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Cost Approach Theory - I'm Confused

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Roger Murdock

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In my appraiser education classes I was taught that the Cost Approach is considered to be especially important for the valuation of special-purpose properties, where sales and rentals etc. may be difficult or impossible to find.

My question is as follows:

Appraisal theory states that the Cost Approach is only considered meaningful when it can be shown that the improvement(s) represent(s) the highest and best use of the site.

However, in order to properly ascertain the highest and best use of the site, it is necessary to consider the construction costs and market values of the various types of improvements legally allowed for the site. This would of course include considering the market value of the existing special-purposes improvement.

But that would seem to be impossible - if the only way to get the market value is through the Cost Approach (since insufficient data exists for any other approach), you're back to square one - i.e. you can't get a value via the Cost Approach unless you first ascertain the current use to the highest and best use, which can only be done by using the Cost Approach....it's the old dog-chasing-it's-tail problem....

Am I missing something very basic here?

(Now I do realize that in practice, a rigorous highest and best use analysis is often eschewed in favor of an informal judgement of the highest and best use based on various factors judged to be sufficient by the appraiser. But if you're looking at a special-use property, it's difficult to really be able to say that the existing use is the highest and best use without hard evidence.....)
 

Stephen J. Vertin MAI

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Illinois
Marc:

Welcome to the forum. There is a lot of the dog chasing his own tail in the cost approach. Few will disagree. However, there are other principles at work beside physically possible, legally permissible, financially feasible and maximally productive. The one that first comes to mind that is applicable in your example is the marginal dollar concept. Which basically states that if the improvement adds one dollar of value to the land it is not financially feasible to remove. This saves a lot of fuss when analyzing existing improvements.

The difficult part in your question revolves around proposed developments of special use improvements. The highest and best use as vacant is relatively easy since there are many users and buyers in competition so most who are not confused usually end with a generic use such as commercial, industrial, institutional or residential. The hard part now becomes the justification of the new highest and best use. Depending on the facilities specialization depends on the direction taken. Do you have a specific special use property in mind?
 

leelansford

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Mar 29, 2002
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Certified Residential Appraiser
State
Illinois
In my appraiser education classes I was taught that the Cost Approach is considered to be especially important for the valuation of special-purpose properties, where sales and rentals etc. may be difficult or impossible to find.

My question is as follows:

Appraisal theory states that the Cost Approach is only considered meaningful when it can be shown that the improvement(s) represent(s) the highest and best use of the site.

However, in order to properly ascertain the highest and best use of the site, it is necessary to consider the construction costs and market values of the various types of improvements legally allowed for the site. This would of course include considering the market value of the existing special-purposes improvement.

But that would seem to be impossible - if the only way to get the market value is through the Cost Approach (since insufficient data exists for any other approach), you're back to square one - i.e. you can't get a value via the Cost Approach unless you first ascertain the current use to the highest and best use, which can only be done by using the Cost Approach....it's the old dog-chasing-it's-tail problem....

Am I missing something very basic here?

(Now I do realize that in practice, a rigorous highest and best use analysis is often eschewed in favor of an informal judgement of the highest and best use based on various factors judged to be sufficient by the appraiser. But if you're looking at a special-use property, it's difficult to really be able to say that the existing use is the highest and best use without hard evidence.....)

For a special-use property, it may not be possible to offer an opinion of market value and only an opinion of value in use may be offered. An opinion of value in use is conducted without regard to the H&B Use of the property.

Tell us more about the Subject property (if you have one in mind). A particular property may be a limited-market property and it may be possible to offer an opinion of market value.
 

Stephen J. Vertin MAI

Senior Member
Joined
Jan 17, 2002
Professional Status
Certified General Appraiser
State
Illinois
Lee:

Liked your article for ICAP. It was much better than prospective and retrospective value (which is a very tough subject).

One thing should be noted on "value in use" if providing the report for lending.

Regulatory issues - the client is probably subject to the federal requirement for market value

If it is not, and the property is highly specialized, value in use is sometimes a fair analysis.

But it really does not go to the heart of the issue of the circular argument.
 

leelansford

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Illinois
Stephen, understand re: MV for use in lending decisions.

Lee
 

Louis Pompeo

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Nov 23, 2007
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Certified General Appraiser
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Mariana Islands
Cost Approach = Market Value

I had to read your post 3 times to make sure I'm following your rationale, but let me attempt an answer....

The first thing you would do (before HBU analysis) is a Market Analysis, and then, especially in the case of a special-use property, a Marketability Analysis.

If both are done properly, then HBU isn't as daunting as it might seem.

Then, when performing HBU "as-vacant", the "ideal improvement" should be identified. This makes measurement of obsolescence of the improvements much easier.

Then, when valuing the subject via the cost approach, care must be taken to conform to the principle of "consistent use", in that the land be valued according to the use which the property in the overall is being utilized.

If you've demonstrated a market for the subject property, established that the existing improvements contribute to value, and performed a comprehensive cost approach - then market value is equal to the cost approach value.

All this is based upon the fact that there is no sales or income data from which to draw a credible estimate of value.

Pat Murphy
 

Fred

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Jan 15, 2002
Professional Status
Retired Appraiser
State
Virgin Islands
If cost approach "theory" is confusing to you, that means you probably have a healty dose of common sense and skepticism. Hold onto them tightly.

I believe the notion (well short of a theory) that the cost approach would apply when there is "no data" is that the cost approach will spit out a number no matter what, as long as you apply a little force.

The obvious question when anyone resorts to the cost approach due to no comps is how did they determine the improvements contribute anything. Maybe they are just a bulldozing problem. After all, if I have a need for a site, why not buy a vacant one and put exactly what I need on it.
 

PL1957

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Jul 19, 2004
Professional Status
Certified General Appraiser
State
Illinois
If you've demonstrated a market for the subject property, established that the existing improvements contribute to value, and performed a comprehensive cost approach - then market value is equal to the cost approach value.

All this is based upon the fact that there is no sales or income data from which to draw a credible estimate of value.
If you've demonstrated there is a market for the subject property, why wouldn't there be any sales/income?

I really can't think of any property where I would place total reliance on a Cost Approach for market value.
 

PropertyEconomics

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Jun 19, 2007
Professional Status
Certified General Appraiser
State
New Mexico
PL .. I agree with you. Ive not ever been able to not find a comparable for my subject property. It may take some looking but they are there. While there may be no income appraoch for a church .. churches sell all the time ... just for example. Often appraisers say a church can only use the cost approach .. I say to those appraisers you havent looked hard enough for church sales. They are there.
 

David Wimpelberg

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Mar 30, 2005
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Certified General Appraiser
State
New York
In my appraiser education classes I was taught that the Cost Approach is considered to be especially important for the valuation of special-purpose properties, where sales and rentals etc. may be difficult or impossible to find.

IMHO, the more unique the property, the less the Cost Approach is applicable, not the other way around.

Not that I think it should be used anyway for market value. But what happens in many cases, say for SFRs, is that the Cost Approach results in a value that is "close enough." So it gives the appearance that it works.

The Cost Approach, when broken down, is simply land value plus contributory value of improvements. To determine the contributory value of improvements, you need to know the market value and the (hypothetical) land value. So you have to perform another approach to determine the market value anyway.
 
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