This video continues the discussion of valuing a property under the cost approach. For last week’s introductory video, see Three Appraisal Approaches: Cost Approach.

Cost approach – beyond the basics

We covered the basics of valuing a property under the cost approach in a prior video. Here, we’ll get into some of the more advanced calculations – the specific methods for estimating replacement cost and depreciation.

However, before we do, a point of clarification would be helpful. Replacement cost is the cost to replace a structure with one having the functional equivalent to the structure being appraised, but constructed with modern materials and methods.

A related term is reproduction cost. The reproduction cost is the cost it would take to rebuild a structure as exactly like the original as possible.

For our purposes here, we’re going to focus on the more common replacement cost.

The estimated replacement cost of the existing improvements is determined using one of four methods:

  • comparative-unit method. This estimates the cost in terms of dollars per square foot or per cubic foot based on known costs of similar structures, adjusted for physical differences.
  • unit-in-place method. This estimates the unit costs for building components such as foundations, floors, walls, windows and roofs, as well as labor and overhead.
  • quantity survey method. This is the most comprehensive and accurate method for estimating the cost of the labor and materials a general contractor would use to build an identical structure, such as lumber, cement, plumbing fixtures and pipes, electrical, roof tiles, labor costs. The list goes on. You’ll notice this is similar to the unit-in-place method. The method to be used would be determined by who is using the information.
  • index method. This method determines building costs by multiplying the original cost of the property by a percentage factor to adjust for current construction costs. It is most frequently used when updating historic costs or backdating current costs.

After the appraiser estimates the replacement costs, the next step is to estimate and deduct depreciation.

Depreciation reflects any value-related loss in the property due to use, decay and improvements that have become outdated.

There are three types of depreciation:

  • Physical deterioration is the loss in the property’s value due to wear and tear. Physical deterioration can be curable or incurable. Examples include damage from termites or damage resulting from deferred maintenance and negligent care. Alternatively, it could be simple wear and tear. A water heater that is five years old has that much less useful life.
  • Functional obsolescence is any loss in the property’s value due to outdated style or non-usable space. Examples include a one-car garage or an outdated kitchen, or a swimming pool in a market that will not absorb the cost, as discussed earlier.
  • Economic obsolescence is the loss in property value due to changes in the property’s neighborhood. Economic obsolescence is external to the property. For example, a property’s value may decrease due to increased noise and traffic if a freeway is built next to it.

Again, calculating the cost to replace improvements as well as the loss in value due to depreciation is essential when valuing property under the cost approach. The formula is straightforward. Fair market value equals the value of the lot plus the cost to replace the improvements minus depreciation.

Editor’s note – Let’s take a moment to decipher some of the terminology used in appraisal. There is a hierarchy of language concerning the words “approach” and “method.”

“Approach” is the more dominant parent term, used to describe the three appraisal approaches: market comparison, cost and income. “Method” is a subset under approach – for example, the comparative-unit method is employed under the cost approach.

Related article:

Three Appraisal Approaches: Cost Approach