Cost approach

Cost approach • Basic idea is that an informed buyer won’t pay more than the cost of constructing an equal, substitute property minus the depreciation and assuming no delay. • Market data is used to value the components of the subject property including the land. • Even though both the cost and sales comparison approaches use market data DO NOT mix the two; the cost approach uses a different methodology.

Cost approach • Most applicable when: • Improvements are new and are highest and best use • Subject property has characteristics typical in the area • Subject property is a special use property • Enough data to value the property components but limited data to value the whole property

Cost approach • Least applicable when: • No vacant land sales available • Construction costs are hard to measure • Depreciation is hard to measure • Improvements are very old

Cost approach • Steps: • Develop a land value opinion; vacant land in highest and best use valued as highest and best use regardless of present use. Use similar highest and best use • Estimate reproduction or replacement costs for improvements. • Estimate amount of depreciation • Subtract the depreciation from the cost estimate • Total the land and building components

Format • New cost of improvements $300,000 • Depreciation -175,000 • Depreciated value of improvements $125,000 • Value of the land $600,000 • Value from Cost Approach $725,000

Land in the cost approach • Land value is the value for vacant land • Unimproved is land without building or structures • Urban usually means land without a house/structure even if there are roads, sewer, etc. • Rural unimproved doesn’t mean there aren’t fences, tile, ponds, etc. Just that there are no buildings or structures. • Why?

Example • Subject property has 160 acres of pasture with fences and stock pond • Three other sales are located for $2800 an acre all with similar fencing and water • The indicated value of $2800 would include the fence and water • If an appraiser valued the land at $2800 and then added the value of the fence and water they’d be overstating • If the request was for an appraisal that valued them separately then the other 3 sales would have to be allocated between the land and site improvements

Land • The Cost approach inventories the land for the subject property into various classes • Cropland, tillable pasture, permanent pasture, woodland, farmstead roads, ditches, etc. • Vacant sales are used to estimate the values for the various classes of land on the subject property • Values are applied to the subject WITHOUT making the plus or minus adjustments used in the Sales comparison approach (except be sure you still make the time adjustments)

Example • Tillable ground: • 90 + CSR Cropland A • 85 – 90 CSR Cropland B • 50 acres of Cropland A $8,000/ac $400,000 • 75 acres of Cropland B 7,500 562,000 Total tillable $962,000 • 15 acres of pasture $1,050 $ 15,750 • 5 acres of farmstead $8,000 $ 40,000 • 2 acres of roads/ditches 0 0 • Total non-tillable $ 55,750 • 22 acres $2,534 • TOTAL $1,017,750 • 147 acres $6,923

Cost approach (cont) • Value of the land determined first • Cost for the building; • Reproduction; cost to construct an exact replica of the existing building • Replacement; cost to construct a building with the utility equivalent to the one being appraised; using modern material, current standards, design, layout, etc. • Using either method use the date of the appraisal and with current prices

Data sources • Local builders • Market abstraction; based on sale of a new building after the land is subtracted; works best with houses, not so good with rural property • Cost services; this is a group that summarizes costs for the appraiser; they provide manuals and other information to use in making the appraisal

Cost approaches • Depreciation is the difference between the cost to reproduce or replace property and its contributory value as of the date of the appraisal • Three types of depreciation to consider: • Physical deterioration; • Functional obsolescence Defects in design; material, design, otherwise obsolete by current standards Sometimes this could be cured • External obsolescence; effect on value from outside property itself; traffic, odor, hazards, etc

Depreciation examples • Corn used to be harvested on the ear and stored in ‘cribs’. Today most of the cribs have been abandoned. This is an example of • Functional depreciation • A modern hog confinement needs greater ventilation of the waste pits. This is an example of: • Functional depreciation • Asphalt singles on the garage are starting to leak. This is an example of: • Physical depreciation • A ethanol plant is located across the road. The resulting dust, traffic, etc. would cause: • External obsolescence • What is an economic term for this?

Physical depreciation • Two kinds of physical depreciation to remember: • Curable; this is when the deterioration is economically feasible to cure and they generally are taken care of; deferred maintenance; be sure to include all costs! • Physical incurable; this is when the deterioration either can’t be corrected or it would cost more to correct than its contributory value to the property • Short lived; roof, furnace, etc. that would be replaced some time but not at the time of the appraisal • Long lived; basically the ones that will last the life of the improvement; foundation, etc.

Estimating depreciation • Economic age-life method: • Depreciation = Effective age/economic life * replacement cost • Actual age is when it was built but there could have been extensive remodeling that would change the effective age; the effective age is based on condition and utility of the structure; there are judgments that has to be made • Economic life is the time where the improvements contribute to the property value; they can be extended • Remaining economic life is time left where the improvements continue to contribute to the property value

Estimating depreciation • Econ. life = effective age + remaining econ. life • Effective age = Econ. Life - remaining econ. life • Remaining econ. life = Econ. life - effective age • A major problem with this approach is that it groups the types of depreciation together.

Example • Reproduction cost $100,000 • Effective age 10 yrs • Economic life 50 yrs • Remaining econ. life 40 yrs. • Ratio for cost 20% • Total Depreciation $20,000 • Depreciated value of improv. $80,000 • Land value $250,000 • Value indicated by cost approach $330,000

Modified Econ. Age/life method • The appraiser can recognize the curable items of physical deterioration and functional obsolescence by estimating the cost to ‘cure’ them. • This amount is then subtracted from the replacement costs. • The appraiser has to recognize the impact this adjustment might have on the effective age and economic life

Example of modified econ. life • Reproduction cost $100,000 • Minus curable items $3,000 • Effective age 9 yrs • Economic life 50 yrs • Remaining econ. life 41 yrs. • Ratio for cost (9/50) 18% • RC minus the curable $97,000 • Other depreciation 17,460 • Total Depreciation (+ $3,000) $20,460 • Depreciated value of improv. $79,540 • Land value $250,000 • Value indicated by cost approach (rounded $329,500

Estimating Depreciation • Market abstraction • First step is to estimate the depreciation from a sale • Second step is to apply this estimate to the subject building • This works for properties either with similar problems as the subject with respect to curable and incurable or for properties without physical curable or incurable short live items • The appraiser is trying to estimate the annual percentage depreciation from the sale and apply it to the subject

Annual Percent depreciation example • Sales price $400,000 • Land value $100,000 • Contributory value of improve. $300,000 • Reproduction cost new (RCN) $500,000 • Accrued Depreciation ($500,000 - $300,000) $200,000 • Overall percentage ($200/$500) 40% • Effective age 10 • Annual percent depreciation 4%/yr.

Application to the subject • Reproduction cost $600,000 • Effective age 15 years • Total depreciation percentage 60% • Total depreciation ($600,000 * 60%) $360,000 • Contributory value of improvements $240,000 • Land value $150,000 • Value estimated by cost approach $390,000

Considering curable items • The market abstraction approach can also be modified to consider the curable depreciable items • Similar process

Sales price $1,700,000 • Land value $100,000 • Contributory value of improve. $1,600,000 • Reproduction cost new (RCN) $2,875,000 • Accrued Depreciation (RCN – contrib. value) $1,275,000 • Physically curable 200,000 • Long lived depreciation 1,075,000 • Long lived costs (RCN – curable) $2,675,000 • Long lived dep. ($1,075/$2,675)40% • Effective age 20 • Annual percent depreciation 2%/yr.

Reconciling the estimates • Remember that the whole purpose of this is to come up with an estimated value for the property. • We want to correlate the values indicated from the different approaches we used and to come up with a single value. • “Reconciliation is the method of bringing together all of the data and analyses into one final estimate of value.”

Reconciling the estimates • The reliability of the data is crucial, garbage in, garbage out • A wide spread in the estimates from the different approaches indicates a strong possibility there were mathematical and/or technical errors made. • In theory, all of the approaches should lead to the same estimate. But, for this you need; • The markets to function perfectly • The appraiser to function perfectly

Reconciling the estimates • That’s not likely to happen • The market is the market and sometimes things don’t happen the way you’d expect. I think this is especially true with land and land values • It is important to strive for perfection but don’t let that get in the way of being honest; don’t manipulate data beyond its limits; one paired sale isn’t the same as multiple and so on • At the end, don’t forget to ask yourself, if the property is really worth the value stated!

Cost approach

Cost approach

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