The Cost Approach

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 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

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

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

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

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

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.

The parties or “profit centers” involved in “cost” 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.

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

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

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

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

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

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

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.’

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?

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

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

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

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.

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.

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

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

Apply the Cost Approach with care and market support... Are there any Questions?