6 Common Misconceptions about the Cost Approach
Updated: Jan 31
Although appraisers and others often malign it as unreliable, the Cost Approach offers the appraiser a way to illustrate the factors at play when estimating market value. How do the "site value" and "contributory value of the improvements" combine to make up the property's overall value? Also, how do various forms of depreciation factor into the equation? After working through the Cost Approach, the appraiser may discover that certain assumptions made in the Sales Comparison Analysis should be questioned and even reconsidered. Properly developed, the Cost Approach may also provide the first indication of a "runaway" market or a "declining" market. A thorough understanding of the Cost Approach to Value and an easy way to process it are vital components in developing the final value conclusion for the subject property. The "key" to this equation is solid, verifiable replacement cost numbers.
THE COST APPROACH "RESULT" REPRESENTS REPLACEMENT COST:
The Cost Approach is a tool to help the appraiser estimate value. Don't believe it? Just read the bottom line of the cost approach on form 1004, "Indicated Value by Cost Approach." We have heard many appraisers indicate that they are just fine with the Cost Approach result being 30 or 40% higher than the result of the Sales Comparison Analysis. This isn't possible (with a few rare exceptions) in an adequately developed Cost Approach. It may not have been developed improperly, but it has just not been "completed." Usually, some form of depreciation has yet to be accounted for - and this is the point of the exercise; to recognize and account for all forms of depreciation.
UPGRADES AFFECT CONDITION, BUT NOT QUALITY:
Of course, upgrading or remodeling improves the condition; however, it can also significantly affect the quality of the improvements. The quality of improvements is based on the materials used to "finish" the interior and exterior as much as it is based on the quality of the "bones" of the structure. We have heard appraisers remark, "if it's in the same tract, it's the same quality." Of course, while most times this statement is true, many times it isn't - and it is certainly not a "given." Even UAD quality definitions reference the level of "upgrades" affecting the overall quality.
YOUR REPLACEMENT COST DATA PROVIDER CAN PROVIDE AN ESTIMATE OF DEPRECIATION:
Determining the amount of deprecation in the improvements is the appraiser's job as part of the appraisal process. Put simply, accrued depreciation is the difference between "cost" and "value," and no replacement cost data provider can determine the contributory value of improvements for you. Straight-line methods of estimating physical depreciation have consistently proven to be inaccurate, and what about functional or external depreciation?
SITE TO-VALUE RATIO MUST BE UNDER 30%:
The most frustrating thing we have heard recently is that some appraisers are increasing their Replacement Cost New (RCN) numbers to push their site value estimate below 30%. This is done in the [mistaken] belief that site value must be under 30% of appraised value. In most cases, clients require the appraiser to comment on high "site to value" ratios, and most appraisers make this a standard comment in areas where site values are typically greater than 30%. Lowering the site value to avoid making this comment (or raising it to avoid commenting on functional or external depreciation) is not only unacceptable appraisal practice but also a violation of USPAP.
FUNCTIONAL & EXTERNAL DEPRECIATION DO NOT AFFECT EFFECTIVE AGE OR REMAINING ECONOMIC LIFE:
This common misconception comes from the belief that "effective age" is a purely "physical" concept, and the Effective Age can be estimated by "observing" the improvements. While physical deterioration factors into Effective Age, it is not the whole equation, especially if functional or external obsolescence is present. The site value "is whatever it is," and improvements can only "contribute" value over and above the site value. So, what are the improvements contributing, in terms of value, relative to their cost? If it's 50%, then it's 50%, and your Effective Age is exactly ½ of your "total economic life." The question becomes, "what type of depreciation is the source of any loss in value from the Replacement Cost New" (physical, functional, or external)? And what is causing the loss in contributory value? If this sounds crazy and you say that external depreciation does NOT contribute to Effective Age, open ANY appraisal textbook ever written and research "effective age" - it will answer the question definitively. Are you stating an "Effective Age" in the body of the report that is inconsistent with the Effective Age indicated by your completed cost approach? Reviewers frequently recognize the inconsistency - do you?
· ESTIMATING REPLACEMENT COST NEW (RCN) REQUIRES THE APPRAISER TO ESTIMATE THE COST OF THE IMPROVEMENTS THAT CURRENTLY EXIST:
Estimating Replacement Cost New (RCN) in the Cost Approach does NOT require you to estimate the replacement cost of what currently exists (this is a common misconception). Instead, we are called on to calculate the cost of a market-suitable "replacement" (a structure having usefulness equivalent to the building being appraised but constructed with modern materials and according to current standards, building codes, layout, and design (on the Effective Date of Appraisal). For this reason, questions like "single or dual pane windows" (try building a house today with single pane windows) or "how many corners are there" are entirely unnecessary. This is because we are not estimating the cost of a "replica" but what it would cost to construct a new but "current" version of the subject improvements. When appraising SFRs, that means a new dwelling with equivalent utility (usefulness). If items increase costs significantly without contributing value, then we should eliminate them (or Reproduction Cost should be estimated - and then the items must be functionally depreciated). For the Effective Age of "new" improvements to be -0- there can be NO functional depreciation and, quite simply, no items that add significant cost without adding value.
Brian Mathews is a State Certified Appraiser. AQB Certified USPAP Instructor, Trainer, and Speaker. Click here for a schedule of live courses and events.
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