Real Estate Appraisal: Cost and Income Approaches to Value

Estimating Replacement Cost

The replacement cost of a building can be estimated using three primary methods:

1. Square Foot Method

2. Unit-in-Place Method

3. Quantity Survey Method

Square Foot Method

• Simplest method for estimating replacement cost.

• Also known as the comparative cost method or comparative unit method.

• Process:

  • Appraiser analyzes the average cost per square foot of construction for recently built comparable homes.

  • The number of square feet in the subject home is determined by measuring the outside dimensions of each floor.

  • The appraiser then multiplies the estimated cost per square foot by the total number of square feet in the subject property to calculate the replacement cost of improvements.

• Example:

  • Subject property: Two-story house with a wooden exterior, containing $2,600$ square feet.

  • Estimated cost per square foot (based on comparable homes): $202.35$

  • Calculation: $\$202.35 \times 2,600 = \$526,110$

    • This results in an estimated cost of replacing improvements of $\$526,110$.

• Caveats:

  • A comparable structure (or "benchmark" building) is unlikely to be exactly the same as the subject property.

  • Variations in design, shape, and construction grade can moderately or substantially affect the square-foot cost.

  • If recently built comparable homes are not available, the appraiser may rely on current cost manuals to estimate basic construction costs.

Unit-in-Place Method

• Involves estimating the cost of replacing specific components of the building, such as floors, roofs, plumbing, and foundations.

• Costs are determined from cost manuals.

• Examples of component estimates:

  • A certain number of dollars per one hundred square feet of roofing.

  • A certain amount per cubic yard of concrete for an installed foundation.

• The appraiser adds all these individual component estimates together to determine the total replacement cost of the structure.

Quantity Survey Method

• Involves a detailed estimate of the quantities and prices of all construction materials and labor required.

• These direct costs are then added to indirect costs (e.g., building permit, survey).

• Generally regarded as the most accurate replacement cost estimate.

• Complexity: It is complex and time-consuming.

• Usage: Typically used only by experienced contractors and price estimators due to its complexity.

Cost Approach Fundamentals

• The overall cost approach to value calculates the value of the subject property as follows:
  $\text{Replacement cost of improvements} - \text{Depreciation of improvements} + \text{Value of land} = \text{Value of subject property}$

Estimating Depreciation

Definition and Purpose

• When appraising a used home, it is presumed to be less valuable than a comparable new home; it has depreciated in value.

• After estimating replacement cost (which indicates what improvements would be worth if new), the next step is to estimate depreciation.

• Depreciation is defined as a loss in value due to any cause.

Appraiser vs. Accountant Depreciation

• Accountants: Concerned with book depreciation for tax or budgeting purposes.

• Appraisers: Concerned with actual losses in the value of real property.

Land and Depreciation

• Land does not deteriorate or become outmoded in design, so its value is not adjusted for depreciation.

• Only the value of the improvements is adjusted for depreciation.

Types of Depreciation

Value can be lost due to three types of depreciation:

1. Physical Deterioration

   • Definition: A loss in value due to wear and tear or damage.

   • Visibility: Easier to spot and estimate its impact on value compared to other types.

   • Curable: Depreciation is considered curable if the cost of correcting it could be recovered in the sales price when the property is sold.

   • Incurable: Depreciation is considered incurable if it's impossible to correct, or if the cost to correct it would be impractical (exceed the value added).

   • Curable physical deterioration is often referred to as deferred maintenance.

2. Functional Obsolescence

   • Definition: A loss in value due to functional inadequacies, often caused by age or poor design.

   • Examples:

     • Inconvenient floor plan (e.g., a bedroom opening directly off the living room).

     • Unappealing design elements (e.g., massive cornices on the building exterior).

     • Outdated fixtures (e.g., an old stove with no dishwasher).

     • Too few bathrooms in relation to the number of bedrooms (e.g., a four-bedroom house with only one bath).

   • Functional Utility: Whenever a building lacks functional utility, functional obsolescence results. A building's functional utility is its ability to fulfill the desires of its occupants or users, encompassing both attractiveness and actual usefulness.

   • Curable or Incurable: Like physical deterioration, functional obsolescence may be curable or incurable.

3. External Obsolescence

   • Definition: Caused by conditions outside the property itself.

   • Examples:

     • Adverse zoning changes.

     • Traffic problems.

     • Exposure to nuisances (e.g., noise from airport flight patterns).

     • Neighborhood deterioration.

     • Poor access to downtown or employment centers (this specific type may also be referred to as economic obsolescence).

   • Appraiser's Role: Identifying external obsolescence is the primary purpose of an appraiser's neighborhood analysis.

   • Nature: It is beyond a property owner's control, making it virtually always incurable.

• General Note: More value is typically lost due to functional and external obsolescence than to physical deterioration.

Methods of Estimating Depreciation

• Accurately estimating accrued depreciation is the most difficult phase of the replacement cost approach.

• Depreciation estimates are highly subjective and rely heavily on the appraiser's judgment and skill.

• Methods are divided into indirect and direct.

Indirect Methods

1. Capitalization Method

   • Appraiser uses the income approach to value (explained later) to estimate the current value of the building.

   • This current value is called the capitalized value.

   • The capitalized value should be lower than the replacement cost estimate (as replacement cost assumes a new building).

   • Depreciation Calculation: The difference between the replacement cost and the capitalized value is the amount of accrued depreciation.

   • Example:

     • Replacement cost: $\$700,000$

     • Capitalized value: $\$610,000$

     • Depreciation: $\$700,000 - \$610,000 = \$90,000$

2. Market Data Method

   • Appraiser uses the market data (sales comparison) approach to estimate the current value of the building.

   • Depreciation Calculation: This estimated value is subtracted from the replacement cost estimate, and the difference is the depreciation.

Direct Methods

1. Straight-Line Method (Age-Life Method)

   • The easiest method to apply.

   • Useful life (economic life): The appraiser estimates the expected productive life of the building if it were new.

   • Annual Depreciation: Calculated by dividing the building's replacement cost by its estimated useful life.
     $\text{Annual Depreciation} = \frac{\text{Replacement Cost}}{\text{Useful Life (in years)}}$

   • Total Depreciation: The annual depreciation amount is then multiplied by the building's effective age.

   • Effective Age vs. Chronological Age:

     • Appraisers are concerned with a building's effective age, not its actual chronological age.

     • Effective age depends on how long the appraiser believes the structure will remain productive in its present use.

     • Example: A 75-year-old building might have an effective age of 7 years if it has 33 productive years ahead and similar buildings generally have a 40-year useful life ($40 - 33 = 7$ years effective age).

     • A building's physical life is typically longer than its useful life (hence the axiom: "More buildings are torn down than fall down").

   • Example Calculation:

     • Replacement cost: $\$800,000$

     • Expected useful life: $40$ years

     • Annual Depreciation: $\$800,000 \div 40 \text{ years} = \$20,000 \text{ per year}$

     • Assume remaining useful life: $33$ years

     • Effective Age: $40 \text{ years (useful life)} - 33 \text{ years (remaining useful life)} = 7 \text{ years}$

     • Estimated Depreciation: $\$20,000 \text{ (annual depreciation)} \times 7 \text{ (effective age)} = \$140,000$

     • Depreciated Value of Building: $\$800,000 - \$140,000 = \$660,000$

   • Percentage Expression: Straight-line depreciation can also be expressed as a percentage.

     • $\frac{100\%}{\text{Useful Life (in years)}} = \text{Percentage loss per year}$

     • Example: $100\% \div 40 \text{ years} = 2.5\% \text{ per year}$

   • This method is called the age-life method because it bases depreciation on effective age relative to typical economic life.

2. Engineering Method (Observed Condition Method)

   • Requires the appraiser to inspect the structure and make observations about actual depreciation.

   • Conclusions are largely a matter of the appraiser's judgment and skill.

   • Generally considered the most reliable method for estimating depreciation.

Adding Land Value

• The final step in the replacement cost process (cost approach) is to add the value of the land to the depreciated value of the improvements.

• The value of the land is estimated primarily by the sales comparison method.

• Prices recently paid for lots similar to the subject lot are compared to determine the subject lot's worth.

Income Approach to Value

• The third major method of appraisal, also known as the capitalization method.

• Foundation: Based on the relationship between the income a property generates (its productivity) and its market value to an investor.

• Objective: Seeks to determine the present value of a property's future income.

Gross Income

• Economic Rent: The rent the property would command if it were presently available for lease on the open market.

• Contract Rent (or Historical Rent): The rent the property is actually earning now.

  • A pattern of rent increases or decreases in contract rent can indicate if it's above or below economic rent.

  • Rental rates of comparable buildings are valuable indicators.

• Potential Gross Income (PGI) / Gross Scheduled Income:

  • The property's economic rent, representing what it could earn if it were fully occupied and all rents owed were collected.

• Vacancy Factor:

  • A deduction from potential gross income to account for occasional vacancies and unpaid rents (it's unrealistic to expect full occupancy).

  • Expressed as a percentage of the potential gross income (e.g., deducting $5\%$).

• Effective Gross Income (EGI):

  • The more reliable income figure remaining after the vacancy factor is deducted from the potential gross income.

Operating Expenses

• Deducted from the Effective Gross Income.

• Fall into three classifications:

  1. Fixed Expenses:

     • Occur at regular intervals and remain the same regardless of the building's occupancy rate.

     • Examples: Property taxes, hazard insurance, salaries.

  2. Variable Expenses:

     • May increase or decrease depending on changes in the occupancy rate or the extent of services provided.

     • Examples: Utilities, supplies, cleaning, repairs, services for tenants, administrative expenses, management fees.

  3. Reserves for Replacement:

     • Regular allowances set aside to replace structures and equipment expected to wear out.

     • Examples: Roofs, heating equipment, air conditioners, kitchen appliances (in residential buildings).

• Excluded Expenses: Some expenses related to ownership are not considered operating expenses and are not deducted from EGI to arrive at NOI:

  • Owner's income taxes.

  • Mortgage payments (known as debt service).

Net Operating Income (NOI)

• The income remaining after operating expenses are deducted from effective gross income.
  $\text{Net Operating Income (NOI)} = \text{Effective Gross Income (EGI)} - \text{Operating Expenses}$

• It is the net operating income that is capitalized to determine the property's value.

Capitalization

• Definition: The process of converting net operating income into a meaningful value.

• Mathematical Procedure (Capitalization Formula):
  $\frac{\text{Annual Net Operating Income}}{\text{Capitalization Rate}} = \text{Value}$

• Example:

  • Property's Net Operating Income (NOI): $\$45,700$

  • Capitalization Rate: $11\%$

  • Calculation: $\$45,700 \div 0.11 = \$415,455$

    • According to the capitalization formula, the property's value is $\$415,455$.