1. Chapter 14: Cost Approach

2. Cost Approach  The Cost Approach is most useful when:  Property is unique  Property is reasonably new and the improvements represent the highest and best use of the site

3. Cost Approach  Value equals value of land plus value of improvements  Improvements value equals reproduction cost new less loss in value because of depreciation caused by age, wear and tear, and functional and external problems  Value must be adjusted for interests other than fee simple

4. Cost New  Reproduction cost  Best for new or nearly new improvements that represent contemporary construction methods  Replacement cost  Eliminates most forms of functional obsolescence  Reproduction cost and replacement cost may differ for older buildings.

5. Cost New  Types of costs  Direct  Indirect  Entrepreneurial profit

6. Methods of Estimating Costs 1.Comparative unit method 2.Segregated cost method 3.Unit in place method 4.Quantity survey method

7. Comparative unit method  Cost estimate derived from lump-sum unit cost base on either the square footage or the cubic footage  Construction classification  Type  Quality  Find unit cost for similar structures  Adjust for possible differences in mechanical systems, size, loading docks and so forth.  Multiply modified unit cost by the actual size of the subject structure

8. Comparative unit cost example Gross building area24,000 sqft Construction typeMasonry load Bearing walls qualityGood Number of stories2 Number of elevators1 Base building cost/sqft$64 Plus HVAC adjustment$1.04 Plus sprinkler adjustment$2.06 Adjusted unit cost$67.10 Story height multiplierx1.030 Perimeter multiplierx0.947 Adjusted unit cost$65.45 Building cost ($65.40 x 24,000 sqft)$1,570,800 Elevator55,000 Reproduction cost new$1,625,800

9. Segregated cost method  Cost of each structural component is estimated separately and summed to derive cost of total building  Often used when  The comparative unit method is difficult to apply because of an unusual design or mix of components  Lack of unit cost data  All components in the building do not represent the same level of quality

10. Segregated cost example ItemSize, sqftUnit cost per sqftCost Site preparation12,000$0.67$8,040 Foundation24,000$2.57$61,680 Frame24,000$5.47$131,280 Floor structure - 1st floor12,000$3.31$39,720 Floor structure - 2nd floor12,000$9.88$118,560 Floor cover - carpet24,000$3.70$88,800 Ceiling24,000$6.20$148,800 Interior partitions24,000$15.78$378,720 Sprinkler24,000$2.06$49,440 Plumbing24,000$3.40$81,600 HVAC24,000$4.45$106,800 Electrical/lighting24,000$4.51$108,240 Exterior wall12,480$12.77$159,370 Roof structure12,000$6.07$72,840 Roof cover12,000$1.85$22,200 Elevator24,000$2.30$55,200 Total $1,631,290

11. Unit in place method  Costs of structural components are summed to derive cost of total building  An allowance for contractor’s profit and overhead are built into the unit costs used

12. Quantity survey method  Cost of each item is identified and estimated separately, then summed  Adjustments for hours of labor, overhead and profit are added  Most accurate method  Is seldom used for the following reasons:  Time consuming  Some construction materials may not be readily visible  May be used to estimate the value of unusual components if they exist in a structure

13. Sources of cost information  Professional cost estimating companies  Actual costs of newly completed buildings  Contractor’s estimates  Appraiser’s files

14. Methods of Estimating Depreciation 1.Age life method 2.Breakdown method 3.Market extraction method

15. Age life method  Effective age  Total economic life  Remaining economic life  Modified age-life method  Deferred maintenance

16. Age-Life method example Reproduction cost new (30,000 sqft@$19/sqft)$570,000 Total economic life40 years Remaining economic life30 years Effective age10 years Depreciation %: 10/40 (25%)($142,500) Depreciation value of improvements$427,500 Contributing value of site improvements$15,000 Land value$65,000 Total value $507,500

17. Breakdown method  Physical curable depreciation  Measured as cost to cure  Physical incurable depreciation  Short-lived  Measured individually as the effective age/economic life x replacement (or reproduction) cost and summed  Long-lived  Measured as replacement cost new minus deferred maintenance and short-lived items multiplied by the effective age/economic life.

18. Breakdown method: Identify component cost Excavation and site preparation$9,600 Frame97,500 Floor structure67,200 Floor cover, office3,850 Ceiling, office13,500 Partitions, office36,000 Sprinkler40,500 HVAC warehouse21,950 HVAC, office11,700 Plumbing47,200 Electrical53,000 Exterior wall93,000 Roof cover25,000 Roof structure40,000 Total$560,000

19. Breakdown method: Deferred Maintenance Cost NewReplacement cost to cureRemainder Roof leak$25,000$3,500$21,500 Space heaters$21,950$23,5000 Total $27,000

20. Breakdown method: Physical incurable depreciation – Short- lived items Replacement cost Economic ageEffective life% DepreciationDepreciation Roof cover$21,500101567$14,405 Floor cover$3,8502825$962 Ceiling$13,500102050$6,750 HVAC, office$11,700101567$7,839 Plumbing fixtures$6,500102050$3,250 Electrical fixtures$14,30081553$7,579 Total$71,350 $40,785

21. Breakdown method: Physical incurable depreciation – Long- lived items Replacement cost new $560,000 Less Deferred maintenance$27,000 Less Incurable short-lived items$75,350 Total short-lived items-102,350 $457,650 Effective age8 years Remaining useful life42 years Deprciation percentage16%$73,224

22. Breakdown method  Curable functional obsolescence  Superadequacy  Deficiency  Measured as the difference between the cost to add the item today minus the cost to add the component originally  Must be less than the value added by adding or modifying the existing structure  If the deficiency results in the replacement of an existing item, any remaining value attributed to the item at this point must also be deducted

23. Breakdown method: Curable functional obsolescence Deficiency: Installation of truck-height loading dock$4,500 Original cost of installation-2,500 Loss in value$2,000

24. Breakdown method  Incurable functional obsolescence  Deficiency  Superadequacy — measured as  The extra cost of construction minus physical depreciation  The income difference between the level needed to support the superadequacy and current functional income levels capitalized by the overall capitalization rate

25. Incurable functional obsolescence  Method 1: Excess cost adjustment Incurable Functional Obsolescence: Superadequacy Exterior wall (added cost)$40,000 Less depreciation taken-6,400 Depreciation$33,600

26. Incurable functional obsolescence  Method 2: Rent loss Incurable Functional Obsolescence: Superadequacy Rent needed to support masonry construction$2.10 per sqft Market rent-1.95 per sqft Rent difference$0.15 per sqft

27. Incurable functional obsolescence  Method 2: Rent loss (continued)…  Note that in the previous example the operating expenses do not change, but the management fee is reduced by 3% of the difference. Net loss per year is [0.15(1-.03)]=$0.1455 per sqft or $4,365 per year. Assuming a cap rate of 10.5, this results in a loss in value of $41,571. Value loss$41,571 Less depreciation taken-6,400 Depreciation$35,171

28. Breakdown method  External obsolescence  Economic  Locational  Measured as the present value of the NOI lost

29. External obsolescence: Locational Market rent$1.95 per sqft Current rent-1.75 per sqft Rent difference$0.20 per sqft Note: operating expenses are identical but management fee is reduced by 3% of the difference. The net loss is [.20(1-.03)]=$0.194 per sqft or $5,820 per year. Assuming an overall cap rate of 10.5, this results in a loss in value of $55,429. The value represents total loss in property value. Since the land contributes to 20% of total value, the portion of the loss in value that can be attributed to the improvements is $55,429 x.80 = $44,343.

30. Depreciation summary Physical Deterioration Curable, deferred maintenance$27,000 Incurable, short-lived items$42,905 Incurable, long-term items$73,224 Total$143,129 Functional obsolescence Curable$2,000 Incurable$33,600 Total$35,600 External obsolescence $44,343 Total accrued depreciation $223,072

31. Summary of Final Value Estimate Reproduction cost new$560,000 Less accrued depreciation-223,072 Depreciated value of improvements$336,928 Plus contributing value of improvements$15,000 Plus land value$65,000 Fee simple value indication$416,928

32. Market extraction method  Percentage loss is extracted from market sale of similar properties  Comparable sales must be available  Difficult to apply if comparable and subject vary significantly in age, quality and/or condition  Assumes same market forces affect comparable and subject

33. Market extraction method example Sales price$1,400,000 Less land value-300,000 Less contributing value of site improvements-50,000 Depreciated value of the improvements$1,050,000