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

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

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.

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

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

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

Comparative unit cost example
Gross building area
Construction type
Bearing walls quality
Number of stories
Number of elevators
Base building cost/sqft
Plus HVAC adjustment
Plus sprinkler adjustment
Adjusted unit cost
Story height multiplier
Perimeter multiplier
Adjusted unit cost
Building cost ($65.40 x 24,000 sqft)
Elevator
Reproduction cost new
24,000 sqft
Masonry load
Good
2
1
$64
$1.04
$2.06
$67.10 x1.030
x0.947
$65.45
$1,570,800
55,000
$1,625,800

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

Segregated cost example
Item
Site preparation
Foundation
Frame
Floor structure - 1st floor
Floor structure - 2nd floor
Floor cover - carpet
Ceiling
Interior partitions
Sprinkler
Plumbing
HVAC
Electrical/lighting
Exterior wall
Roof structure
Roof cover
Elevator
Total
Size, sqft Unit cost per sqft Cost
12,000
24,000
24,000
$0.67
$2.57
$8,040
$61,680
$5.47 $131,280
12,000
12,000
24,000
24,000
24,000
24,000
24,000
$3.31
$3.70
$39,720
$9.88 $118,560
$88,800
$6.20 $148,800
$15.78 $378,720
$2.06 $49,440
$3.40 $81,600
24,000
24,000
12,480
12,000
12,000
24,000
$4.45 $106,800
$4.51 $108,240
$12.77 $159,370
$6.07 $72,840
$1.85 $22,200
$2.30 $55,200
$1,631,290

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

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

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

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

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

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

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.

Breakdown method: Identify component cost
Excavation and site preparation
Frame
Floor structure
Floor cover, office
Ceiling, office
Partitions, office
Sprinkler
HVAC warehouse
HVAC, office
Plumbing
Electrical
Exterior wall
Roof cover
Roof structure
Total
$9,600
97,500
67,200
3,850
13,500
36,000
40,500
21,950
11,700
47,200
53,000
93,000
25,000
40,000
$560,000

Breakdown method:
Deferred Maintenance
Roof leak
Space heaters
Total
Cost New
$25,000
Replacement cost to cure Remainder
$3,500 $21,500
$21,950 $23,500
$27,000
0

Breakdown method: Physical incurable depreciation – Shortlived items
Roof cover
Floor cover
Ceiling
HVAC, office
Plumbing fixtures
Replacement cost
$21,500
$3,850
$13,500
$11,700
$6,500
Electrical fixtures
Total
$14,300
$71,350
Economic age
10
2
10
10
10
8
Effective life % Depreciation Depreciation
15 67 $14,405
8
20
25
50
$962
$6,750
15
20
15
67
50
53
$7,839
$3,250
$7,579
$40,785

Breakdown method: Physical incurable depreciation – Longlived items
Replacement cost new
Less Deferred maintenance
Less Incurable short-lived items
Total short-lived items
Effective age
Remaining useful life
Deprciation percentage
$27,000
$75,350
$560,000
-102,350
$457,650
8 years
42 years
16% $73,224

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

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

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

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

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

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
Less depreciation taken
Depreciation
$41,571
-6,400
$35,171

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

External obsolescence:
Locational
Market rent
Current rent
Rent difference
$1.95 per sqft
-1.75 per sqft
$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.

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

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

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


Market extraction method example
Sales price
Less land value
Less contributing value of site improvements
Depreciated value of the improvements
$1,400,000
-300,000
-50,000
$1,050,000
Depreciated %

1

Depreciation value of improvements
Cost new of improvements