Cost Adjustment: Methods and Depreciation

Chapter: Cost Adjustment: Methods and Depreciation

Introduction

This chapter delves into the crucial aspects of cost adjustment and depreciation within the context of real estate appraisal. Understanding these concepts is paramount for accurately estimating property value using the cost approach. We will explore various methods for determining reproduction or replacement costs, and then comprehensively analyze depreciation, its types, and methodologies for its calculation.

I. Cost Estimation Methods

The cost approach to value hinges on accurately estimating the cost to either reproduce or replace an existing structure. Several methods are employed, each with varying levels of detail and complexity.

A. Comparative Unit Method (Square Foot Method)

This is a common and relatively simple method for estimating construction costs, particularly for residential properties.

• Principle: It relies on the average cost per square foot of similar new buildings.

• Calculation:

  1. Determine the square footage of the subject property (living area, garage, etc.).
  2. Identify appropriate unit costs ($ per square foot) for each component.
  3. Multiply the square footage of each component by its corresponding unit cost.
  4. Sum the costs of all components to arrive at the total building cost.
  5. Add the estimated value of site improvements (driveway, landscaping).
  6. Consider adding entrepreneurial profit.

  Formula:

  Total Cost = ∑ (Area_i * Unit Cost_i) + Site Improvements + Entrepreneurial Profit

  where:

  • Area_i is the area of the i-th component (e.g., living area, garage).
  • Unit Cost_i is the unit cost per square foot of the i-th component.

Example:

As given in the file content,
Living area is 1280 square feet at $60 per square foot
Garage is 576 square feet at $25 per square foot.
Site improvements cost $8,500.

Cost of living area = 1280 sq. ft. x $60/sq. ft. = $76,800

Cost of garage = 576 sq. ft. x $25/sq. ft. = $14,400

Total cost of building = $76,800 + $14,400 = $91,200

Total cost of improvements = $91,200 + $8,500 = $99,700

• Unit Cost Derivation:

  1. Market Analysis: Gather sales data of comparable new homes. Subtract the site value from the sales price and divide the result by the square footage. This yields a unit cost.
  2. Cost Estimating Manuals/Services: Utilize published cost manuals (Boeckh, Marshall & Swift, R.S. Means) for average unit costs.

Example from File Content (Market Analysis Method):

A new 1,500 sq ft rambler sold for $120,000. Site value is estimated at $30,000.

Building value = $120,000 - $30,000 = $90,000

Unit Cost = $90,000 / 1,500 sq ft = $60 per sq ft

• Adjustments:

  • Construction features (quality of materials, finishes).
  • Size and shape (unit costs are generally higher for smaller buildings).
  • Time (adjust for changes in construction costs over time).
  • Location (regional cost variations).
  • Entrepreneurial Profit (adjust if the cost manual does not account for it).

B. Unit-in-Place Method

This method is more detailed than the square foot method and focuses on the cost of installing individual building components.

• Principle: It involves estimating the cost of each major component (foundation, walls, roof, etc.) separately and then summing the costs.

• Calculation:

  1. Identify the major building components.
  2. Measure the quantities of each component (e.g., square feet of flooring, linear feet of walls).
  3. Determine the unit cost for each component (including materials, labor, equipment, and overhead).
  4. Multiply the quantity of each component by its unit cost.
  5. Sum the costs of all components to obtain the total building cost.

  Formula:

  Total Cost = ∑ (Quantity_i * Unit Cost_i)

  where:

  • Quantity_i is the quantity of the i-th component.
  • Unit Cost_i is the unit cost per unit of quantity of the i-th component.

Example:

5,000 sq. ft. of flooring @ $7 = $35,000

300 linear ft. of walls @ $200 = $60,000

And so on, for each component.

• Considerations:

  • Ensure consistent units of measurement (linear feet vs. square feet).
  • Adjust for differences in time and location.
  • Account for any indirect costs or entrepreneurial profit not included in the unit costs.

C. Quantity Survey Method❓❓

This is the most detailed and accurate cost estimation method, commonly used by contractors and builders.

• Principle: It involves a comprehensive breakdown of all costs, including labor, materials, equipment, and overhead, for each construction component.

• Calculation:

  1. Identify all materials and labor required for each component.
  2. Estimate the quantity of each material (e.g., board feet of lumber, square feet of sheathing).
  3. Determine the unit cost for each material and labor item.
  4. Multiply the quantity of each item by its unit cost.
  5. Sum the costs of all items, including equipment and overhead, to obtain the total building cost.

Example:

Exterior Wall Framing (Quantity Survey Method):

*   Framing Lumber: x board feet @ $y/board foot = $z
*   Sheathing: a square feet @ $b/square foot = $c
*   Carpentry Labor: d hours @ $e/hour = $f
*   Scaffolding: Rental cost = $g
*   Total exterior wall framing cost: $z + $c + $f + $g

• Process:

  • Specialty subcontractors typically prepare estimates for their respective sections (foundation, plumbing, electrical, carpentry).
  • The general contractor combines the sub-estimates into a total cost estimate.

D. Cost Index Trending

This method is used to estimate the current reproduction cost of a building based on its original construction cost and changes in construction cost indices.

• Principle: Construction cost indices track the relative changes in construction costs over time.

• Calculation:

  1. Determine the original construction cost.
  2. Identify the construction cost index value at the time of construction.
  3. Identify the current construction cost index value.
  4. Divide the current index value by the original index value.
  5. Multiply the result by the original cost to estimate the current cost.

  Formula:

  Current Cost = Original Cost * (Current Index / Original Index)

Example from File Content:

A house was built in 1980 for $100,000. Index was 150 in 1980 and is currently 200.

Current Cost = $100,000 * (200/150) = $133,000

• Limitations: This method is generally considered less reliable than other cost estimation methods, as it assumes that the original construction cost was typical for similar buildings at that time.

II. Depreciation: Concepts and Terminology

Depreciation is the loss in value of an improvement compared to its cost, due to any reason. It is the difference between the market value of the improvement and its cost.

A. Key Definitions

• Accrued Depreciation: The total depreciation that has occurred between the time the improvement was built and the effective date of the appraisal.

• Actual Age: The chronological age of the improvement.

• Effective Age: The apparent age of the improvement based on its condition and marketability. It can be the same as, greater than, or less than the actual age.

• Economic Life: The period during which the improvement contributes to the value of the property.

• Physical Life: The total expected lifespan of the improvement with normal maintenance.

• Remaining Economic Life: The time remaining from the effective date of the appraisal until the end of the improvement’s economic life.

Formula relationships:

• Economic Life = Effective Age + Remaining Economic Life
• Effective Age = Economic Life - Remaining Economic Life
• Remaining Economic Life = Economic Life - Effective Age

III. Types of Depreciation

Depreciation is categorized into three main types based on the cause of the value loss.

A. Physical Deterioration

This is depreciation caused by wear and tear, damage, or the aging of physical components.

• Curable Physical Deterioration: The cost to correct the deterioration is less than the resulting increase in value. (e.g., repainting).

• Incurable Physical Deterioration: The cost to correct the deterioration exceeds the resulting increase in value. (e.g., cracked foundation repair).

• Long-Lived Items: Components expected to last the entire economic life of the building (e.g., foundation).

• Short-Lived Items: Components that require replacement during the economic life of the building (e.g., carpeting, paint).

B. functional obsolescence❓❓

This is depreciation caused by design defects, outdated features, or inefficiencies within the improvement.

• Curable Functional Obsolescence: The cost to correct the defect is less than the resulting increase in value. (e.g., inadequate insulation).
• Incurable Functional Obsolescence: The cost to correct the defect exceeds the resulting increase in value. (e.g., substandard ceiling height).
• Deficiencies: Design flaws that negatively impact value (e.g., lack of closet space).
• Superadequacies: Over-improvements whose costs exceed their contribution to value (e.g., overly expensive wall framing).

C. External (Economic) Obsolescence

This is depreciation caused by factors external to the property, such as negative influences from surrounding properties or poor local economic conditions. (e.g., location near an industrial area, economic downturn). External obsolescence is generally considered incurable.

IV. Methods of Estimating Depreciation

Accurately estimating depreciation is a challenging aspect of the cost approach. Different methods exist, each with its own assumptions and data requirements.

A. Economic Age-Life Method (Straight-Line Method)

This method assumes that an improvement loses value at a constant rate throughout its economic life.

• Calculation:

  1. Estimate the effective age and economic life of the improvement.
  2. Calculate the accrued depreciation rate: Accrued Depreciation Rate = Effective Age / Economic Life
  3. Multiply the accrued depreciation rate by the cost to determine the amount of depreciation: Depreciation = Accrued Depreciation Rate * Cost
  4. Calculate the depreciated value: Depreciated Value = Cost - Depreciation

Example:

Reproduction cost: $220,000

Economic life: 60 years

Effective age: 15 years

Accrued Depreciation Rate = 15/60 = 0.25 (25%)

Depreciation = 0.25 * $220,000 = $55,000

Depreciated Value = $220,000 - $55,000 = $165,000

Variations:

A variation of this method involves deducting the cost to cure curable physical deterioration and functional obsolescence from the total cost before applying the age-life calculation. This is based on the rationale that curable items should be valued at their cost to cure.

B. Sales Comparison Method

This method uses market data to determine the amount of depreciation.

• Principle: Comparing the sales prices of properties with and without a specific defect reveals the value loss associated with that defect.

• Process:

  1. Identify comparable properties with the same defect.
  2. Identify comparable properties without the defect.
  3. Calculate the difference in sales prices between the two groups. This difference represents the depreciation caused by the defect.

Example:

Houses with a poor floor plan sell for $110,000. Similar houses with a functional floor plan sell for $120,000.

Depreciation due to poor floor plan = $120,000 - $110,000 = $10,000

C. Capitalization Method❓❓

Similar to the sales comparison method, this approach uses income data to estimate depreciation.

• Principle: The difference in income between properties with and without a specific defect is capitalized to determine the value loss.

• Process:

  1. Identify comparable rental properties with the same defect.
  2. Identify comparable rental properties without the defect.
  3. Calculate the difference in rental income between the two groups.
  4. Capitalize the income difference using an appropriate capitalization rate. This yields the amount of depreciation.

Example:

Properties near a busy airport rent for $800/month. Similar properties in better locations rent for $900/month. Capitalization rate is 8%.

Annual income difference = ($900 - $800) * 12 = $1,200

Depreciation = $1,200 / 0.08 = $15,000

D. Cost to Cure Method

This method values curable depreciation based on the cost to remedy the defect.

• Principle: The amount of depreciation due to curable physical deterioration or functional obsolescence is equal to the cost to cure the defect.

Example:

Worn-out carpets: The depreciation is equal to the cost of replacing the carpets.

E. Observed Condition Method (Breakdown Method)

This comprehensive method involves estimating each type of depreciation (physical, functional, and external) separately, using a combination of the other methods described above.

V. Uniform Residential Appraisal Report (URAR)

The URAR provides a structured format for reporting the cost approach findings, including sections for:

• Estimated Site Value
• Estimated Reproduction or Replacement Cost New
• Depreciated Cost of Improvements
• “As-is” Value of Site Improvements

The URAR includes fields for comments regarding the source of cost estimates, site valuation, square footage calculations, and remaining economic life.

Conclusion

Accurate cost estimation and depreciation analysis are vital components of the cost approach to value. Choosing the appropriate cost estimation method, understanding the different types of depreciation, and applying sound depreciation estimation techniques are essential skills for real estate appraisers. While the cost approach may not always be the most reliable indicator of value, it provides a valuable check and balance to other appraisal methods, particularly in situations where market data is scarce or unreliable.