Real Estate Appraisal: Chapter 8 Cost Approach to Value

Terms in this set (70)

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)
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.
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
Effective Age = Economic Life - Remaining Economic Life
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.
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
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.
(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.
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.
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.