EXCERPT FROM:

Hamilton, Stanley. 1998. Real Estate Investment Analysis and Appraisal. Vancouver: UBC Real Estate Division

Chapter 7: Cost Method of Appraisal

I. INTRODUCTION

The cost method of appraisal is based upon the principle of substitution. According to this appraisal method, no purchaser would be willing to pay more for a property than the cost of a new replica property. This proposition leads to a second conclusion which declares that the replacement cost of a new property sets the upper limit of market value: No one will pay more for a new property than the cost to create a property which provides equal utility.

The framework for the cost method, which is universally accepted, can be summarized as follows:(1)

MV = L + B D

where

MV = the market value of the property;

L = the market value of the site, as if vacant, at the date of the valuation;

B = the cost (new) of the structural improvements at the date of the valuation; and,

D = the accumulated depreciation for the improvements on the site

In the case of a new building, the depreciation would be zero.

II. HISTORICAL BASIS OF THE COST METHOD

The notion that cost and value are equal can be traced in the development of economic thought. The classical economists of the 18th and 19th century maintained that value was the sum of the costs of producing a commodity. This proposition was consistent with the notion that a commodity had an intrinsic value which is determined by the cost of production.(2)

The more contemporary school of economic thought holds that value is the outcome of market interactions including the demand as well as the supply considerations -- market value is what a commodity will fetch in the market. This notion does not imply that cost and value are unrelated. Economic theory maintains that in the long run, cost and value tend to approach one another. Producers will continue to produce commodities providing they can earn a normal profit. If producers earn abnormally high profits, they will continue to produce and new competition will enter the market. As new production (supply) increases relative to demand for the product, profits will decline. If profits decline below a normal level, producers will cut back on their output. It is only at that point where profits are normal that cost and value are equal (a long run equilibrium point in the market).

So far as economic theory is concerned, there is no valid proposition that, at a given moment of time, the cost of a particular good is equivalent to market value. The most relevant statement in this regard is that values in the long run would tend to equal the average costs of representative firms under conditions of perfect competition. This is of no help to the appraiser who is seeking to find market value, at a given moment of time, in a market in which competition is highly imperfect, even if it were possible to identify average costs of representative firms.

III. RELATIONSHIP BETWEEN COST AND MARKET VALUE

Perhaps no single subject in appraisal theory and practice has aroused as much controversy as the method of appraisal which presumes an equivalence between cost and market value. Although the method is widely used in North America (especially for local taxation purposes and property insurance), there is a formidable list of writers who have expressed considerable doubts as to the justification for the extent of its use -- except as an expediency in mass appraisals.

One of the earliest and clearest statements of the limitations of cost as evidence of value has been made by F.M. Babcock, an American appraiser of considerable repute:

Cost in the investment sense is not value. A standard illustration which makes this assertion clear is the one which assumes a 30-storey hotel to have been built in a remote and inaccessible spot in a desert. It is self-evident that the building is not worth an amount represented by the investment which would be required to replace it. There is rarely, in fact, any connection between the cost of replacement of a building and its value. The notable exception and the only exception is the case of a building just completed which represents the highest and best use of its site. In the latter case, a building is worth precisely its cost of replacement. However, its value at any future time may not bear any relation to either its replacement or original cost of construction... The fact that in most kinds of real estate the values at a given time cannot greatly exceed replacement cost in no way modifies the general statement that cost and value are distinct and that the cost method of valuation is unsound... A building is worth its cost of replacement provided it is new, represents the highest and best use of the site, and provided its construction is justified by the expected returns which it will produce. In all other cases its value must be discovered by some other process...(3)

In particular, attention is drawn to the last paragraph of the passage cited which sets out the circumstances under which the cost method is most effective. However, it will be argued in this chapter that the cost method of appraisal has a somewhat different range than Babcock is prepared to allow.

In a more contemporary setting, Professor R.U. Ratcliff notes:

The fatal defect in the conventional Cost Approach to market value is that the value of the whole is not the sum of the independently determined values of the components of the commodity. Any complex product or enterprise generates an indifferentiated stream of productivity through the interaction of its components. It is impossible to assign to any single component the measure of its contribution to the composite... Certainly cost-new is no measure of the contribution of the structure if new, which it is not. Thus, it is a meaningless figure to which the depreciation adjustment futilely strives to give significance.(4)

Given these strong condemnations, which are shared by many contemporary writers,(5) one may well ask why the cost method continues in use today and under what circumstances it is best used. Ratcliff suggested five reasons for the continued use of the cost method:(6)

The persistent notion that real estate has intrinsic value independent of prevailing market conditions, hence dependent on production costs;

The simplicity and specious logic of the approach;

Widespread acceptance of the cost approach by clients and the courts;

The fact that professional appraisal organizations preach the "three approaches to value;" and

The ease with which the cost data can be managed in order to produce a value close to that which the appraiser had already determined on another basis.

One might reasonably add two further reasons to this list.

Certain appraisal problems require separate value estimates for land and improvements (i.e., insurance, property tax assessment); and

Certain appraisal problems arise where there is no market evidence (i.e., valuation of churches, pulp mills).

In the case of appraisal problems requiring separate values for the land and the improvements, the appraiser may use a combination of appraisal methods. For example, the appraiser may use the market comparison method to determine the market value of the entire property, then use the cost method to determine the value of the improvements. The land value can then be estimated by deducting the value of the improvements from the total property value.

In those cases where no market evidence is available (i.e., no recent sales), the appraiser may be forced to resort to the cost method of appraisal. This problem commonly arises in the field of real property assessment where assessors are required to determine the market value of properties which do not commonly sell in the marketplace (i.e., pulp mills).

It is clear from the criticisms that the cost method will be most accurate in estimating market value when:

The property represents highest and best use of the site;

The market is at or near a long run equilibrium (no short term over, or under, supply); and,

The improvements are new (hence no need to estimate depreciation).

Initially the discussion of the cost method of appraisal will deal with the question of estimating market value expressed as a capital sum when the building represents highest and best use development.

IV. MEANING OF "COST"

The first step in the application of the cost method is to establish the meaning of cost, which, like value, is a word capable of a variety of meanings. Consider the following alternative definitions:

Historic cost - is the original cost of construction of the property.

Current cost - is the construction cost of the property at contemporary or current prices.

Reproduction cost - is the current cost of constructing an exact replica of the subject property, using exactly the same materials.

Replacement cost - is the current cost of the improvements which would afford the same utility as the subject property, but does not incorporate features which do not contribute to present day utility or satisfaction. Replacement cost may include the cost of materials different from those used in the subject property at the time it was originally built.

The choice between reproduction and replacement costs is not so easy to determine. Reproduction cost is the cost of an exact replica of the subject property while replacement cost is the cost of a new building which would afford the same degree of utility, but it is not necessarily constructed of the same materials or even in the same way. Reference to any standard Building Construction manual will remind the reader of the considerable changes which technological progress, and new economic and social conditions have brought in standards of construction. The evidence of this is plain enough on every street. These changes make it meaningless in many cases to attempt to calculate the cost of an exact replica of the subject property (reproduction cost) since the materials and labour skills necessary to carry out such work are either non-existent or are prohibitively expensive in a contemporary setting. Replacement cost is therefore used since it measures the cost of a building which, while not necessarily a reproduction of the subject property, does offer the same utility. For example: the subject property might have a lath-and-plaster surface on the interior walls whereas, in estimating replacement cost, it might be legitimate to include a suitable dry wall finish instead; or a concrete block and steel frame-wall might be regarded as a substitute for one of brick masonry construction. In respect of design, if the subject property is an old house, it might be found to have ten-foot ceilings. But, today, this may not be considered an advantage. In arriving at replacement cost, a house with eight-foot ceilings would be taken as the current standard.

The difficulty in estimating the cost of a building with the same utility as the subject property lies in deciding what contributes to utility (or dis-utility). For example, would a brick fireplace provide the same utility as a stove fireplace? Do aluminum windows provide the same utility as wood frame windows? Does gyproc provide the same utility as brick and mortar walls? Having made such decisions as seem to be warranted, the appraiser is in the curious position of having created, for costing purposes, a building which may be quite different from that which is to be appraised. Paradoxical as this may seem, it is nevertheless a logical development of the basic principle which holds that the value of the subject property cannot exceed the cost of building a substitute (i.e., a building affording similar utility or satisfaction). For the reasons given, the substitute may be different from the subject property in several respects and yet afford the same level of satisfaction.

V. ELEMENTS OF COST

Using the cost method, market value is stated to be the sum of the market value of the bare site plus the replacement cost of the improvements less an allowance for accumulated depreciation. The basis of this approach to market value may be illustrated as follows:

(1) Estimated Market

Value of Land (by market comparison) $ 500,000

(2) + Cost of Improvements: New 2,340,000

(3) = Cost New (Market Value New) $ 2,840,000

(4) Accumulated Depreciation 60,000

(5) = Market Value as Indicated by the Cost Method $ 2,780,000

A more complete example of the cost method is given later in this chapter.

The market value of the site is generally estimated using the market comparative method and should reflect the highest and best use of the site. The particular problem is to determine the replacement cost of the improvements. The process of estimating the costs of improvements requires an understanding of the factors which comprise cost.

A developer might decide to develop a site in a central business district as an office building and the proposed building represents the highest and best use of the site. After identifying the site, the developer must decide, before construction commences, whether the expected market value of the finished building will be greater than the price paid for the land, the price paid to the contractor, and the developer's overhead and profit. If the developer cannot obtain the profit he deems necessary to compensate him for time and risk, there will be no incentive to proceed with the development.

A successful development will yield several kinds of profit although these may frequently be shown as a single figure. The general contractor will include his profit in the price at which he agrees to do the work. This price will incorporate the amounts that the general contractor must pay to the sub-contractor and such amounts will include the sub-contractor's profits. In addition, the developer, who has organized this production process, will expect a profit from such a successful venture.

This form of business activity is not unusual. In our economy, highly specialized skills exist. To minimize risk, it is thus profitable for the efficient developers to pay an appropriate amount to specialists (individuals or firms) and these profits must be obtained by the specialists at each level of production.

The developer's function resembles the function of a manufacturer who buys parts from numerous firms, assembles them and sells the finished product. The satisfactory price paid for the finished product must prove profitable to the manufacturer as well as to the makers of the component parts.

Assuming the developer and the builder (contractor) are separate entities, the allocation of the ultimate market value of the finished building may be as follows:

Market Value on Completion (New)

$2,840,000 (Found Using Cost Approach)

Developer's Profit "Normal profit" for this type of project

$40,000 before he will undertake development

Developer's Overhead All overhead or "soft" costs

$300,000

Building Costs and Normal building costs obtained by

Builder's Profit bids or from cost surveyor, includes

$2,000,000 builder's profit

Site Value Market value by comparison approach

$500,000

Thus, if a new property has a market value on completion of, say, $2,840,000, and it was erected on a site which had a market value of $500,000, and the level of values has not changed during the period of development, the total cost of improvements would be $2,340,000. And if the project has proceeded according to forecasts, the figure of $2,340,000 will be the aggregate of: the contractor's price, including the contractor's profit; the developer's overhead; and the developer's profit. These three items represent the elements of cost. In practice, the truth of this statement tends to be obscured by the fact that the general contractor and the developer are sometimes one and the same entity and that profit levels are subject to strong competition. But the total profit must still provide remuneration for the two separate activities.

VI. CALCULATION OF THE COST OF IMPROVEMENTS

A. Contractor's Price (or Construction or "Hard" Costs)

Babcock, in the quotation given previously, states that the cost method should be limited to the appraisal of new buildings which represent highest and best use development. When the problem of estimating construction costs is examined, it is easy to understand the reason for this opinion. If the subject property is new and it represents highest and best use development, the four classifications of cost (historic, current, replacement and reproduction) are unnecessary because all will be equal unless there has been a sudden and dramatic change in market conditions during the development period. It is only when the building is not new that it becomes necessary to choose between the different standards of cost to which reference has been made. For the present, the discussion focuses on methods of estimating costs of new buildings.

Three main methods of cost estimation include:

(1) quantity survey;

(2) unit-in-place; and

(3) unit-of-area or unit-of-volume.

The latter is generally the most practical for the appraiser. For this reason, only a brief description is given of the quantity survey and unit-in-place methods.

1. Quantity Survey

Estimating costs by this method is undoubtedly the most accurate method. It is used by contractors in computing tender bids. It involves determining the quantity and quality of all of the component materials used, computing the amount of labour required and pricing these various individual components. In addition, items are included to cover the cost of the contractor's overhead and profit.

The objection to the use of this method in appraisal is that it requires a considerable degree of skill which few appraisers can hope to obtain and it takes far more time (and, therefore, expense) than is warranted in most appraisals, especially residential appraisals. However, in the case of a significant improvement, or for purposes of litigation, such detail may be warranted.

2. Unit-In-Place

The unit-in-place method (best described as an element cost system) is a modification of the quantity survey method. It employs the cost of installed materials expressed in terms of a convenient module of measurement: such as foundation, roof, plumbing, wiring, heating, exterior walls, etc.

Thus, for example, in estimating the cost of a brick veneer wall by this method, there would first be an estimate of the cost of installing bricks (material and labour) plus the cost of the studding and sheathing installed, plus the cost of insulation installed, plus the cost of lathing and plastering, plus the cost of painting. In this way, the installed costs of all of the materials in the wall are estimated. The cost per square foot, and therefore the cost of the whole wall module of a building, can be readily determined, remembering that if the cost of overhead and profit is not included in the unit costs, these must be added as separate items. Costs of roofs, foundation walls, excavations, and so on, can be estimated in the same fashion. Once the costs of a sufficient range of units-in-place have been determined, it is a quicker way to estimate cost than the quantity survey method.

The difficulty with this method, however, is that it calls for the same kind of skill as is required in the quantity survey method. Consequently, it can usually be used in appraisal work only when the appraiser is able to have such an estimate made on his behalf by a person competent enough to use the method.

3. Unit of Area or Volume - Comparative Methods

The method of estimating cost by unit-of-area or unit-of-volume involves taking the known total cost of a building (including contractor's overhead and profit) and dividing that by the total area or cubic capacity. The resultant cost per square foot or cubic foot is then applied in estimating the cost of buildings of similar construction. In principle, evidence of costs is collected and used in exactly the same way as evidence of value using the comparative method. For this reason, this way of cost estimating is sometimes known as the comparative method of cost estimating.

It will be apparent that the validity of such cost estimates depends on the degree of similarity between the subject property and the buildings used for the purpose of obtaining the unit costs. Similarity in this respect bears some relationship to similarity when using the comparative method of appraisal. In particular, it is important to recognize that differences in roof design, the shape of a building and ceiling heights will exercise a considerable influence on costs.

As a simple illustration, a building measuring 60' × 100' encloses 6,000 square feet of space at ground level, and a building measuring 30' × 200' encloses a similar area. But the total length of the perimeter wall in the former case is 320 feet whereas it is 460 feet in the latter. If the buildings are similar in all other respects, it is apparent that the second one will cost considerably more than the first because of the extra walls. It is thus essential to establish similarity in respect of standards of construction and design. Adjustments can be made for minor differences. For example, if the subject property were a single detached house with a finished basement whereas, in the building used for cost comparison purposes, the basements were unfinished, an additional amount would be added to the cost estimate of the subject property to represent the cost of finishing the basement. Conversely, if some items in the subject property were inferior, a deduction would be made to reflect the cost differential.

For the purpose of measuring area or volume, the appraiser may adopt such standards of measurement as seem to him to be most convenient, provided of course that the standards are used consistently. Generally, where costs are to be expressed per square foot or metre, the area of the building is obtained by taking measurements externally and taking the aggregate of each floor of finished space. Thus, if a basement were unfinished, its area would not be included in the total and if part of it were finished, the area would be excluded, but the cost of the finishing in the basement would be treated as a separate item.

Volume is calculated by taking the area at ground floor level (measuring externally) and the average height. Average height for a gable roof is measured from the underside of the basement floor to a point halfway between the ridge and the eaves. But the upper limit of average height varies with the design of the roof. It does not necessarily correspond with that for a gable roof. Parts of a building which project, such as bay windows and porches, are usually excluded from the measurement of area and are shown as separate items. Similarly, the volume of a building with set-backs is calculated in parts.

Generally, there is not much to choose between the square foot (or metre) and the cubic foot (or metre) as a unit of cost since, in each case, it is important to ensure similarity of story heights. But it seems probable that the square foot is more widely used especially in respect of residential property.

The construction costs of buildings which are used to arrive at costs-per-unit should be those of a contractor of average efficiency. They should not reflect either the savings of superior management or the wastage of incompetence. It is also important to determine the items of overhead and proportion of profit which are included in the costs. The best sources of information are local contractors and architects. But if the necessary data cannot be obtained in this way, recourse must be had to one of the various construction cost services. Costs obtained from such a source should be treated with caution because they represent general figures which at times may be at variance with local conditions and, to the appraiser, they represent second-hand evidence.

The collection of cost data is a continuous process and the information collected should be recorded systematically. Various categories of buildings and different standards of construction should be established (e.g., single-story ranch style houses with an area of 1,600 square feet or thereabouts and of superior construction). Known costs are then recorded in the appropriate category. Since information of this kind soon goes out of date, every opportunity should be taken to obtain contemporary cost data(7).

B. Developer's Overhead (or "Soft" Costs)

As has already been pointed out, a contractor may also act as a developer. In this case, the overhead will be combined and included as one item in computing contractor's price. But in order to simplify the discussion, it is intended to deal with developer's overhead by reference to the situation existing when the developer (i.e., the person who arranges for the building to be erected) employs a contractor to do the building work. The easiest way of indicating the principal items which may appear as part of the developer's overhead is to list them. In order to distinguish these from contractor's overhead, the latter will also be listed.

Table 1

Principal Overhead Items

Developer

Legal fees - including conveyance, title registration, contracts; expenses in disposal of completed building either by sale or leasing.

Professional fees - architects; engineers; and other specialists; surveyors; soil.

Taxes - during construction.

Insurance - other than is carried by contractor.

Administrative - including office expenses.

Interim financing costs.

Contractor

Contract supervision.

Office expenses.

Depreciation and rental of equipment.

Management and office salaries.

Technical staff salaries - estimators; draftsmen.

Travelling costs.

Insurance - e.g. public liability

Financing costs - i.e. short term loans during construction.



Since the amount of overhead expenses is a function of managerial ability, it follows that this item is subject to wide variations. It will be appreciated from the nature of the items included in the developer's overhead that it would be wildly optimistic to expect any great degree of accuracy in their estimation by an appraiser. The approximate nature of this estimate is one of the measurement weaknesses of the cost method. However, the more familiar the appraiser is with development and construction work, the more reliable his estimate will be. It must be remembered that the appraiser is not working for the actual costs incurred in a particular case, but for those costs which might reasonably be expected by a developer of average efficiency.

The contractor's overhead listed above (for the purpose of comparison) and the contractor's profit will be included in the contractor's price. They do not, therefore, have to be computed separately. It is essential, however, to know the items which are covered by contractor's overhead in order to eliminate duplication. Reference to the quantity survey cost estimate will show if the contractor's overhead and profit have been included in total cost.

C. Developer's Expected Profit

The developer's expected profit depends on his skill in anticipating market demand for the development undertaken and his ability to satisfy that demand at a price which buyers are prepared to pay. If the market value of the project on completion is less than had been expected and/or if the costs are higher than had been forecasted, the developer's profit will be reduced or perhaps eliminated. On average, the developer will make a profit which will be commensurate with his competence and risk. Keep in mind, however, that once the project is commenced, profit becomes strictly a residual amount after all other costs are paid.

Once more, the appraiser is concerned with the developer of average efficiency. The appraiser will find that in marginal areas (from the development viewpoint), the expected profit is higher than in well established areas to offset the higher risks. For example, the developer of a speculative, residential subdivision in a fringe suburban location would normally expect to earn a higher profit than the developer of one of the few remaining sites in a flourishing business area to reflect the higher risks. Developer's profits fluctuate violently with changes in economic conditions and any generalization as to their amount is extremely dangerous. But, as a very rough indication, the percentage in central business districts with a full allowance for overhead might be about 15% of the contractor's price + developer's overhead + value of site. In a marginal area, 25% to 30% of the same items would be nearer the mark. In some cases, where overhead expenses defy exact computation, it will be necessary to increase the developer's profit in order to take care of the omission or errors in forecasting.

D. Exception to the Analysis of Cost of Improvements

The most common exception to the analysis of the costs of improvements arises in the case of residential development, especially the speculative construction of low-price houses. Depending on the scale of operations, such development may be carried out in a variety of ways. Thus, major contractors may acquire raw acreage, and install roads and services before building houses on the lots created. In this case, the organization combines the role of the subdivider, the developer and the contractor. But where the contractors are small firms, it is more usual for the acreage to be subdivided by a developer and the lots sold, usually several in one transaction, to builders who then proceed to erect houses for sale. In these cases, the work of development is principally represented by the process of land subdivision and the developer's profit and overhead are included in the market value of the lots. For this reason, in appraising residential property by the cost method, it would generally be incorrect to include in the cost of improvements a developer's profit and overhead (although some of the items contained in the previous schedule of developer's overhead might have to be transferred to contractor's overhead; for example, disposal costs - such as advertising and sale commissions).

It should be noted, however, that where the site of the subject property is such that little or no work is required to make it ready for building, and no land assembly or subdivision is involved, then developer's profit and overhead must enter into the calculation.

VII. OLDER PROPERTIES - PROBLEM OF DEPRECIATION

As soon as an attempt is made to adapt the principles of the cost method to properties which are no longer new - i.e., those which are suffering from depreciation - the force of Babcock's criticism and the severe limitations which he proposed for the use of this method of appraisal become apparent. The market value, expressed as a capital amount, for a property which has depreciated in value, but which still represents highest and best use value, is equal to:

Market Value = Site Value + Improvement Costs Accumulated Depreciation

Site value is estimated using the comparative method and presents no new difficulty. But it is necessary to examine further the nature of cost of improvements and estimation of depreciation.

In the case of an older property, it must be determined whether the cost to be used should be historic or current costs, and whether it should be reproduction or replacement costs. Recent inflation is probably a sufficient argument to decide the issue of whether costs should be historic or current. No sensible person is going to appraise his own services by reference to the salary paid for his job in 1959. Consequently, the original cost of a building is no guide to its current market value.

In any case, the proposition on which the cost method rests is simply that a new building similar to the subject property would cost, say $X. Therefore, the existing subject property is worth $X, less that amount which represents the disadvantage of age. This logical concept applies to a wide range of second-hand commodities (e.g., cars, boats, furniture and appliances). But it might be noticed in passing that the statement is not universally true. For some used goods market value is sometimes the cost of a new article plus an amount representing the advantage of age. Anyone who has compared the price of reproduction furniture with that of a genuine antique will be familiar with this exception.

The nature of the problem concerning the cost measurement might become clearer if an example is used for the purpose of illustration. Assume that a subject property of new construction conforms with the tastes of the typical buyer, except for its ten-foot ceilings. Other properties in the same category are designed, without exception, with eight-foot ceilings. One can thus surmise that buyers are not prepared to pay the extra cost of ten-foot ceilings because the extra satisfaction (if any) is not worth the extra cost. The replacement cost of the subject property would be cost if it had been built with the usual ceiling heights of eight feet. It is desirable to carry the analysis of this case a few steps further, even though this will impinge on the subject of depreciation.

By taking the replacement cost of a building with an eight-foot ceiling, a reduction has been made in the cost estimate of the subject property (assuming a ten-foot ceiling costs more than an eight-foot ceiling). But this reduction is not necessarily of the right amount to equate cost to market value. It was stated that the extra cost of the higher ceilings did not make an equal contribution to market value and any addition to market value would be smaller than the additional cost. But it is necessary for the appraiser to decide whether a higher ceiling adds anything to market value, does not affect market value, or detracts from market value. In the first case, due to the nature of the demand for homes, the typical buyer might be sufficiently impressed with the greater spaciousness of the rooms to pay something extra, even though it is not sufficient to meet the additional costs. If this is true, the amount of the extra price would have to be added to replacement cost based on an eight-foot ceiling.

In the second case, any advantage is cancelled by the disadvantages, or buyers are indifferent to this characteristic of design and no adjustment of replacement cost is required. In the third case, the typical buyer may feel that with a ten-foot ceiling his heating bills and decorating costs will be higher. Since, in his opinion, the larger ceiling height is a disadvantage, he will offer a lower price for the property in order to compensate for the heating and decorating disadvantage. Where this condition exists, a deduction must be made from replacement cost.

By contrast, if reproduction cost had been used, deductions would have been required in all three cases because some part of the cost of construction is not market value. It is certainly easier to remember that any adjustment in regard to reproduction cost is a deduction. But this simplicity is more than offset by the extra difficulty of calculating reproduction cost, and the use of replacement cost is generally preferred.

VIII. ESTIMATION OF DEPRECIATION

The definition of depreciation used in this chapter is as follows:

Broadly speaking, depreciation is the loss, not restored by current maintenance, which is due to all factors causing the ultimate retirement of the property. These factors embrace wear and tear, decay, inadequacy, and obsolescence.

An explanation of depreciation must, therefore, cover wear and tear, decay, inadequacy and obsolescence. Wear and tear and decay fall into one category - often called physical depreciation. Inadequacy and obsolescence are called functional depreciation. A third element of depreciation, economic obsolescence, represents the loss in value due to locational factors external to the property.

A. Physical Depreciation

Physical depreciation refers to the loss in market value that is due to structural defects, and wear and tear which either have not been or cannot be remedied. For the purpose of illustration, we can take a purely hypothetical example. Suppose there is a thirty-year old house in which all of the fixtures and fittings (i.e., baths, basins, tubs, heating installation, etc.) have recently been renewed. Suppose further that an exact replica of this house has just been constructed on an adjoining lot of similar size and value. The only difference between these two properties is the age of the materials in the building, and the difference in market value will be solely attributable to wear and tear, and decay which the older building has suffered. Part of the difference in market value will represent defects in the condition of the older house which can be corrected (for example, repainting and decorating or renewing the porch steps). The remainder will be due to decay which cannot be restored, except through major renovations, such as the deterioration of structural timbers. The former type of defect is called curable physical depreciation and the latter is called incurable physical depreciation, although the distinction between these two is at times hard to draw. To what degree the typical buyer of a house would discount his price because of the age of materials is, of course, only a matter for conjecture; and so far as is known, there is no evidence to support any particular theory because a controlled experiment of the kind indicated above has never been conducted. For the present, we can recognize what physical depreciation is and that the value of curable physical depreciation can be calculated (the cost of doing the work). But we can only speculate on the loss of market value attributable to incurable physical depreciation, even if it can be separately identified.

B. Functional Depreciation

For the purpose of describing what is meant by functional depreciation, a different fact pattern will be used. If the thirty-year old house is a bungalow with three bedrooms, let us imagine that there is constructed, on an adjoining lot of similar size and value, a modern bungalow providing similar accommodation. In the modern house, it is to be expected that the design will be different. This may result in some saving of space in halls, while extra space may be required elsewhere. However, the overall size is the same. If the market value of this modern house is compared with the thirty-year old house, the difference will be due entirely to functional depreciation. Home functional depreciation relates to the ability of the improvements to operate efficiently (by current standards).

In cases where functional depreciation is due to old-fashioned fixtures and fittings, the cost of replacing them can be ascertained. But outmoded floor plan or style is something which cannot be so remedied. Functional depreciation which can be remedied is labelled curable; the remainder is labelled incurable.

Table 2

Types of Depreciation



TYPES


EXAMPLE
1. Physical - Curable Painting, broken window
2. Physical - Incurable Structural decay
3. Functional - Curable Outdated bathroom fixtures
4. Functional - Incurable Outdated floor plan
5. Economic Obsolescence Undesirable neighbourhood change




C. Methods for Determining Depreciation

It is, of course, impossible to establish precisely the amount of depreciation in the manner described above because the market value of the subject property is not known. In practice, two methods for determining depreciation are used.(8) These include:

Age-life method; and

Observation method.

Each of these techniques will be discussed in more detail.

1. Age-life Method

It would be possible to adopt an age-life or accountancy approach and to assume that depreciation is in some way proportional to the age and life expectancy of the building. This is the easiest technique of estimating depreciation and it was the first method used. It should be emphasized that this age-life method is not based on market evidence. As shown in Exhibit 1, it is typically used to measure physical curable depreciation.

The age-life method uses an estimate of the effective age of a building and the concept of remaining "economic life." Effective age is the appraiser's estimate of the age of the structures having weighted the chronological age, the degree of maintenance, and the extent of modernization. There are costing services, such as the Marshall Valuation Service which provides recommended life expectancies for buildings by type of occupancy and class of contribution. For example, a building may have been built 25 years ago, but underwent extensive renovation 10 years ago. In this case the appraiser may decide that a reasonable effective age is closer to 10 rather than 25 years. The ratio of the effective age to the lifespan times the replacement cost (new) is a measure of depreciation. Note that the effective age may, or may not, equate to the actual or chronological age of the building since maintenance, design, etc., may increase or decrease the aging process. As an example, a house which is thirty years old (chronological) is to be appraised. The appraiser may determine the depreciation as follows:

Actual chronological age 30 years

Effective age (Appraiser's Estimate) 20 years (well maintained, some modernization)

Remaining economic life (Appraiser's Estimate) 25 Years

Life Span (Effective Age + Remaining Economic Life) 45 Years

Cost of replacement $98,000 (new)

Accumulated Depreciation = × New Cost of Replacement

= × $98,000

= $43,556

Note the appraiser considers the building to have depreciated by 20/45 or 44.4%.

If the appraiser estimates the vacant site to be worth $45,000, then the market value of the property using the cost method of valuation would be:

Site Value $ 45,000

+ Construction (New) 98,000

= Market Value if New 143,000

Accumulated Depreciation 43,556

= Estimated Market Value $ 99,444

This is a popular but not a sound concept for appraisal purposes although it is commonly used by accountants. It must be remembered that the accountant is not concerned with arriving at the market value of the asset which is being depreciated. He is merely writing off its historic cost. The reason that this basis is not sound is that the economic life of a building is an economic question rather than a physical one. It is impossible to predict with any semblance of accuracy when economic conditions will reach a point that it will be more profitable to demolish a building than to continue to maintain it.

There is an old saying which emphasizes the economic aspects of the life expectancy of buildings, namely, that more buildings are torn down than fall down. There are numerous examples of the fact that, given a sufficient financial incentive and barring natural calamities, buildings can be used indefinitely. Public and historic buildings are obvious examples but there are many others in the private sector of the market. Recently, much publicity has been given to restoration projects in the older cities of Canada in which old houses in residential sections near the city centre are being entirely remodelled and translated from the category of slum or near-slum property to the upper price bracket. Frequently, these houses are more than seventy years old at the time of remodelling, and in view of the expense involved it is apparent that the market expects them to have a continued existence at least equal to that of a newly constructed property. On the other hand, there are plenty of examples of buildings which are in very good physical condition and, perhaps of fairly recent construction, which are demolished to make way for some more remunerative project. Except insofar as physical condition affects current maintenance costs, the chronological age of a building has little to do with economic life.

2. Observed Depreciation Method

If accountancy methods of depreciation such as straight line, reducing balance or sum-of-the-digits methods(9) (see Appendix 1) are rejected, we are left with what is known as observed depreciation method. The basis of depreciation estimates using this method is simply the judgment and experience of the appraiser. It is not necessary to estimate the age or the life of the building except for the purpose of forming a basis for judgment. The method requires the cost of improvements to be calculated using the quantity survey method or unit-in-place (element cost) method. Each item is then depreciated by a percentage amount which, in the appraiser's judgment, represents the loss in value due to depreciation. In general, this will take care of the estimate for physical depreciation but will not include an allowance for functional depreciation. This must be calculated separately.

As a matter of technique, it is better to calculate curable depreciation separately, and to estimate incurable depreciation as a separate item. Curable physical depreciation (sometimes referred to as accrued maintenance) refers to defects of the structure which can be remedied and where the costs to remedy can be readily obtained. This includes broken fixtures and fittings, roof repairs or replacement, painting, decorating, plastering, repairing, and repairs or replacement of the plumbing system. The cost of such work can be reasonably estimated without difficulty. Curable functional depreciation comprises the cost of remodelling in order to eliminate obsolescence. This will include renovation of the kitchen and bathroom and the replacement of old-fashioned fixtures and fittings.

There is a risk of double-counting when making an estimate of curable functional depreciation. For example, a wash basin may be cracked and may also be old-fashioned. If the cost of replacing it is already included in the estimate of physical depreciation, it would be incorrect to allow for the effect of obsolescence in the functional depreciation estimate. It may also be incorrect to equate the loss of value due to obsolescence with the cost of the work required to eliminate it. For example, the cost of remodelling an old-fashioned kitchen might be $3,400 but this does not necessarily equal the loss in market value due to this factor.

Incurable physical depreciation is generally estimated as a percentage of new replacement cost such as using the age life technique. Incurable functional depreciation can only be a capital sum representing the appraiser's opinion. It might as well be stated plainly that estimates of incurable depreciation are guesses because, even if a controlled experiment could be made to measure depreciation, the result would combine curable and incurable depreciation as one item. In many cases, the result would not distinguish between physical and functional depreciation. Such experiments are impracticable and as there is no known method of obtaining depreciation estimates by market analysis, the appraiser is guessing when he makes his estimate of incurable depreciation.

Attempts are sometimes made to give the "guess" an aura of sophistication by relating the loss in value due to incurable functional depreciation to a loss in rental value and capitalizing this using a gross rent multiplier. Such a procedure raises more questions than it answers. First, in order to determine the loss in rental value, it would be necessary to know the rental value of the subject property as well as the rental value of a property or properties otherwise similar but not suffering from depreciation. Secondly, it would be necessary to know the appropriate gross rent multiplier. But if rental values and also multipliers (which can only be obtained from market analysis) are known, why bother with the cost method at all? The investment method of appraisal would be much sounder since it would eliminate the various chances of error in arriving at replacement cost.

The example below summarizes the application of the cost method in the valuation of an older building. A more detailed summary is illustrated in Exhibit 1.

Example: Summary of the Cost Method

Site Value (Market Value, vacant) $ 35,000

+ Cost of Improvement (Replacement, new)(10) $ 53,868

= Market Value (new) before depreciation $ 88,868

Curable physical depreciation(11) 920

Curable functional depreciation(12) 3,100

Incurable physical depreciation 23,941

Incurable functional depreciation(13) 0

Total Accumulated Depreciation $ 27,961

MARKET VALUE (Existing Property) $ 60,907


Exhibit 1

Sample Form for Cost Appraisal of a Single Detached House

Cost Approach to Value
- Use sq. ft. basis for all calculations.

House

Garage

Porch or Patio

Other Buildings

Extras

1100 sq. ft. at $45 per sq. ft. is

330 sq. ft. at $ 8 per sq. ft. is

288 sq. ft. at $ 6 per sq. ft. is

0 sq. ft. at $ 0 per sq. ft. is

0 sq. ft. at $ 0 per sq. ft. is

Total Gross Value

$49,500

$ 2,640

$ 1,728

$ 0

$ 0

$53,868

Depreciation
Physical Curable (needed repairs)

Paint Patio

Replace Shutters

Other



$ 520

$ 400

$ 0





$ 920
Physical Incurable

Actual Age

Effective Age

Estimated Remaining Economic Life

Life Span

× $53,868



22 years

20 years

25 years

45 years







$23,941
Total Physical

$24,861
Functional Curable (recommended improvements)

Replace Kitchen Cabinets

Other

Functional Incurable (none)

Total Functional



$ 3,000

$ 100





$ 3,100

$ 0

$ 3,100

Economic Incurable (if apparent, explain) (none)

Total Depreciation (all cases)

Depreciated Improvement Value

Land Value

Total Market Value

$ 0

$27,961

$25,907

$35,000

$60,907





IX. ECONOMIC OBSOLESCENCE

Economic obsolescence is the third type of depreciation and it is a loss in value caused by external influences, such as the intrusion of non-harmonious uses into the neighborhood of the subject property (e.g., the location of a factory opposite residential property). If the residential use cannot be converted to factory use, the market value is likely to depreciate. The depreciation will affect the market value of the site. But if, in the application of the cost method, site value has been determined by comparison with similar lots, some allowance, at least, has thus been made for economic obsolescence. It is sometimes suggested, however, that a deduction ought to be made from replacement cost in order to make allowance for the building's economic obsolescence.

Where the building still represents highest and best use, there is no logical ground for such a deduction since (by definition) the building represents the optimum development of the land. But in most cases where the surroundings of the property have changed, the improvements will have ceased to represent highest and best use. In these circumstances, the property will have development potential and the cost method is wholly inappropriate to the problem because it does not take into account alternative and more profitable development.

There is a further objection to the cost method in that the site value will have been determined by the comparative method and, if the sale prices of vacant lots have been used as evidence of value, these land prices will reflect the probability of highest and best use development whenever the owner considers the market to be ripe for such development.

However, the subject property may not present the same opportunity for such development. It is therefore likely to have a lower market value. The inability to estimate site value, when the property is not highest and best use, is an additional reason for rejecting the cost method. For these reasons, the calculation of economic obsolescence in the proper application of the cost method is irrelevant. This is just as well because there is no satisfactory way of checking the results of any such calculation against market experience. The method generally proposed is to capitalize an estimated loss of rent due to economic obsolescence, using an appropriate gross rent multiplier. This is similar to the means sometimes adopted to calculate incurable functional depreciation. The weakness of the procedure has already been discussed and it is not necessary to repeat the argument here.

While properties with redevelopment potential are under review, a word might be said about the problem of appreciation. Suppose the subject property is a single-family house on a lot large enough to provide a site for a small two-storey office building for which there is a demand. The zoning provisions have recently been changed to permit the erection of commercial buildings but new development is proceeding slowly because of unfavorable economic conditions which are expected to be of a temporary nature. If this house is valued by the cost method, the most extraordinary adjustments will have to be made in order to obtain an answer that makes any sense. If site value reflects the prospects of commercial development, and depreciation will have to amount to something approaching 100% - irrespective of the age of the building - and functional and economic obsolescence will have no meaning. If site value is based on residential development, then a most important item must be the addition of appreciation caused by the improved economic prospects.

X. THE COST APPROACH AND VALUE TO THE OWNER

There is something to be said for the cost method as a means of measuring value to the owner, at least if the property is a new one. If a man spends $30,000 on a lot and then erects a house at a cost of $55,000, the finished property is presumably worth at least $85,000 to him. He may not, of course, be able to sell the property for that amount - or he may get more - but $85,000 would be the minimum value to him (a position held in expropriation laws where compensation is based on value to the owner).

XI. THE COST APPROACH AND RENTAL APPRAISALS

Little need be said about rental appraisals because the cost method itself is not capable of being used to determine market value expressed as an income or rental flow. If necessary, the annual equivalent of capital amounts estimated by reference to cost can be calculated using the techniques of the investment method. But this represents an investment (or income) rather than a cost method of appraisal.

XII. SCOPE OF THE COST METHOD

Certain limitations of the cost method have already been indicated. But it is desirable to summarize the main flaws in the principles on which the method rests. There is the danger of equating cost and value. Equivalence between value and cost is not by any means universal in real estate markets. It can only be guaranteed when a property is new, represents highest and best use of the site and when the market is at or near a point of long run equilibrium. Costs are difficult to measure because they comprise several elements which cannot be readily identified by an appraiser. Similarly, there is no satisfactory method of measuring depreciation. Both of these weaknesses derive from the same cause, namely, that market transactions which provide the only reliable evidence of market value cannot be analyzed using the cost method. In areas where there is no possibility of building a substitute property because of the lack of available sites, it is unlikely that the cost method of estimating market value could be used because it is not representative of the way in which buyers and sellers are likely to arrive at their asking and bid prices.

It should also be apparent that the cost method is not relevant in the appraisal of a leasehold interest. Value, whether it be market value or value to the owner, is the sum of future expected returns. For the leaseholder, "future" is the unexpired term of the lease. Beyond this period, the property has no value to the tenant and the condition of the improvements at the end of the lease is immaterial. Replacement cost based on freehold ownership is therefore no guide to the value of a leasehold interest. For similar reasons, a freehold subject to lease cannot be valued using the cost method since the method does not distinguish between the returns under the existing lease (the contract) and the reversionary rights, these latter being prime parameters for the comparable approach.

Subject to one qualification, these remarks merely endorse Babcock's opinion expressed earlier, namely, that the cost method should be limited to cases in which the subject property is new and represents highest and best use development. The qualification is that if evidence of market value cannot be obtained from analysis of recent market transactions (using either the comparative and/or the investment methods), then the cost method may be used in the valuation of freehold interests in possession. In these cases, the appraiser should be careful not to be too dogmatic in asserting the accuracy of an appraisal made in this way.

So far as value to the owner is concerned, it is not necessary to add anything to the notes already given. With necessary changes, the remarks made about the application of the cost method in estimating market value apply equally in this context.

APPENDIX 1

METHODS OF DEPRECIATION

The straight line method of depreciation involves a fixed dollar amount of depreciation each year. For example if a building has an expected economic life of 40 years, the annual depreciation is 2.5%.

The reducing balance method (similar to capital cost allowance for income tax purposes) uses a fixed percent depreciation times the undepreciated balance. For example, a reducing (or declining) balance method of depreciation may provide for 5% depreciation. Each year the depreciation is calculated as 5% of the cost less the sum of all previously calculated depreciation.

The sum of the digits method of depreciation gives heavier depreciation in the early years. If a building has an expected economic life of 40 years, the sum of the digits is found as:

Sum of Digits = [40 + 39 + 38 + 37 + ... + 2 + 1]

This can be solved as: × 40 = 820

The annual depreciation is then found by taking the remaining economic life as a percent of the sum of the digits and multiplying by the cost. Hence in the first year the depreciation would be:

First year Depreciation × $Cost

If a building has a cost of $100,000 these three methods would result in the following annual depreciation:

Building Cost = $100,000

Expected Economic Life = 40 Years

Annual Depreciation
Year

1

10

20

40

Straight Line

$ 2,500

2,500

2,500

2,500

Declining 5% Balance

$5,000

3,151

1,887

676

Sum of Digits

$4,878

3,659

2,439

122



D = D = (100,000 - Prior Dep) × .05 = $100,000 ×

D = $100,000 × = $2,500

SELECTED REFERENCES

Standard Texts

R.U. Ratcliff, Valuation for Real Estate Decisions, Santa Cruz: Democrat Press, 1972, Chapter 5.

A.F. Ring, The Valuation of Real Estate, Englewood Cliffs: Prentice-Hall Inc., 1970, Chapters 12 and 13.

W.M. Shenkel, Modern Real Estate Appraisal, New York: McGraw Hill, 1978, Chapters 8 and 9.

P.F. Wendt, Real Estate Appraisal, New York: Henry Holt and Co., 1956, Chapter 8.

Articles

J.B. Corgel and H.C. Smith, "The Concept and Estimation of Economic Life in the Residential Appraisal Process: A Summary of Findings," The Real Estate Appraiser and Analyst, Winter 1982, pp 4-11.

M.J. Derbes, "Is the Cost Method Obsolete," The Appraisal Journal, Vol L. No. 4, October, 1982, pp 581-590.

J.L. Sackman, "The Limitations of The Cost Approach," The Appraisal Journal, 36, January 1968, pp 53-63.

1. 1 The cost method is sometimes called the summation method because the value is determined by taking the sum of the costs of the component parts.

2. 2 See, for example, P.F. Wendt, Real Estate Appraisal, New York: Henry Holt and Co., 1956, Chapter 8.

3. 3 F.M. Babcock, The Valuation of Real Estate, New York: McGraw-Hill, 1932, pp. 36, 40 and 477.

4. 4 R.U. Ratcliff, Valuation for Real Estate Decisions, Santa Cruz: Democrat Press, 1972, p.109.

5. 5 See, for example, J.L. Sackman, "The Limitations of the Cost Approach," Appraisal Journal, 36, January 1968, pp.53-63.

6. 6 Ratcliff, op cit., pp. 109.

7. 7 There are at least three building cost services available in Canada: The Dow-Cost Calculator; Boeckh Building Valuation Manual; and Marshall and Stevens Valuation Services. They all work on the same basis by providing unit cost information for bench mark structures at a given date and for specific locations. They also provide information for making individual cost adjustments.

8. 8 For a comprehensive discussion of methods, see W.M. Shenkel, Modern Real Estate Appraisal, New York: McGraw Hill, 1978, Chapters 8 and 9.

9. 9 F.M. Babcock, The Valuation of Real Estate, New York: McGraw Hill, 1932, pp.36, 40 and 447.

10. 10 Cost of improvements will include contractor's price + developer's overhead + developer's profit (except in the case of a residential property where the developer's profit and some part of the developer's overhead are excluded). The contractor's price may have to be adjusted for special features in the subject property. These costs represent replacement costs as of the date of valuation.

11. 11 Curable physical depreciation is the estimated cost of repairs immediately required (e.g. broken windows, painting).

12. 12 Curable functional depreciation is the cost of work not covered by curable physical depreciation, but which is needed to eradicate obsolescence (e.g. replace outmoded kitchen cabinets).

13. 13 The amount is a lump sum estimate based on the appraiser's experience.