Chapter 14:Cost Approach

Cost Approach The Cost Approach is most useful when:Property is uniqueProperty is reasonably new and the

improvements represent the highest and best use of the site

Cost ApproachValue equals value of land plus value of

improvementsImprovements 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

Cost NewReproduction costBest for new or nearly new improvements that

represent contemporary construction methods

Replacement costEliminates most forms of functional

obsolescence

Reproduction cost and replacement cost may differ for older buildings.

Cost NewTypes of costsDirectIndirectEntrepreneurial profit

Methods of Estimating Costs1. Comparative unit method

2. Segregated cost method

3. Unit in place method

4. Quantity survey method

Comparative unit method

Cost estimate derived from lump-sum unit cost base on either the square footage or the cubic footage

Construction classificationTypeQuality

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

Comparative unit cost example

Gross building area 24,000 sqftConstruction type Masonry loadBearing walls quality GoodNumber of stories 2Number of elevators 1   Base building cost/sqft $64 Plus HVAC adjustment $1.04 Plus sprinkler adjustment $2.06 Adjusted unit cost $67.10 Story height multiplier x1.030Perimeter multiplier x0.947Adjusted unit cost $65.45 Building cost ($65.40 x 24,000 sqft) $1,570,800 Elevator 55,000Reproduction cost new $1,625,800

Segregated cost method

Cost of each structural component is estimated separately and summed to derive cost of total building

Often used whenThe comparative unit method is difficult to apply

because of an unusual design or mix of components

Lack of unit cost dataAll components in the building do not represent

the same level of quality

Segregated cost example

ItemSize, sqft

Unit cost per sqft Cost

Site preparation 12,000 $0.67 $8,040 Foundation 24,000 $2.57 $61,680 Frame 24,000 $5.47 $131,280 Floor structure - 1st floor 12,000 $3.31 $39,720 Floor structure - 2nd floor 12,000 $9.88 $118,560 Floor cover - carpet 24,000 $3.70 $88,800 Ceiling 24,000 $6.20 $148,800 Interior partitions 24,000 $15.78 $378,720 Sprinkler 24,000 $2.06 $49,440 Plumbing 24,000 $3.40 $81,600 HVAC 24,000 $4.45 $106,800 Electrical/lighting 24,000 $4.51 $108,240 Exterior wall 12,480 $12.77 $159,370 Roof structure 12,000 $6.07 $72,840 Roof cover 12,000 $1.85 $22,200 Elevator 24,000 $2.30 $55,200

Total    $1,631,29

0

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

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 consumingSome construction materials may not be readily visible

May be used to estimate the value of unusual components if they exist in a structure

Sources of cost information

Professional cost estimating companies

Actual costs of newly completed buildings

Contractor’s estimates

Appraiser’s files

Methods of Estimating Depreciation

1. Age life method

2. Breakdown method

3. Market extraction method

Age life method

Effective age

Total economic life

Remaining economic life

Modified age-life methodDeferred maintenance

Age-Life method example

Reproduction cost new (30,000 sqft@$19/sqft) $570,000 Total economic life 40 years  Remaining economic life 30 years  Effective age 10 years  Depreciation %: 10/40 (25%) ($142,500)Depreciation value of improvements $427,500 Contributing value of site improvements $15,000 Land value $65,000 Total value   $507,500

Breakdown method

Physical curable depreciationMeasured as cost to cure

Physical incurable depreciationShort-lived

Measured individually as the effective age/economic life x replacement (or reproduction) cost and summed

Long-livedMeasured as replacement cost new minus deferred

maintenance and short-lived items multiplied by the effective age/economic life.

Breakdown method: Identify component cost

Excavation and site preparation $9,600 Frame 97,500Floor structure 67,200Floor cover, office 3,850Ceiling, office 13,500Partitions, office 36,000Sprinkler 40,500HVAC warehouse 21,950HVAC, office 11,700Plumbing 47,200Electrical 53,000Exterior wall 93,000Roof cover 25,000Roof structure 40,000Total $560,000

Breakdown method: Deferred Maintenance

  Cost New Replacement cost to cure Remainder

Roof leak $25,000 $3,500 $21,500

Space heaters $21,950 $23,500 0

Total   $27,000  

Breakdown method: Physical incurable depreciation – Short-lived items

 Replacement

costEconomic

ageEffective

life%

Depreciation Depreciation

Roof cover $21,500 10 15 67 $14,405

Floor cover $3,850 2 8 25 $962

Ceiling $13,500 10 20 50 $6,750

HVAC, office $11,700 10 15 67 $7,839 Plumbing fixtures $6,500 10 20 50 $3,250 Electrical fixtures $14,300 8 15 53 $7,579

Total $71,350       $40,785

Breakdown method: Physical incurable depreciation – Long-lived items

Replacement cost new   $560,000

Less Deferred maintenance $27,000  

Less Incurable short-lived items $75,350  

Total short-lived items -102,350

  $457,650

   

Effective age 8 years  

Remaining useful life 42 years  

Deprciation percentage 16% $73,224

Breakdown method

Curable functional obsolescenceSuperadequacyDeficiency

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

Breakdown method: Curable functional obsolescence

Deficiency:Installation of truck-height loading dock $4,500

Original cost of installation -2,500

Loss in value $2,000

Breakdown method

Incurable functional obsolescenceDeficiencySuperadequacy — 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

Incurable functional obsolescenceMethod 1: Excess cost adjustment

Incurable Functional Obsolescence: Superadequacy

Exterior wall (added cost) $40,000

Less depreciation taken -6,400

Depreciation $33,600

Incurable functional obsolescenceMethod 2: Rent loss

Incurable Functional Obsolescence: Superadequacy

Rent needed to support masonry construction $2.10 per sqft

Market rent -1.95 per sqft

Rent difference $0.15 per sqft

Incurable functional obsolescenceMethod 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.

Value loss $41,571

Less depreciation taken -6,400

Depreciation $35,171

Breakdown methodExternal obsolescenceEconomicLocationalMeasured as the present value of the

NOI lost

External obsolescence: Locational

Market rent $1.95 per sqft

Current rent -1.75 per sqft

Rent difference $0.20 per sqft

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.

Depreciation summary

Physical Deterioration  Curable, deferred maintenance $27,000 Incurable, short-lived items $42,905 Incurable, long-term items $73,224 Total $143,129    Functional obsolescence  Curable $2,000 Incurable $33,600 Total $35,600    External obsolescence $44,343    Total accrued depreciation $223,072

Summary of Final Value Estimate

Reproduction cost new $560,000

Less accrued depreciation -223,072

Depreciated value of improvements $336,928

Plus contributing value of improvements $15,000

Plus land value $65,000

Fee simple value indication $416,928

Market extraction method

Percentage loss is extracted from market sale of similar properties

Comparable sales must be availableDifficult to apply if comparable and subject vary

significantly in age, quality and/or conditionAssumes same market forces affect comparable

and subject

Market extraction method example

Sales price $1,400,000 Less land value -300,000Less contributing value of site improvements -50,000Depreciated value of the improvements $1,050,000

€

Depreciated% =1−Depreciation value of improvements

Cost new of improvements