Chapter 14: Cost Approach

1. Chapter 14:Cost Approach

2. Cost Approach • The Cost Approach is most useful when: • Property is unique • Property is reasonably new and the improvements represent the highest and best use of the site

3. Cost Approach • Value equals value of land plus value of improvements • Improvements value equals reproduction cost new less loss in value because of depreciation caused by age, wear and tear, and functional and external problems • Value must be adjusted for interests other than fee simple

4. Cost New • Reproduction cost • Best for new or nearly new improvements that represent contemporary construction methods • Replacement cost • Eliminates most forms of functional obsolescence • Reproduction cost and replacement cost may differ for older buildings.

5. Cost New • Types of costs • Direct • Indirect • Entrepreneurial profit

6. Methods of Estimating Costs • Comparative unit method • Segregated cost method • Unit in place method • Quantity survey method

7. Comparative unit method • Cost estimate derived from lump-sum unit cost base on either the square footage or the cubic footage • Construction classification • Type • Quality • Find unit cost for similar structures • Adjust for possible differences in mechanical systems, size, loading docks and so forth. • Multiply modified unit cost by the actual size of the subject structure

8. Comparative unit cost example

9. Segregated cost method • Cost of each structural component is estimated separately and summed to derive cost of total building • Often used when • The comparative unit method is difficult to apply because of an unusual design or mix of components • Lack of unit cost data • All components in the building do not represent the same level of quality

10. Segregated cost example

11. Unit in place method Costs of structural components are summed to derive cost of total building An allowance for contractor’s profit and overhead are built into the unit costs used

12. Quantity survey method • Cost of each item is identified and estimated separately, then summed • Adjustments for hours of labor, overhead and profit are added • Most accurate method • Is seldom used for the following reasons: • Time consuming • Some construction materials may not be readily visible • May be used to estimate the value of unusual components if they exist in a structure

13. Sources of cost information Professional cost estimating companies Actual costs of newly completed buildings Contractor’s estimates Appraiser’s files

14. Methods of Estimating Depreciation Age life method Breakdown method Market extraction method

15. Age life method • Effective age • Total economic life • Remaining economic life • Modified age-life method • Deferred maintenance

16. Age-Life method example

17. Breakdown method • Physical curable depreciation • Measured as cost to cure • Physical incurable depreciation • Short-lived • Measured individually as the effective age/economic life x replacement (or reproduction) cost and summed • Long-lived • Measured as replacement cost new minus deferred maintenance and short-lived items multiplied by the effective age/economic life.

18. Breakdown method: Identify component cost

19. Breakdown method: Deferred Maintenance

20. Breakdown method: Physical incurable depreciation – Short-lived items

21. Breakdown method: Physical incurable depreciation – Long-lived items

22. Breakdown method • Curable functional obsolescence • Superadequacy • Deficiency • Measured as the difference between the cost to add the item today minus the cost to add the component originally • Must be less than the value added by adding or modifying the existing structure • If the deficiency results in the replacement of an existing item, any remaining value attributed to the item at this point must also be deducted

23. Breakdown method: Curable functional obsolescence

24. Breakdown method • Incurable functional obsolescence • Deficiency • Superadequacy— measured as • The extra cost of construction minus physical depreciation • The income difference between the level needed to support the superadequacy and current functional income levels capitalized by the overall capitalization rate

25. Incurable functional obsolescence Method 1: Excess cost adjustment

26. Incurable functional obsolescence Method 2: Rent loss

27. Incurable functional obsolescence Method 2: Rent loss (continued)… Note that in the previous example the operating expenses do not change, but the management fee is reduced by 3% of the difference. Net loss per year is [0.15(1-.03)]=$0.1455 per sqft or $4,365 per year. Assuming a cap rate of 10.5, this results in a loss in value of $41,571.

28. Breakdown method • External obsolescence • Economic • Locational • Measured as the present value of the NOI lost

29. External obsolescence: Locational Note: operating expenses are identical but management fee is reduced by 3% of the difference. The net loss is [.20(1-.03)]=$0.194 per sqft or $5,820 per year. Assuming an overall cap rate of 10.5, this results in a loss in value of $55,429. The value represents total loss in property value. Since the land contributes to 20% of total value, the portion of the loss in value that can be attributed to the improvements is $55,429 x .80 = $44,343.

30. Depreciation summary

31. Summary of Final Value Estimate

32. Market extraction method • Percentage loss is extracted from market sale of similar properties • Comparable sales must be available • Difficult to apply if comparable and subject vary significantly in age, quality and/or condition • Assumes same market forces affect comparable and subject

33. Market extraction method example