Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
CHAPTER 11
INTRODUCING THE COST APPROACH
STUDENT LEARNING OUTCOMES
This chapter outlines the cost approach, and describes the four common methods of estimating costs.
Chapter 12 will examine depreciation and complete the study of the cost approach.
11.1
11.2
11.3
11.4
Use of Cost Estimates in Appraisals
Practical Cost-Estimating Methods
Understanding Direct and Indirect Costs
Important Factors Affecting Building Cost
Class Activities
[Instructor: Complete as needed.]
Lecture [ ] Discussion [ ] Breakout Groups [ ] Other _____________[ ]
11.1 USE OF COST ESTIMATES IN APPRAISALS
1.
2.
Cost estimates are used in all three approaches to value.
The cost estimates that are used in appraisals should always reflect:



Cost levels as of the date of value, not “book” costs or the historic costs.
Typical or average costs rather than the actual construction costs – which could be the same.
Costs that include all of the charges to the consumer (i.e. “turn-key”).
Purpose and Outline of the Cost Approach
Three main purposes of the cost approach:
1.
2.
3.
To estimate the market value of proposed, new or nearly new buildings or developments.
To appraise institutional or special-use properties, not commonly rented or sold.
To serve as a check against the other value approaches used.
The cost approach is also needed for many insurance appraisals.
[Instructor: Consider having the class discuss the common lender requirement for a cost
approach, and their possible use of the cost new number to set required insurance coverage. Is this
an accurate number? Are there risks for the appraisers?]
Steps in the Cost Approach
The cost approach involves five basic steps:
1.
2.
3.
4.
Estimate the value of the land as if vacant.
Estimate the total cost to reproduce or replace the improvements as of the date of value.
Estimate accrued depreciation (loss in value).
Deduct the accrued depreciation from the cost (as new) of improvements.
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Chapter 11
5.
Add the land value to the depreciated cost of improvements.
[Instructor: Land valuation was covered in Chapter 10; accrued depreciation will be covered in
Chapter 12.]
Limitations on Using the Cost Approach



Some cost elements are difficult to define and to estimate.
Measuring accrued depreciation can be difficult and subjective. The cost approach is not
reliable in the appraisal of older buildings.
In some locations, there may be no reliable information on land values.
The Choice of Reproduction or Replacement Costs
1.
2.
3.
Reproduction cost is the cost of creating a duplicate building.
Replacement cost is the cost of creating a building with similar utility.
The difference in the two costs is important, as it changes the depreciation.
Defining Reproduction Cost Estimates


All physical components are included in the cost estimate, even if obsolete or out of style.
Judgment of the building’s utility is not made until depreciation is calculated.
Defining Replacement Cost Estimates
1.
2.
Replacement cost estimates require a judgment of utility, attractiveness, function, and
marketability of the improvements.
Components to be excluded from a replacement cost estimate would be:


Building materials that are out-dated.
Not consistent with the highest and best use and/or current zoning.
Replacement versus Reproduction
1.
Replacement cost estimates are required for the URAR when performed to Fannie Mae
specifications. They are preferred by appraisers because they are:


2.
Reproduction costs are sometimes used in appraisals of complex properties because:


3.
Less time-consuming to estimate.
More closely related to market demand.
They reflect the actual features of the structure.
Any estimates of loss of utility and depreciation are clearly indicated.
The choice of cost method depends on the intended use of the appraisal and if any contractual
terms specify which method to use.
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Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
11.2 PRACTICAL COST-ESTIMATING METHODS
This section outlines the four basic methods of estimating construction cost.
The Comparative Square-Foot Method



This method uses a typical or average square-foot cost of a similar new building, usually from a
published cost manual.
It is the most widely used and the most practical cost method.
Here is an abbreviated version of the example given in your textbook.
Example 11.3 Comparative Square Foot Cost Estimate of a Single-Family Residence
You are estimating the reproduction cost of an average quality dwelling with three bedrooms and
two baths, and 2,000 square feet. The adjustments for floor area and shape are obtained from the
cost manual. (Note: to simplify the example, the local area and time multipliers have been
ignored.) Proceed as follows:
Base cost factor from manual
Times: Area and shape multiplier
Equals: Base cost factor, adjusted
Base cost:
2,000 sq. ft. x $115.79 =
Plus: Refinements:
Built-in appliances
$14,000
Air conditioning
+ 12,000
Total additives
Equals: Estimated total cost of house
Plus: Garage and yard improvements
Equals: Total cost estimate
Rounded
$119.00 per sq. ft.
x 0.973
$115.79
$231,574
+ 26,000
$257,574
+ 32,000
$289,574
$290,000
The Unit-in-Place Method




Separately prices each building component by its “in-place” cost.
Includes all direct and indirect costs. (To be covered in Section 11.3.)
Is most often used to modify or adjust the comparative square foot method.
Is well suited for estimating the cost of industrial buildings.
How it Works
The appraiser prices the subject building one component at a time. Each component cost includes the cost
of installation and all other direct and indirect costs.
Example 11.4 Unit-in-Place Cost Estimate for a Small Commercial Building
Floors
Walls
Roof structure
Interior partitions
Ceilings
Doors and windows
5,000 sq. ft. at $7.00
300 linear ft. at $200.00
5,000 sq. ft. at $15.00
100 linear ft. at $40.00
5,000 sq. ft. at $4.00
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=
=
=
=
=
$35,000
60,000
75,000
4,000
20,000
5,000
Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
Roof cover
Plumbing lines and fixtures
Electrical system
Heating and cooling
Hardware and all other costs
Total direct and indirect costs
10,000
5,500
5,000
20,000
10,000
$249,500
Note: Before location and time multipliers
The Index Method



Adjusts the actual historic costs of a building to the cost levels as of the date of value, by the use
of published cost index information.
Is used primarily for unique buildings and for mass appraisal work, particularly for the tax
assessment purposes.
Formula: Original cost x (Index on date of value /Historical year index) = Cost on the date
of value.
To use the index method, follow these steps:
1.
2.
3.
4.
Verify that the original cost figure included all building components.
Find the applicable cost index figure closest to the date of value and for the original or historic
year. Verify both indexes use the same base year!
Divide the date of value index by the historic-year index to derive an adjustment factor.
Multiply the original cost by the adjustment factor.
[Instructor: The following is an abbreviated example from your text.]
Assume that you are estimating the current cost of a Class D wood frame building that
cost $80,000 in 1975. Your cost index chart for this type of building at this location
shows a current-year index figure of 1760.6, and a year 1975 index of 705.2. Current
construction cost would then be estimated as follows:
$80,000 ×
1760.6
= $80,000 × 2.50 = $200,000 (Rounded)
705.2
The Quantity Survey Method



This most detailed method uses a complete construction cost breakdown.
All labor, materials, and profit items are priced out and summed up.
While the most accurate, this method requires construction expertise.
The four cost methods are compared in TABLE 11.1 of your text.
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Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
11.3 UNDERSTANDING DIRECT AND INDIRECT COSTS
Direct Costs
These include the following:
1.
2.
3.
4.
Labor
Materials and equipment
Design and engineering
Subcontractor’s fees
Labor Costs
Labor costs include all wages and salaries paid for direct work on the construction project, whether paid
by the builder or the subcontractors.
Materials and Equipment
These include all the items that become integral parts of the structure: concrete, steel, lumber, doors,
windows, appliances, etc.
Design and Engineering



All engineering and architectural costs are included.
Engineering for soil grading, compaction, and retaining walls are excluded, as they are typically
part of the site value.
Structures built from standardized plans may need no engineering.
Subcontractor’s Fees
Amounts paid to subcontractors represent direct construction cost elements. An increasing percent of the
total direct cost is for work by subcontractors.
Indirect Costs
Indirect costs include:
1. Legal fees, appraisal fees, and building permits and licenses
2. Interest charges and other fees for construction financing and fees for permanent financing
3. Construction liability and casualty insurance
4. Property taxes during construction
5. Construction administration and management
6. Interest on the owner’s invested funds
7. Builder’s and entrepreneurial profits
8. Marketing and selling costs
[Instructor: A brief description of several of the listed items follows. Refer to your text for
relevant discussion and examples.]
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Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
Interest on Construction Financing
These indirect costs include:


Interest paid by the borrower on outstanding loan amounts
Loan fees, points, and other construction loan charges
Property Taxes during Construction
In some jurisdictions, the amount of property taxes depends on the construction stage on the lien date.
Construction Liability and Casualty Insurance
Insurance costs during construction.
Construction Administration and Management


Often referred to as builder’s overhead, these costs generally include office rent, employee
salaries, utilities, and transportation costs.
Builder’s overhead costs should not be added, if already included in the contract cost.
Interest on Investment and Loss in Rental
The owner’s investment in land and buildings deserves a fair return during:


The construction period, on any equity investment beyond the construction loan funds.
The marketing period, to provide a return on the owner’s funds tied up in any vacant space.
Builder’s and Developer’s Profit




Charges for these services are largely dependent on competition.
Prevailing builder fees should be obtained from local builders.
Developers who “package” a project are entitled to an entrepreneurial profit, with amounts
depending on economic conditions.
Most cost manuals exclude entrepreneurial profit.
11.4 IMPORTANT FACTORS AFFECTING BUILDING COST
This section outlines the site, location, design and construction features that affect construction costs. A
discussion of published building cost services is also included.
Site and Location Factors
1.
Site factors that affect the cost of construction include:


2.
The size, shape, topography and accessibility of the site
The type of soil, geology, and climate
Examples of lot features that may incur higher design, engineering and foundation costs, and/or
higher utility service connection costs:

Irregularly shaped sites
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


3.
Uphill, downhill, and sidehill lots
Sites with poor soil or unstable geology conditions
Severely hot or cold climates
Location factors affecting construction costs include:



Local variations in labor, material, and service costs
Building code requirements in different political jurisdictions for structural, mechanical,
electrical, and sanitary components
Costs are often higher in cities than in unincorporated areas
Design and Construction Cost Variables
Seven building characteristics affect the cost of construction:
1.
2.
3.
4.
Design or use type
Type of construction
Quality of construction
Size
5.
6.
7.
Shape
Height
Yard or site improvements
Design or Use Type


The design or use category (“type of occupancy”) generally defines the building’s features.
Construction cost manuals cover many use types. These can be grouped as residential,
commercial, industrial and institutional.
Construction Classification



Buildings are typically classified in four or five cost groups, according to the type of structural
frame, walls, floors, roof, and fire-proofing.
Higher construction costs are typical for the A and B classifications. Examples: high-rise and
institutional buildings.
Lesser costs are associated with Class C and D buildings.
Examples: low-rise residential, commercial, and industrial buildings.
Quality of Construction



Construction quality is generally the most important cost variable.
In residential appraisals, quality is usually rated as good, average, fair, or poor. Other ratings may
apply.
UAD ratings range from Q1 (best) to Q6 (lowest).
Size and Shape
Because of the economies of scale, larger buildings can cost less per square-foot, even though they may
cost more overall. (See Example 11-5 in the text.) Building size also affects construction cost per squarefoot for:
1.
Building Shell costs, because floor areas change at different rates than other quantities (for
example, linear feet of walls).
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Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 11
2.
Residential buildings, because some costly components are “fixed”, that is, stay constant with
size changes (for example, kitchens & baths).


Any increase in square-foot area tends to reduce the cost per square-foot. Total cost is, of
course, greater.
Any decrease in size tends to increase square-foot costs.
The shape of a structure also affects its construction cost.


Building Shells vary in cost with shape because some component quantities (for example,
linear feet of exterior walls) change even when floor areas remain the same. More materials,
more cost. (See Example 11-6 in the text.)
Residential buildings may increase in cost with complex shapes because of:
o Increased numbers of corners.
o Increased linear feet of perimeter walls, windows, etc.
o Increased roof framing, overhang, and other costs.
Height
Story-height (or wall-height) generally increases the cost of the building because of the increased costs of
taller walls and other systems.
[Instructor: The effects of size and shape on square-foot building costs are shown in Examples
11.5 and 11.6 in the textbook.]
Yard or Site Improvements
Besides the main building, cost estimates must include:




Garage or parking structures
Walks, driveways, and outside lighting
Sprinkler systems, fencing, pools, and patios
Landscaping, usually estimated at its depreciated value (contribution to value)
Using Published Building Cost Services
Examples of cost services available to the appraiser include:



Marshall Valuation Service
Marshall and Swift Residential Cost Handbook
Means Building Construction Cost Data
Many services provide comparative square-foot and unit-in-place costs, as well as cost index tables to
adjust historic costs. Services that base costs on national averages usually provide local adjustment
multipliers. Typically, subscription services available in published manuals, CD-ROM format or online.
General Format of Manuals
Published building cost guides usually are organized and designed around the major cost variables
discussed above:
1.
Design or use type
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Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
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2.
2.
4.
5.
6.
Construction class
Quality of construction
Size, shape, and height
Cost refinements
Yard and site improvements
Suggested Procedure for Cost Calculations
1.
2.
3.
4.
5.
6.
Select the use-type, the building construction class, and the quality range based on the listed
specifications. Read the base cost factor from the table.
Calculate the area, shape, corner, story-height and/or unit size multipliers; multiply (as required)
times the base cost factor.
Multiply the adjusted base cost times the area of the building.
Add any needed unit-in-place costs.
Add lump-sum costs of the various site or yard improvements.
Apply current and local cost multipliers as indicated in the manual.
Using On-Line Cost Services
Several cost manual services provide on-line access to a central cost data bank, and/or updated cost
programs to run on the appraisal office computer.
SUMMARY
[Instructor: To review the session, refer to your text, or back to the beginning of this chapter
outline. The list of important terms may assist you in your summary.]
Important Terms and Concepts
Base costs
Builder’s profit
Building shell
Building size and shape
Comparative square-foot
method
Construction classification
Cost approach
Cost Manuals
Design use or type
Developer or entrepreneurial
profit
Direct costs
Historic costs
Index method
Indirect costs
Lump-sum costs
Quantity survey method
Replacement cost
Reproduction cost
Story height
Unit-in-place method
REVIEWING YOUR UNDERSTANDING
[Instructor: See end of your text chapter for student review questions. Answers are in the back of
the book.]
STUDENT EXERCISES
[Instructor: Suggested Multiple Choice and True/False questions are available to use for Chapter
11.]
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