Deep Dive - The Cost Approach

[alebrewer]

So site valuation aside, I'd be interested to engage a discussion on how different folks perform the CA, including the tools they use to estimate TEL, EA, annual depreciation, etc. May be a nothing-burger of a discussion, but (a) I believe the CA to be intrinsically flawed - and a discussion of this nature should either support that assumption or disprove that assumption, and (b) I think a discussion of tools used may prove beneficial for those who struggle with development of the CA. It seems to me the two most defensible parts of the development of the CA are: site valuation (either sales comparison or extraction is, IMO, supportable in the context of defending oneself against a state board complaint), and the PPF new - which can be taken from several reputable sources, including M&S, DwellingCost, etc. And, while those sources are easily manipulated via local multipliers, quality of construction, etc., they are nonetheless supportable in the context of defending oneself against a state board complaint. So, then, the topics of interest might be:

• development of TEL
• development of EA estimate
• development of the contributory value of site improvements estimate
• development of estimates of functional and external obsolescence

To Terrel's point in a prior post, it seems to me there are basically two methods of estimating TEL: (1) take it from a cost guide, in which case, the appraiser has not tied the subject's 'market' extracted depreciation to TEL at all, and has (IMO) performed a very lazy TEL estimate, or (2) annualizing the depreciation and then taking the reciprocal of the annualized depreciation. I'll start the conversation by attaching a TEL estimation tool I've played around with for a couple of years. Based on my research, doing a CA on new construction MAY prove beneficial to the appraiser, if for no other reason than being able to extract land value. For properties in the ~ 2-10 year range, however (i.e., properties that have a heavy depreciation load due to not being new - think of used cars), the annualized depreciation tends to be overstated, as the market penalizes a property for not being new, even though there really isn't much depreciation. Then, for homes in the ~ 11-30 year range, the TEL takes on a more reasonable estimate, as the front end depreciation load is distributed over more years now. Then, in the 30+ age range, TEL becomes a bit more numinous again due to differing levels of maintenance/updating/renovations.

If the discussion proceeds down a path of estimating EA, I'll share some curvilinear models I built for different TEL's (75, 70, and 65) that seem to model EA and REL pretty well based on updating/renovation weights I added to the models.

PS - site won't allow an XLS upload, so the TEL form is in PDF. Folks should be able to connect the dots where the fields have formulas (e.g., B15 (Total Cost New) = B13*B14, or Current Construction Cost X Entrepreneurial Incentive)

 

[jay trotta]

During a period of time (way back) I worked with various different contractors/builders who would estimate cost on a SF or design basis (used as a basis + MS/Other building Book references) and at that time there were ample lot sales to utilize (site value) for reference in various areas. This was all back about 20+ years ago and all were good resources at the time.

 

[alebrewer]

Yeah - depending on what I'm appraising, I seldom have to engage extraction in my market(s). However, if I'm appraising in the metroplex - especially new subdivisions - I almost always have to use extraction for site value.

 

[Terrel L. Shields]

development of TEL

Inverse of the rate of depreciation -

development of EA estimate

Epley's method

development of the contributory value of site improvements estimate

buildings, etc. by extraction, deprec. cost, or other traditional methods - so, how do you develop adjustments between comps in the SA? same way.

development of estimates of functional and external obsolescence

ditto - you compare the numbers it should be with what is, and again, how it is different from doing the same in the SA?

If I have, say, a large barn with a dwelling. I can estimate the cost of the barn. Easiest way is to ask the owner what they paid to have it erected and what year. Then the historical index tells me the RCN today. If I account for the dwelling and land, and only have say, $25,000 left over that has to be split between the site improvements and the barn. Since I can extract site improvements the same way as I extract anything else, the remainder is the barn's contribution. And the calculated observed age vs total life (from the book) gives me what it should be worth and, the remainder compared tells me the functional obsolescence (over-built) - I mean outbuildings and excessive site improvements are the primary place to look for such functional obsolescence.

My own experience is that a barn that is over 20-30 years age is likely to contribute zero. Those old traditional barns 50-100 years old, ditto. Although they might be a nice addition to the ambiance of the property, they add little or no value. The more outbuildings, the less some will contribute so you need to rank them by utility and age. The old dairy parlor? Probably zero. That shop built in 2010? Probably does contribute considerable to the property. A well-maintained pool? Yes. An empty pool with broken pump? Nothing. A white picket fence? probably nothing.

Again, the judgments are no different from the judgements you apply in the sales approach. And "extraction"? From what? Do we have the same problem? How do you determine the depreciation in the SA? How many paired sales do you need? One? Then you might as well guess, and I suspect most appraiser do guess. How do you compare that 20-year-old kidney shaped 36' pool with pool room with that 5 year old square 40'salt water pool with zero-entry and vanishing edge? Guessing again, I bet.

How do you estimate the effective age of a 100-year-old house that has been remodeled 3 or 4 times? How do you quantify quality differences in the comps? Over the years, I've seen enough appraisals where the land value is treated as identical even when site sizes are much different. And, I have seen completely bizarre "land" adjustments. And pools and outbuildings? $5,000, $10,000, or, in one case I followed up, a pole barn, dirt floor and sheathed in used galvanized metal was valued at $75,000 even though the owner told me he did the work himself and had $5,500 in the materials and salvaged the metal off a chicken house that was being torn down.

I don't know how you can make valid adjustments in multi-building rural properties without the cost approach or using costs to aid in estimating the contributory value. And I see a tendency to simply make things disappear that I think is no more valid than guessing. I mean if you do make it disappear, I suppose it is easier for the reviewer to ignore it as well.
So, how would you tackle the 5 acre property below using only sales information. It had 5 air-conditioned shop buildings with brick facades, 2 hoists, an indoor pool, a house that was remodeled and added 2,000 SF to a 2,400 SF house, and even had a small paint room for repainting cars.

 

[alebrewer]

If I have, say, a large barn with a dwelling. I can estimate the cost of the barn. Easiest way is to ask the owner what they paid to have it erected and what year.

Do you just make an assumption that what the owner paid is reflective of what a typical market participant would pay? We're in the process of building a barn/shop - three quotes: $75k for a pole barn, $100k for a steel Beam barn and $120k for a steel beam barn. Which one reflects what the market would pay?

If I account for the dwelling and land, and only have say, $25,000 left over that has to be split between the site improvements and the barn.

But how do you know you've adequately accounted for the dwelling if, say, you have $50k left for contributory value of site improvements? Do you assume you did the dwelling RCN incorrectly?

I don't know how you can make valid adjustments in multi-building rural properties without the cost approach or using costs to aid in estimating the contributory value.

How does the market do it? I don't disagree that depreciated cost is a SUPPORTABLE method, but it may or may not reflect actual market participation.

Again, the judgments are no different from the judgements you apply in the sales approach.

Agreed - for external and functional, it seems paired sales is most reflective of market participation. Of course, you could use the formula to estimate functional, but do you really think most res appraisers know how to do this? I'd bet most CG's don't know how to do this.

How do you estimate the effective age of a 100-year-old house that has been remodeled 3 or 4 times?

Exactly my point. Appraisers like age/life because it is intuitive and easy, but it's not right. Do we just take the 'intuitive and easy' approach because it's just that - easy?

How do you determine the depreciation in the SA?

Again - exactly my point. I can tell you how most appraisers determine EA in the sales comparison approach, but again - PFA is not the right way to do it.

ditto - you compare the numbers it should be with what is

If I understand what you're saying here, you're saying you need a 'baseline' (say a sales price?) in order to determine the validity of the CA, right?

And "extraction"? From what?

Extraction is a method of estimating site value (although I know you know that). Not sure the ask?

 

[Terrel L. Shields]

Do you just make an assumption that what the owner paid is reflective of what a typical market participant would pay?

The comps should tell you. You are reverse engineering the comps at the same time. You do not do the cost approach in a vacuum. So, my first task is to select the comps and analyze them.

g if, say, you have $50k left for contributory value of site improvements?

Well, that's pretty common in rural property. A shop, well, septic, driveway, and maybe a hay barn or pool?? Sure, 50k is reasonable. The shop below was in good condition about 15 years old - the pool was in poor condition - the house was in poor condition. It's on 15 acres. Where is the value? BTW, I was by here recently and it is looking much better, and I suspect the pool even functions. But he spent a lot of money to get there. New roof, new interior, new appliances, and cleaned up the place. I bet the garage was about $20k or more contribution. And it sold cheap. So, where would I have found sales comps that were any better than doing it as a cost approach problem?

 

[Terrel L. Shields]

Extraction is a method of estimating site value

or, extracting the value of an item via paired sales...and paired sales are a whole 'nother canna worms. So below is my template for extracting the values of outbuildings. the numbers are just placeholders. But it does the eff. age calculation of the dwelling. TEL is from the table or if I do a separate calculus I substitute that number. Again, your cost book gives you a recommended TEL. RCN is from the book. You have to treat all comps the same way. That's called Purity of Application. Others can use other numbers and come out the same in the end.

 

[alebrewer]

The comps should tell you. You are reverse engineering the comps at the same time. You do not do the cost approach in a vacuum. So, my first task is to select the comps and analyze them.

Just to make sure I'm hearing you correctly: the CA does not have validity without the SCA?

Well, that's pretty common in rural property. A shop, well, septic, driveway, and maybe a hay barn or pool?? Sure, 50k is reasonable

Agreed, but how do you know if it's right? IOW - how do you know your allocations are appropriate and that you haven't underallocated the RCN of the home and overallocated contributory value of site improvements? And vice-versa?

Again, your cost book gives you a recommended TEL.

Yes, but how do you know if that's reflective of actual market participation? How can you have a home where the cost guide tells you TEL is 70 years but the home is 50 years and easily has 30 years REL due to above average maintenance? Even better - what if the home is 150 years old? How do you calculate TEL for that?

 

[alebrewer]

This is a curvilinear approach to estimating depreciation that I've been playing with. It puts a heavier depreciation load on the front end and lighter on the back end - much like you'd expect to see IRL. I then apply a weight of 0.4 to the actual age for 'updated' and 0.7 to the actual age for 'renovated', plug that number into my curvilinear depreciation schedule, and it gives me a fairly workable EA and estimated depreciation. For example: subject is 81 years old - if 'updated', effective age would be ~ 48-49 years and if 'renovated', effective age would be ~ 24-25 years. I've played with several factors, but 0.4 and 0.7 seem to fit real life more closely.

 

[Terrel L. Shields]

the CA does not have validity without the SCA

The CA does not have much validity without extracting adjustments from market data. Neither does the income approach. The gist of the three approaches is they are all dependent upon market data. Sales are market data. Cost is market data. Rents and expenses are market data.

The cost books are not created out of thin air. They are polling national builders for costs. They are checking materials costs. They are analyzing building life, building repair costs and a lot of other things. Same with income, we have vendors who provide national indexes of cap rates, analyzing what buyers and sellers are actually doing. They are market data. Sales allows us to refine the obsolescences that sales can demonstrate.

The one place that the CA is forced to stand alone is the least reliable place for it. That's valuing a public building. There are few or no sales. There is the issue of what a private property owner would spend on a similar building and what the taxpayer has to pay. We had a building here that they wanted to re-roof. $125,00 bid but the city att'y said you have to use an architect or engineer because it was over $50k. In the end, they paid an engineer $50k to engineer a roof that ended up costing over $400,000. Made perfect sense to the government. Makes no sense to the taxpayer nor the market for a similar building.