The cost approach is also known as the summation approach to value.
The principle of substitution is at work with this approach to value and is associated with replacement or reproduction costs for the subject improvement.
Using current and known construction costs or costs provided by a cost service provider, calculations are employed to arrive at a cost new for the subject improvement. Using the known gross living area (GLA) for the subject and applying the derived cost of construction on a per square foot basis, a cost new for the structure (either replacement cost or reproduction cost) is estimated. There are several different methods that can be employed to arrive at the cost new for the structure, but the comparative unit or square foot method is the one appraisers use most frequently, i.e.:
1,000 sq. ft. (GLA) X $ 65.00 (price per sq. ft.) = $ 65,000.00 cost new
If the subject property is not new, the total loss in value from cost new must be subtracted from the cost new figure. That total loss in value is appropriately called accrued depreciation. Accrued depreciation may include physical deterioration, functional obsolescence, and external obsolescence.
Physical deterioration is that loss in value that occurs as a result of the physical deterioration or physical damage to the structure itself. Such depreciation can be either curable or incurable in nature. Some examples of curable depreciation might be worn out carpet, broken windows, or interior paint required. These items can be repaired or replaced, and the incurred costs will be returned by the elimination of the deterioration and the increased value of the property.
Incurable physical depreciation may include such things as foundation settlement and deterioration of wood rafters or floor joists. These items cannot be repaired or replaced in an economically feasible manner, meaning that repair or replacement of these items will not return the costs incurred in terms of increased value to the property. Repair of the foundation settlement may cost upwards of ten thousand dollars, but the value of the property will not automatically increase by ten thousand dollars. That sort of circumstance identifies the physical deterioration as incurable in nature.
Another form of depreciation is called functional obsolescence. This form of depreciation can also be either curable or incurable in nature. Functional obsolescence occurs whenever a structure is said to be inadequate for use in the marketplace today. The curable or incurable labels will be assigned, depending on the costs incurred to relieve that form of obsolescence relative to the increase in value after elimination of the inadequacy. In some markets, a four-bedroom house with only one bathroom is termed to have functional obsolescence. In other markets, a four-bedroom house with one bathroom may be a super-adequacy of sorts. The market will be the determining factor in identifying functional obsolescence.
The third form of depreciation, known as external obsolescence, is always said to be incurable in nature. This type of obsolescence is caused by external factors outside the subject property’s boundaries. The subject property owner does not have any control over the situation and cannot remove the cause of the depreciation. An example of this type of obsolescence may be the presence of a convenience mart offering 24-hour service directly across the street from the subject residential property. The noise, gasoline smell, lights, and general appearance all serve to detract from the value of the subject. As with functional obsolescence, the market will determine the extent of the diminution of value for the subject. In many cases, external obsolescence is a market-extracted dollar figure. The market dictates the loss in value due to conditions beyond the control of the property owner. Here’s an example:
We have two houses that are rental properties. They are very similar in every way, except that one property is located across from the aforementioned convenience mart and the other is in a quiet area of the neighborhood. The property across from the convenience mart rents for $1,100 per month; the other property rents for $1,400 per month. The difference in rent loss per month is $300. The market has indicated a gross rent multiplier (GRM) of 80 for this example.
Rental loss of $300 per month X GRM of 80 = $24,000 loss in value due to external obsolescence. If the loss in value is to the property, as in this case, the portion of the loss that applies to the site must be subtracted because land cannot be depreciated. In this case, we have determined the land represents 25% of the total property value. So, of the $24,000 loss to the property, 25% of the loss ($6,000) is attributable to the land. Therefore, there is an $18,000 loss in the value of the structure due to external obsolescence.
Besides direct extraction, there are several other methods used to identify and calculate the dollar loss in value from the subject’s cost new. In residential appraisal, perhaps the most common is the age-life method, which uses the effective age and total economic life of the improvement to estimate depreciation.
Effective age is defined in the Dictionary of Real Estate Appraisal, Sixth Edition, as: The age of property that is based on the amount of observed deterioration and obsolescence it has sustained, which may be different from its chronological age.
Economic life is defined in the Dictionary of Real Estate Appraisal, Sixth Edition, as: The period over which improvements to real estate contribute to property value.
The effective age of the improvement is divided by its total economic life, to obtain a percentage. This resulting percentage figure is multiplied by the cost new, to arrive at an estimate of accrued depreciation. Here’s an example:
A building has an effective age of 15 years and a total economic life of 60 years.
15 divided by 60 = 25% depreciation
Cost new of structure = $ 65,000
Subtract depreciation @ 25 % = ($16,250)
Depreciated value of building = $ 48,750