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Cost Components of Real Estate Valuation

Instructor: Eileen Cappelloni

Eileen worked for the Orange County Asssociation of Realtors for 31 years. She has written real estate courses and exams for other publishing companies

This lesson will discuss the cost approach to valuation. We will learn the difference between direct and indirect costs, define entrepreneurial incentives and profits, and discuss replacement versus reproduction costs in the cost approach.

Methods Used to Estimate Property Value

Appraisers can implement different methods to estimate the value of a property. The income approach defines value as the present value of future expected cash flow on the property. The sales comparison approach compares the estimated value of the subject property with similar properties that have recently sold in the same area. The cost approach estimates the property value as the value of its components, which include the underlying land and the depreciated value of the improvements. The cost approach is a method that is not dependent on an active market for the type of property that is being considered.

Cost Approach in Appraisal

The cost approach or the cost-depreciation approach is defined as an approximation of the current cost of replacing or reproducing a building, subtracting an estimate for depreciation, and adding the value of the land. This method is also based on the principle of substitution, which simply means that no one will pay more for a current existing property than they would spend to purchase land and have a similar or a comparable improvement erected on that land. The value of the property in question may be estimated by using either reproduction or replacement cost.

The cost-depreciation approach is used mostly to estimate the value of newer properties or for insurance purposes. Sometimes, the cost-depreciation approach may be the only available approach to use to estimate the value of unique or historical properties.

Replacement vs Reproduction Costs

Replacement Cost

The replacement cost is often used to evaluate older buildings. An appraiser can estimate the costs of replacing the current structure with a similar building that has approximately the same utility and function as the subject building, but uses more modern materials and features. It is not necessary to have exact duplicate features or to use the same materials since many materials, particularly in some older buildings, may no longer be available.

Reproduction Cost

The reproduction cost is the approximate current cost it would take to construct an exact duplicate of the subject property by using the same materials, construction, design, and layout of the original property. Reproduction cost estimates are usually applied to historic properties where exact replicas of the subject property are desired.

Considerations

For example, an older building on a property needs to be replaced. Unless it is a historical building where care must be given to exactly duplicate the original, using modern materials and construction methods that look similar will be stronger and more weather resistant because of newer construction codes. However, if it is a historic property, it may be desired to utilize salvage or reproduction materials and techniques to exactly replicate the property and in order to keep its historic value.

Cost Considerations

In order to determine the approximate value of the property, an appraiser must consider both the direct costs and the indirect costs.

Direct costs are usually any costs directly associated with either updating an existing structure or constructing a new one and include the basic cost of labor and materials. Commissions, manufacturing supplies and direct labor and materials are all examples of direct costs.

Indirect cost components consist of financing costs, taxes and insurance during construction, architects' fees, engineering studies, filing for permits, advertising costs, brokerage fees, quality control costs, depreciation and builder profits.

If the appraiser only uses the direct costs in the construction cost estimate, the value conclusion will underestimate reproduction cost.

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