Cost Approach vs Sales Comparison

[jamie marie]

An underwriter (from a management co.) is asking to explain why the cost approach is higher then the sales comparison value. Any concise answer without telling then where I think they should go? Or is this such a ridiculous question it isn't worth explaining to someone who doesn't know the field.

 

[CANative]

Temporary external obsolesence. It costs more to create the property than would be returned in the market.

You didn't do the cost approach correctly.

 

[jamie marie]

Temporary external obsolesence. It costs more to create the property than would be returned in the market.

You didn't do the cost approach correctly.

Why can't it cost more to build? Should I do more for depreciation?

 

[CANative]

Why can't it cost more to build? Should I do more for depreciation?

You have to figure out why the cost approach to MARKET VALUE is different than the sale approach to MARKET VALUE.

 

[hastalavista]

Why can't it cost more to build? Should I do more for depreciation?

You should consider this form of depreciation (The Dictionary of Real Estate, 4th Ed.):

economic depreciation
A decline in the economy that negatively impacts real estate values.

Here's another definition (my bold):

depreciation
1. In appraising, a loss in property value from any cause; the difference between the cost of an improvement on the effective date of the appraisal and the market value of the improvement on the same date.
2. In accounting, an allowance made against the loss in value of an asset for a defined purpose and computed using a specified method.

Finally, to tie it all in (again, my bold):

cost approach
A set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including an entrepreneurial incentive, deducting depreciation from the total cost, and adding the estimated land value. Adjustments may then be made to the indicated fee simple value of the subject property to reflect the value of the property interest being appraised.

 

[jamie marie]

Thank you both, I've got it.

 

[Lee Lansford]

An underwriter (from a management co.) is asking to explain why the cost approach is higher then the sales comparison value. Any concise answer without telling then where I think they should go? Or is this such a ridiculous question it isn't worth explaining to someone who doesn't know the field.

How certain are you of the site value?

Is there anything extraordinary regarding the improvements that might create difficulty in providing a reasonable estimate of cost to build?

What is the opinion of Market Value? What is the indicated value via the Cost Approach?

 

[Terrel L. Shields]

First, how much higher? If substantial, then they should question it in a residential property. And yes, you likely need to focus on the external obsolescence of current market conditions.

Unfortunately, I saw a report recently where the appraiser actually used a RCN of $50 per SF in an area where you cannot possibly find a carpenter to do such a house for less than $75-80/SF. That avoided the external obsolescence.

Think of External Obsolescence as the inverse of Entreprenuerial profit. No builder attempts to build without some entreprenuerial INCENTIVE, but his "Profit" may disappoint and thus, Ext Obsol. comes into play.
This is the link to an Appraisal Journal article that is worth the reading...
http://www.federalappraisal.com/Pomykacz,%20Defining%20and%20Supporting%20Entrepreneurial%20Profit%20and%20External%20Obsolescence.pdf

 

[jamie marie]

The sales comparison indicated $124 and the cost approach was $158. The site value was accurate. Also note, the subject had a functional obs. for being a one bedroom.

 

[Terrel L. Shields]

Then almost certainly you have a large adjustment to make for external obsolescence. Take some comps (preferrably the ones you used), reverse engineer it, and calculate the Ex. Obsolescence.. I bet it will work out to about 20%.

Sale Price = $136,000
Land = $50,000
RCN = $150,000
Observed age = 10
Total Econ Life from cost book = 50
Physical deprec = $30,000
DC before Ext. = $120,000 + land value = $170,000
$170,000 - 136,000 = 34,000 = 20% Ext (usually applied to both improvements and land)
External obsolescence is usually thought of as "incurable" but if "cured" it is not in the control of the property owner (i.e. - market conditions improve, or that cell tower next door or junk yard next door goes away..)


Notice Swiftestimator explicitly says it does not calculate External Obsolescence

This calculation does not include either abnormal or excessive functional depreciation, or any external obsolescence, which you must add separately

This is one way using rent info...
webs.wichita.edu/longhofer/RE614/.../RE614_Depreciation.doc