Basic steps in the cost approach are:
- Estimate the value of the land as if vacant
- Estimate the replacement cost new of the improvements
- Estimate the loss in value from all forms of depreciation
- Deduct the total amount of depreciation from the replacement cost new
- Estimate the same amount for any other improvements
- Add the land value estimate to the depreciated cost value to arrive at the total property value
Step One, land valuation, may involve any of the methods already mentioned (allocation, abstraction, etc.).
Step Two, estimating the replacement cost new of the improvements, requires that a distinction be made between replacement cost and reproduction cost.
Replacement Cost vs. Reproduction Cost
Replacement cost is defined as: the cost and overhead that would be incurred in constructing an improvement having the same utility as the original, without necessarily reproducing exactly the same characteristics of the property, but using today's materials, labor, and building techniques. In other words, replacement cost represents the cost to create an equally desirable substitute property
Reproduction cost is defined as: the cost, including material, labor, and overhead, that would be incurred in constructing an improvement having exactly the same characteristics as the original improvement.
Reproduction cost is sometimes difficult to measure because the same building materials or methods are not available. Reproduction cost for an older building with 12-foot ceilings, working fireplaces in every room (as opposed to modern central heating systems), and elaborate trim would be computed on the basis of creating an identical structure today. The reproduction costs of these types of physical characteristics in older structures often tends to create an element of depreciation (value loss) identified as functional obsolescence. This is illustrated using the principle of substitution, which states that in a competitive market, a buyer will typically not pay more for a particular property than the amount to acquire a similar property with comparable utility (a satisfactory substitution). Thus, reproduction cost may often require adjustments for construction techniques, building materials and various forms of depreciation to be indicative of current market value.
The Replacement cost rather than Reproduction cost is used as the basis for the cost approach in most appraisal situations where cost is considered an appropriate measurement of value. Replacement Cost New is generally applicable to most classes of property and leads to a greater degree of uniformity and equity in assessed values.
There are several methods used to arrive at a cost value: the quantity survey method, the unit-in-place method, and the square foot method.
The quantity survey method requires that the appraiser create a detailed inventory of every item of material, equipment, labor, overhead, and fees involved in the construction of a property. This method is not routinely used by appraisers because it is extremely time-consuming.
The unit-in-place method is less detailed than the quantity survey method, but still reasonably accurate and complete. This method combines direct and indirect costs into a single cost for a building component (the unit-in-place) which is then multiplied by the area of the portion of the building being valued to arrive at a total cost for that component. This is the method used in the Construction Cost Manual prescribed by the Arizona Department of Revenue, for many building components. These allow the appraiser to make adjustments for individual components for various types of structures.
The square foot method combines all the costs for a particular type and quality of structure into one value as a cost per square foot (or cubic foot). This method produces a value based on the floor area of the structure. The cubic foot method is used when the wall height varies within a building class, such as warehouses or factories. Generally the square foot or cubic foot methods are not considered sufficiently accurate compared to the first two methods for estimating cost.
Once replacement cost new (RCN) has been calculated, depreciation must be estimated in order to arrive at a current value (unless an improvement is new, some depreciation exists). Depreciation is defined as a loss in value due to any cause. Land does not depreciate, only Improvements. Land may suffer value loss, but not due to depreciation. Depreciation is divided into two types: physical deterioration and obsolescence.
Physical deterioration, as the name implies, is a loss in value due to normal aging and deterioration. It can be subdivided into four types:
- Wear and tear from normal use
- Negligent care or lack of maintenance
- Damage from dry rot, pests, etc.
- Wear and tear from the elements (wind, rain, etc.)
Obsolescence is further divided into two subgroups: functional obsolescence and economic obsolescence.
Functional obsolescence is a loss in value to the improvements due to certain existing physical characteristics, and can be divided into four types:
- Poor design or style; inefficient floor plan; excessive ceiling height
- Lack of modern facilities
- Out-of-date equipment
- Superadequacy (over-improvement), or inadequacy (under-improvement)
Economic obsolescence is caused by conditions outside the property such as economic changes, legal restrictions, development of new processes, etc. It may divided into five types:
- Proximity to negative environmental influences
- Zoning restrictions
- Adverse influences of supply and demand
- Changes in neighborhood social or economic factors
- Changes in locational demands
Curable or Incurable Depreciation
Regardless of the type of depreciation, it can be classified as either curable or incurable. Loss in value due to physical causes can usually be controlled by proper care, usage, or maintenance. Losses due to functional obsolescence are less likely to be curable. Losses in value due to economic obsolescence are rarely curable. For depreciation that can be cured, the cost to cure may be so high that it prohibits the restoration of the property. All of these factors must be taken into consideration when arriving at replacement cost new less depreciation (RCNLD).
In the tables in the Department's Construction Cost Manual, depreciation rates reflect only physical factors affecting the value of structures. These tables are developed by market analysis, and assume that normal maintenance will be performed. The rate of physical depreciation is calculated based on the age of the structure and the quality of the construction. When the overall quality of an improvement is low, normal physical deterioration is more rapid than for fair or good construction.
Normal physical deterioration is calculated according to actual age. Other factors are computed as they arise in individual structures. If a structure has a serious physical defect, the appraiser will first estimate the RCN, and then compute the cost to cure the physical defect (if curable) and then deduct that amount from the RCN to arrive at RCNLD.
In ad valorem appraisal, deferred maintenance is not normally included in a valuation consideration. This would have the effect of punishing property owners who kept a property in good condition and rewarding those who let properties rundown. Special obsolescence factors may be noted and taken into consideration, but the aim is to achieve equity, so that owners of similar properties bear an equal share of the tax burden, regardless of whether they perform regular maintenance.
Maintenance should not be confused with remodeling or rebuilding. In some cases special obsolescence due to economic factors will affect an entire group of properties such as a town or a market area. This loss should be documented and applied equally to all properties in the community affected by the obsolescence.
In situations where modernization has occurred during the life of a structure, the appraiser must estimate the RCN of each type of structure and compute the effective age and/or the weighted age.
The effective age is calculated by taking the percentage of the remodeling or modernization in relation to the whole. For example:
50% of the total structure of a house is 40 years old, 20% is 20 years old, and 30% of the structure is 5 years old.
0.50 × 40 = 20.0
0.20 × 20 = 4.0
0.30 × 5 = 1.5
20.0 + 4.0 + 1.5 = 25.5
The effective age of the structure is 25.5 years.
The weighted age differs from the effective age in that it is used when an improvement has two or more "segments", each with a different construction date (as opposed to modernization or remodeling). The age is weighted according to the percentage attributable to each construction date. This approach may be used when the quality of construction is the same for both the original building and the addition(s). For example:
A 10,000-square-foot building was constructed in 1977. An addition built in 1987 is of equal quality. The addition is 2,000 square feet. The total square footage is therefore 12,000.
10,000 ÷ 12,000 = 0.833, or 83.3% is original improvement
2,000 ÷ 12,000 = 0.167, or 16.7% is original improvement
0.833 × 1977 = 1,646.84
0.167 × 1987 = 331.83
1,646.84 + 331.83 = 1,978.67
The weighted age of the building is 1,978.67, rounded to 1979. If an improvement has both remodeling and additions of differing ages, the effective age of the modernized portions is calculated first, then a weighted age of the entire improvement is calculated.