The cost approach is a valuable mental model that allows real estate professionals to understand market value.
Because market value should be lower than replacement value, by studying the reproduction value, we learn what the maximum value of the property should be.
The math is simple. We add the cost of building a comparable property in terms of size, material, and functionality; add land value; and after subtracting for depreciation expenses, we find the replacement value.
Note: replacement value is not reproduction value.
The reproduction value is the total cost for developing a replica in terms of design and building materials. Because it is uneconomic to replicate a building, especially an older one, the emphasis is on its similar functionality.
We need to be comfortable with four terms: physical depreciation, functional obsolescence, locational obsolescence, and economic obsolescence.
Physical depreciation: relates to the effective age of the building. If ten years ago, an office building had an expected economic life of 50 years, then physical depreciation is 20 percent of its market value.
Depreciation for appraisal-purposes is different from tax-purposes. For appraisal- purposes, the focus is on property-specific outcomes. For tax purposes, the annual depreciation charge is dependent on the cost-basis and an accelerated amortization period schedule and is not dependent on the operations of the property.
Physical depreciation can be either curable or incurable. Replacing a roof is an example of a curable depreciation. Curable means that fixing the problem will add value that is at least as great as the cost of the cure. Discovering a structural problem with foundation of the building is an incurable depreciation.
Functional obsolescence relates to the design and functionality. If an office-building owner has poorly functioning elevators, and as a result, lines of people are forming each day, the vacancy rate may increase The calculation of functional obsolesce is the present value of loss income. If a building has an economic life of 20 years, a capitalization rate of seven percent and $25,000 is loss due to below-market leases, and then functional obsolesce would be $265,000.
Locational obsolescence describes a situation where a property, originally adjacent to a park, is situated next to manufacturing plant due to the city's rezoning of the park. Because tenants are likely to demand lower market lease rates, the property will lose value. As with functional obsolescence, we calculate the loss using the present value calculation.
Economic obsolescence results when new construction is unfeasible under current economic conditions. This usually occurs when rent levels are not sufficiently high to generate a value for a newly constructed property that is at least equal to the development costs (including the profit to the developer). If it costs $20 million to build a 40-unit apartment building, where market rents are $1,000 then expected capitalization rate is 1.44 percent – a paltry return.
The cost approach will allow you (1) to have a point of reference, (2) to focus on value using property-specific qualities such its repairs and maintenance costs, and (3) to test your real estate broker.
First, by including the cost approach in your evaluation tools, you get three complementing approaches to value. If the cost approach shows a market value substantially lower than the purchase price, you need to further research your value conclusion.
Second, by focusing on property-specific qualities, such as landscaping, building materials, and overall maintenance, you will be familiar with on-going operations.
Third, because brokers often market properties by claiming that purchase price is below reproduction cost, calculating the replacement value , you will allow follow what a Russian author, Ms. Suzanne Massie, advised President Ronald Reagan: “Trust but verify”.