Also referred to as the summation approach, the cost approach requires (1) an estimate of the building cost of construction, (2) the building depreciation, and (3) the land value. These steps are illustrated in the following table. The estimated market value is a summation of the land value and the depreciated building value. The method is appropriate for valuing properties that are typically not rented, that is, single-family dwellings, industrial plants, public buildings, and special-purpose properties, such as wharves, piers, and single-purpose manufacturing plants.
It is generally true that the method is more accurate if a property is employed at its highest and best use, if the building is relatively new, if it has suffered little or no depreciation, and if it is constructed like similar buildings. For the valuation of older structures, for example, 50-year-old dwellings or old-style multiple-story industrial buildings, the cost technique usually lacks the objectivity of the market and income approaches.
An Illustration of the Cost Approach
|Step 1||Estimate Building Cost
1. Quantity Survey
2. Unit in Place
3. Square Foot/Cubic Foot
|Step 2||Deduct Building Depreciation
Depreciated Building Value
|Step 3||Add Land Value
Estimate from Comparable Sales
Indicated Market Value
Estimate Building Costs
To estimate building costs, you must first identify a reliable source of current costs of construction. Given an adequate source of cost data, it must then be determined whether the costs relate to reproduction or replacement costs. Even if these issues are resolved, a decision must be made on the method of estimating costs: the quantity survey, unit-in-place, or square foot/ cubic foot technique. Even assuming that these problems have been solved, appraisers do not always agree on the types of cost data to include in the cost estimation. Indeed, the variations among appraisers in calculating costs of construction indicate that the cost technique is subject to a high degree of person bias. A separate discussion of these issues illustrates the main problems inherent in the cost technique. This is quite different from the condo for sale estimates.
Type of Cost. The valuation of a four-story, 500,000-square-foot industrial building built in 1895 is considerably more complex than estimating the value of a modern, 500,000-square-foot, one-story industrial building. In the former case, a multiple-story building is usually constructed with an outside brick wall, three feet thick at ground level and tapering to 12 inches on the fourth floor. Even if such an industrial building were to be constructed today, it would probably be built with a combination of concrete and steel and constructed like a high-rise apartment Cr office building. The solid brick wall of 1895 is obsolete; no recent construction of this type would be available to guide the cost estimate. Because of the difficulty of trying to calculate cons ruction for obsolete construction, the appraiser must identify his cost estimate as either a reproduction or a replacement cost estimate.
1. Reproduction Costs. Reproduction cost refers to the cost of reproducing a building identical to the property under valuation. It is assumed that the cost refers to the same materials, the same architectural design, and the same quality of construction. Accordingly, in applying the cost approach to, say, a five year old single family dwelling, appraisers would ordinarily estimate the reproduction cost. In appraising an obsolete four-story industrial building constructed in 1895, however, the market value estimate would refer to replacement costs.
2. Replacement Costs. For old buildings, be-cause it is difficult to defend the estimated cost of materials which are no longer produced or sold and of workmanship which is no longer available, the appraiser is virtually forced to apply the cost of replacement. The replacement cost refers to the cost of a building having the same utility as the property appraised. The American Institute of Real Estate Appraisers defines replacement costs as the cost of construction at current prices of a new building having utility equivalent to the building being appraised but built with modern materials and according to current standards, design and layout. Hence, for the appraisal of a multiple story industrial building constructed in 1895, the appraiser must deter-mine the value of an industrial blinding which would have equal utility. If the four story industrial building is to be valued under the cost approach, the appraiser must hypothetically assume a similar building which would allow the same type of production to be undertaken but would illustrate modern construction practices.
It will be appreciated that the necessity of basing the value on a hypothetical building having the same utility introduces highly subjective judgments. It would be preferable to supplement such replacement cost estimates by the market or income approach.
I will continue to provide more cost estimating techniques next week.