” • Less Depreciation • Depreciated Cost or Contribution of Improvements • Site Value estimate Indicated Value by Cost Approach

16. Depreciation • Depreciation is loss in value due to any cause from cost as though new • Three Types • 1. Physical Deterioration • 2. Functional Obsolescence • 3. External Obsolescence • Land or Site does not depreciate • Not the same as accountant’s ‘depreciation” or ‘book depreciation.’

17. Physical Deterioration • Physical ‘wear and tear,’ aging, wearing out. • Curable (repairs, deferred maintenance) • Incurable (basic structure) • Short-Lived and Long Lived Components • Note; The test of curability is economic rather than physical • Physically about anything can be ‘cured’; but it is curable only if it makes economic sense to do so: i.e. if the problem is fixed, is more added to value than the cost to repair?

18. Functional Obsolescence • Loss in value because of inappropriate building style, design, materials, utility - by market standards • Curable: sometimes the problem can be cured or fixed. Curable if cost to cure is less than the value added. • Incurable: When it does not make economic sense to make changes to remove the functional obsolescence. • Curability is an economic consideration, not physical • Obsolescence is by market standards

19. External Obsolescence • Loss in value to the total property, site and improvements, because of adverse influences outside the property boundaries. • May be physical or economic • Always incurable; beyond the owners control • Must be allocated between improvements and site • automatically considered in site value estimate; allocation must be to improvements

20. Reminders about Depreciation • Loss in value from any cause; three types of causes • Depreciation is the difference between cost as though new as of the date of appraisal, and market value

21. Reminders about Depreciation, con’t... • Economic life and age, rather than physical life and calendar age, is the important standard. (“more buildings are torn down than fall down”) • All depreciation is by market standards and amounts must come from the market.

22. Cost Approach is least reliable when • Site value has poor support • Depreciation or obsolescence are involved and require significant judgements about effective life, etc. • Obsolescence cannot be supported from market data • Cost factors are difficult to support; for example with unusual construction, some rural areas.

23. Cost Approach works best when... • Improvements are ‘normal’ and cost estimates can be well supported • Improvements are new, or young, so do not have much depreciation • There is little or no obsolescence • Site value can be supported by recent sales of similar sites

24. Cost Approach should be given strong consideration & influence when... • Amounts involved for cost factors, depreciation, and site value are, or can be, well supported • Buyers think in terms of cost of alternatives in using the Principle of Substitution • i.e. it simulates the thinking of buyers in the market place

25. Apply the Cost Approach with care and market support... Are there any Questions? Wayne Foss, MBA, MAI, Fullerton, CA USA Phone: (714) 871-3585 Fax: (714) 871-8123 Email: wfoss@fossconsult.com