Deep Dive - The Cost Approach

[Artemis Fowl]

not an issue at all. I'm not trying to convince anyone of anything. My point was that, if depreciated cost is ALL you have (and I agree that is the case sometimes), and if the only way to quantify the validity of the adjustment is through sales comparison, yet there are no sales with which to quantify the depreciated cost adjustment, then you really have no idea whether it's accurate or not. Which goes back to my original point that the CA really doesn't have a lot of merit (on the residential side) as a stand alone approach.

Missing it. What sales are there none of? People buy wood, nails, tile and labor. Those are markets too.
Direct sale comparisons are always better. Proxy sales work when there are no direct sales. Residential units, in most cases, have direct sales available which is why the cost approach is not applicable as the PRIMARY approach as often. The cost approach is not some disassociated "stand alone" thing...it is based on market comparisons...just different but related markets.

 

[alebrewer]

Missing it. What sales are there none of? People buy wood, nails, tile and labor. Those are markets too.
Direct sale comparisons are always better. Proxy sales work when there are no direct sales. Residential units, in most cases, have direct sales available which is why the cost approach is not applicable as the PRIMARY approach as often. The cost approach is not some disassociated "stand alone" thing...it is based on market comparisons...just different but related markets.

ok.

 

[TerryRohrer]

Missing it. What sales are there none of? People buy wood, nails, tile and labor. Those are markets too.
Direct sale comparisons are always better. Proxy sales work when there are no direct sales. Residential units, in most cases, have direct sales available which is why the cost approach is not applicable as the PRIMARY approach as often. The cost approach is not some disassociated "stand alone" thing...it is based on market comparisons...just different but related markets.

So, much like cost equals value, if anyone anywhere has one, it has to contribute to market value? While there is no doubt that an estimated cost can be developed for anything, and some arbitrary measure of depreciation applied, how can the impact of that feature on the value of the property as a whole be supported without sales of properties that include that feature? I don't use this methodology, so I don't know what assumptions everyone makes, but I have never seen them state all of their assumptions as required by USPAP.

For example, most, I assume, develop an overall depreciation rate to sales in the subject market area, and then apply that rate to the replacement cost of the special feature not included in any sale, and move along without stating the implicit assumption that said feature has the same economic, physical, and functional life of all other components. I have never seen an appraiser apply the breakdown method of depreciation in a report, but even if one went to that length, how do you estimate functional obsolescence suffered by a feature not represented in the market? If the subject has the only one in the subject market area, how can it be argued that "the one" does not suffer from functional obsolescence? If that is a legitimate question, how is that loss in value estimated? It seems to me that adjusting for special features through depreciated cost without pointing out all these (and very certainly other) weaknesses, results in a misleading representation of value.

 

[CGinMN]

A proper cost approach requires:
-estimating the subject's land value using similar comps, developing market-based adjustments for significant differences, reconciling a final opinion of the site value
-estimating the RCN using a cost manual, which involves selecting the appropriate quality rating and multipliers.
-estimating all forms of depreciation, which requires estimating land values, TEL, RCN for comps
-estimating entrepreneurial incentive based on market extraction
-estimating the cost of site improvements
-reconciling a final opinion of value based on the cost approach

A lot can go sideways in any one of these steps. Wheras the beauty and simplicity of the sales comparison approach is that all of the above is built-in to each and every sale, and you have multiple sales to work with. The cost approach, even when done correctly, in most cases will be less credible than your weakest comp. For this reason, the sales comparison will always be king.

In terms of applying a breakdown method, I think it can be very instructive. I wouldn't say it's going to be the most credible approach, especially when there is functional obsolescence, but it can be developed quickly and easily in scenarios when you have decent data. I think if appraisers took 15 minutes to do it, some might find they've been under-adjusting for condition/effective age, GLA, baths, etc. Just having the underlying knowledge of costs and how they breakdown in a project is valuable

No method is perfect, but it doesn't mean it's misleading. I can omit variables in a regression or expand/limit the data pool, and that will change the coefficients. Paired sales aren't super helpful in most cases. When I do find the perfect pair, does the $25,000 composite deck adjustment apply equally to these comps which have numerous other differences? Grouped data is subject to positive correlation to other variables. Sensitivity analysis can result in overfitting. And so on... The idea is to understand all of the above, and apply the methods when it makes most sense to do so.

 

[alebrewer]

No method is perfect, but it doesn't mean it's misleading.

I wouldn't say it's misleading either - in fact, I'd even go so far as to say it can be 'supportable'. I just wouldn't say it accurately reflects the subject's true market value without validation from the SCA. I use extraction quite often for site value estimation sans site sales - and it's supportable insofar as I have my extraction methodology documented in my workfile. Is it truly reflective of what that market value for the site really is, though? Chi sa?

 

[CGinMN]

I think we validate paired sales and regression adjustments based on our intuitive knowledge of costs as well. If paired sales or regression tells you a pool adjustment is $300,000 when you know the cost is $75,000, are you going to cross-check?

 

[Ricky LaFleur]

I just wouldn't say it accurately reflects the subject's true market value without validation from the SCA. I use extraction quite often for site value estimation sans site sales - and it's supportable insofar as I have my extraction methodology documented in my workfile. Is it truly reflective of what that market value for the site really is, though?

This same old argument comes around the forum primarily from the same individuals. Why should the three approaches be developed in a vacuum? Do you get cap rates from thin air? Does your SA never have income form the basis for adjustments?

https://cre.org/real-estate-issues/myth-three-independent-approaches-value/

 

[alebrewer]

This same old argument comes around the forum primarily from the same individuals. Why should the three approaches be developed in a vacuum? Do you get cap rates from thin air? Does your SA never have income form the basis for adjustments?

https://cre.org/real-estate-issues/myth-three-independent-approaches-value/

I don't disagree, but cap rates and incomes are extracted directly from the market - not from a cost guide. IOW, the following is what you get from the cost guide (and assume it's accurate): TEL, local multipliers, PPF new for both improvements and outbuildings, quality rating, cost multiplier, and - depending on level of breakdown - Cost new of any components. That's a LOT of info you 'assume' to be correct (or a lot of info you're able to manipulate - depending on how you see the CA). On the IA side, how do you get cap rates? Market sales prices and market rentals, right? How do you see that as being similar to the vagaries of the CA components?

 

[CGinMN]

the sales comparison is the only approach that can stand on its own. The cost and income approaches rely on sales comparison

 

[TerryRohrer]

the sales comparison is the only approach that can stand on its own. The cost and income approaches rely on sales comparison

How so? They all rely on sales, yes. When I do a cost approach, my sales comparison and income approaches are irrelevant (my site adjustments in the sales comparison approach are almost never based on vacant site sales). I don't object strongly to any of the approaches, but I do not practice using one to complete the other as I think that tends to diminish them all.