COST APPROACH

COST APPROACH

The Cost Approach views value as the combination of:

the value of the land as if vacant; and

the cost to reconstruct the appraised building as new on the date of value, less the accrued depreciation the
building suffers in comparison with a new building.

The principle of substitution applies: i.e., value tends to be set by the price of an equivalent substitute.

The total cost of the land as if vacant, plus the reconstruction cost new of the building with all direct and
indirect expenses and profit, and before deduction of depreciation, will tend to set the upper limit of value. In
this view, the cost new can be used as a benchmark for measuring the other approaches.

The Procedure in Brief

1. Estimate the value of the land as though vacant and available for development to its highest and best use.

2. Estimate the replacement or reproduction cost of the existing improvements as of the appraisal date.

3. Estimate the amount of accrued depreciation to the improvements from all causes (physical deterioration,
functional obsolescence, or external obsolescence).

4. Deduct the amount of the accrued depreciation from the replacement cost new to find the estimate of the
depreciated value of the improvements.

5. Add the estimated present depreciated value for the improvements to the value of the land. The result is an
indication of the value for the subject property.

Cost New Bases

The Cost Approach views the value of the building at its cost of reconstruction as new on date of value. There
are three bases of reconstruction cost as new:

1. Historic Cost indexed to Cost New;

2. Reproduction Cost New; and

3. Replacement Cost New. Each basis has value to a cost-as-new study, but terms should not be confused.

Historic cost indexed to cost new. Historic Cost is the actual cost of the building when originally constructed,
yesterday or fifty years ago. By use of price indices from building or engineering cost services, or from the
original building contractor, Historic Cost can be “indexed” to Cost New on date of value. Indexed Historic
Cost can be very useful if the building is fairly new and/or it is so unique that it is the only reliable value base.
The advantage of Indexed Historic Cost is the accuracy of employing actual building costs. The disadvantage is
that the older the costs are the less reliably they can be indexed. When considering Indexed Historic Costs, the
appraiser should be certain that historic costs were normal costs at time of construction and that historic costs,
as indexed, will accurately reflect Cost New on date of value in the then current dollars.

Reproduction cost new is the cost, on date of value, of constructing a replica of the appraised building. This is
a replica in actual design and materials. In this method, the cost-as-new estimate is made as if looking at plans
of an exact duplicate of the present building. The advantage of Reproduction Cost New is the greater accuracy
of duplicating the building in actual design and materials. The disadvantage is that advances in building
construction and methods, materials and design make cost estimates of obsolete building construction very
difficult and wildly distorted for materials no longer reasonably available or requiring large amounts of hand
labor. Reproduction Cost New is most useful for study of refined methods of depreciation, unique construction,
and occasional legal requirements for court testimony.

Replacement cost new views the building as if reconstructed with modern methods, design and materials that
would most closely replace the use of the appraised building but provide the same utility. For example, an older
brick warehouse would be constructed today with concrete block or tilt-up cast slab construction. The advantage
of Replacement Cost New is the ready availability of accurate current costs, and a better understanding by all
parties of modern methods, design and materials. The disadvantage is the subjective decisions of proper current
replacement materials and design for older construction. In actual practice, the Replacement Cost New is the
most frequently used Cost Approach base.

Steps in the Cost Approach

A. An estimate is made as to the land’s current market value, assumed vacant and available for improvement
to its highest and best use. Land value is usually based on a market approach utilizing comparable market
data of similar sites in the area.

B. An estimate is made of the cost new of reconstructing the buildings and other improvements.

1. The appraiser selects the proper cost new base:

a. Historic Cost of appraised building indexed to cost new on date of value.

b. Reproduction Cost of duplicating the replica of the appraised building using original materials and
design on date of value.

c. Replacement Cost of replacing the use and utility of the appraised building using modern
materials, methods, and design on date of value.

2. The appraiser completes property inspection, description, measurement, inventory, and plot plan of
appraised building improvements and equipment, with notes regarding type, style, quality, and
condition of building materials, workmanship and condition.

3. The appraiser selects appropriate method of cost new estimating.

a. The Square-Foot Method is the most common method used by appraisers on the West Coast to
estimate the cost of construction. The property being appraised is compared with similar structures
where costs are known, and which have been reduced to units per square foot of floor area.
Standard type buildings whose costs are known are broken down to a cost per square foot of floor
area. The building being appraised is compared with the most comparable standard building and
its cost per square foot is used for the subject property. Adjustments must be made for size of
building, and various exterior and interior features. Though adjustments cannot be made for many
variables, this method, in most instances, is accurate enough for the real estate appraiser. The
square-foot method can be used and applied faster than any other estimate.

b. The Cubic-Foot Method is similar to the square-foot method, except the cubic contents of
buildings are compared instead of the square footage of the floor area. This method is most
popular in the Eastern United States. If used properly, it is more accurate than the square foot
method, since the height as well as area of the building is taken into consideration. This method is
most often used for industrial or warehouse buildings.

c. The Quantity Survey Method involves a detailed estimate of all labor and materials for each
component of the building. Items such as overhead, insurance, and contractor’s profit must be
added to direct costs. This is a very accurate but time-consuming method to arrive at costs.
Because of the detail and time required, this method is seldom used, except by building contractors
and professional cost estimators.

d. The Unit-in-Place Cost Method entails calculation of the cost of units of the building as installed.
The total costs of walls in place, heating units, roof, etc. are obtained on a square foot basis,
including labor, overhead, and profit. This is a detailed, accurate method generally used for
checking on new construction units. It is seldom used by appraisers because specialized
knowledge is necessary to gather all elements of unit costs.

4. The appraiser investigates cost sources and estimates cost-as-new of all buildings and improvements.
Costs must be measured accurately. They are classified as direct (hard) costs and indirect (soft) costs.
Indirect costs are usually associated with the administration of the project while direct costs are
expenditures for labor, equipment and materials, overhead and profit.

a. Cost sources:

(l) Costs of comparable buildings under construction.

(2) Owners, builders, and/or contractors of comparable buildings.

(3) The contractor of original building, if available.

(4) Published cost services (handbooks or computerized services providing current
comprehensive cost data, by local areas and general construction types).

(5) Professional cost estimators.

b. The appraiser completes the cost estimate to include all:

(l) Direct expenses of construction such as labor, materials and equipment and engineering for
the building, site preparation, street and utility work, landscaping, etc.

(2) Indirect expenses such as legal, title, appraisal and feasibility study fees, licenses, permits, ad
valorem taxes during construction, demolition and removal costs, inspections, insurance
during construction, financing charges, accounting, etc.

(3) Developers’ overhead, supervision, and profit; for planning, construction, and sale of the
project to “turnkey” condition (that is, completely ready for a new purchaser/occupant) and
selling costs.

C. The appraiser estimates the accrued depreciation and deducts from cost-as-new estimate. This amount must
be deducted from the cost-as-new to determine the present value of the improvements. The difficulties of
correctly estimating depreciation tend to increase with the age of the improvement. Experience and good
judgment are among the necessary qualifications for making a realistic estimate of proper depreciation.
There is no justification in assuming that improvements necessarily depreciate at a rate corresponding to
their age.

D. The appraiser adds the land value to depreciated value of improvements for indicated value by Cost
Approach.