The Cost Approach

1
The Cost Approach

• An introduction

Wayne Foss, MBA, MAI Wayne Foss Appraisals,
Inc. Email wfoss_at_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
• Contractors profit and overhead

6
Cost also includes . . .

• Indirect Costs include the developers
• Architectural and engineering fees, surveys
• Consulting, Accounting, Legal, Appraisal
• Construction period holding costs, interest,
  taxes, insurance
• marketing, sales, and leasing costs
• developers 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

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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
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.

10
Methods of Cost Estimating

• Comparative Unit
• I.e. - Square Foot or Cubic Foot
• Unit-In-Place
• Quantity Survey

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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 contractors profit
• includes all direct and indirect costs
• developer profit added separately
• expensive and time consuming to do

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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

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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 accountants depreciation or
  book depreciation.

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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

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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

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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

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Reminders about Depreciation, cont...

• 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.

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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

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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
[phone] Fax [phone] Email
wfoss_at_fossconsult.com