Is The Cost Approach Flawed?

[Michigan CG]

It Is Better to Keep Quiet and Be Thought a Fool Than to Speak and Remove All Doubt.—Empeco

 

[hastalavista]

The cost approach has been a topic of controversy (for residential properties) as long as I've been on this forum. It was interesting to read that excerpt of mine from 10+/- years ago; that exchange was part of a discussion I was having with Santora (aka Fred) and Greg Boyd.
What's clear to me is how my view and understanding of the cost approach has continued to develop. Reading what I wrote, I see one startling consistency in my view (which I'm better able to express now): The weakness of the cost approach, when it exists and presuming it is done correctly, is not the methodology; the weakness is the data. And that weakness can only be measured in the context of alternative approaches, which presumably are done correctly as well.
But that's why we have something called the reconciliation process.

 

[ucbruin]

https://appraisersforum.com/forums/threads/lender-wants-cost-information.219307/

https://appraisersforum.com/forums/threads/VA-and-cost-approach.102550/

https://appraisersforum.com/forums/threads/VA-cost-approach.205488/


What a coincidence....
Interesting that on the VA forum the cost approach is being discussed....
I'm don't do VA appraisals so I'm not quite sure if VA doesn't require the cost approach in general....
Or
Does not require the cost approach just for Manufactured houses....

If the VA doesn't require the CA...
Maybe the CA is not as important as some on the AF want to believe....

 

[TRESinc]

If the VA doesn't require the CA...
Maybe the CA is not as important as some on the AF want to believe....

you may be on to something eli...

 

[ucbruin]

you may be on to something eli...

Next time take more than 10 minutes to gather your thoughts....
This is the best you got????

Do you do VA work???
Do they not require CA???
Dazzle us...

 

[hastalavista]

Maybe the CA is not as important as some on the AF want to believe....

I don't think the discussion is about "importance". If it is necessary for credible results, I doubt you'll have anyone argue that it shouldn't be done (presumably, if necessary, it is important).
The real discussion consists of two parts:
A. Does it work? The answer is, "yes", if done correctly and the reliability of the results, if done correctly, are significantly dependent on the quality of the data.
B. Is it necessary? The answer is, it depends, but many times it is not necessary for credible results.

A spin-off of the discussion is:
C. Is it applicable? Again, yes it is if the valuation problem to be solved includes land and improvements. The cost approach can always be applied to that problem.
D. For me, the most important question is: If I have to do it, regardless if I think it is necessary or if I think the results are reliable, do I have to do it correctly? Most emphatically, I say "yes"; emphatically because (as I posted earlier) we are required to correctly employ the techniques we use.
The three easiest things for an appraiser-regulator to cite as issues in a typical residential report (what I call the low hanging fruit) are:
1. H&BU not summarized; only a check-box.
2. Zoning not summarized or correctly identified; it is only stated.
3. Cost Approach not adequately supported (especially when using the 1004 form, which specifically requires that the information be provided so the analysis can be replicated, and calls for the data used to support the opinion of the site value).

Does it take additional steps to do it right? Yes, of course it does. Are those steps necessarily onerous? No. I do the cost approach in San Francisco, a market where I repeatedly read, when reviewing reports, that there are no land sales. Amazing how many assignments I do for land in the City, or the number of improved properties where the improvements no longer contribute value and the site is sold for new development and the value is based on the land.
The excuses used to not do the cost approach correctly are legion. The consequences of not doing it correctly can be significant. The ability to learn how to do the cost approach correctly is within the grasp of any licensed/certified appraiser who has passed the basic courses (where it was taught... for many, that is a long time ago). The problem with much of the instruction of the cost approach is that the classes use text-book examples rather than real-life scenarios. But, the techniques are the techniques; with a little thought, anyone competent to hold a license can take the text-book examples and apply them to real-world examples.

There are a lot of what I'd call old-timers who continually believe the cost approach is worthless. That's fine: I think they'd acknowledge it may be worthwhile in some extreme cases; extreme to their normal business, but possible that they might encounter. My issue is regardless of whether it is worthwhile or worthless, if done it still has to be done correctly. The old-timers may never change their view or may never think it is worth the effort to do correctly. Hopefully, the newer entrants into the profession, who may be in 100% agreement that it is worthless, will consider that it is necessary, if it must be done, to do it correctly.

 

[ucbruin]

I don't think the discussion is about "importance". If it is necessary for credible results, I doubt you'll have anyone argue that it shouldn't be done (presumably, if necessary, it is important).
The real discussion consists of two parts:
A. Does it work? The answer is, "yes", if done correctly and the reliability of the results, if done correctly, are significantly dependent on the quality of the data.
B. Is it necessary? The answer is, it depends, but many times it is not necessary for credible results.

A spin-off of the discussion is:
C. Is it applicable? Again, yes it is if the valuation problem to be solved includes land and improvements. The cost approach can always be applied to that problem.
D. For me, the most important question is: If I have to do it, regardless if I think it is necessary or if I think the results are reliable, do I have to do it correctly? Most emphatically, I say "yes"; emphatically because (as I posted earlier) we are required to correctly employ the techniques we use.
The three easiest things for an appraiser-regulator to cite as issues in a typical residential report (what I call the low hanging fruit) are:
1. H&BU not summarized; only a check-box.
2. Zoning not summarized or correctly identified; it is only stated.
3. Cost Approach not adequately supported (especially when using the 1004 form, which specifically requires that the information be provided so the analysis can be replicated, and calls for the data used to support the opinion of the site value).

Does it take additional steps to do it right? Yes, of course it does. Are those steps necessarily onerous? No. I do the cost approach in San Francisco, a market where I repeatedly read, when reviewing reports, that there are no land sales. Amazing how many assignments I do for land in the City, or the number of improved properties where the improvements no longer contribute value and the site is sold for new development and the value is based on the land.
The excuses used to not do the cost approach correctly are legion. The consequences of not doing it correctly can be significant. The ability to learn how to do the cost approach correctly is within the grasp of any licensed/certified appraiser who has passed the basic courses (where it was taught... for many, that is a long time ago). The problem with much of the instruction of the cost approach is that the classes use text-book examples rather than real-life scenarios. But, the techniques are the techniques; with a little thought, anyone competent to hold a license can take the text-book examples and apply them to real-world examples.

There are a lot of what I'd call old-timers who continually believe the cost approach is worthless. That's fine: I think they'd acknowledge it may be worthwhile in some extreme cases; extreme to their normal business, but possible that they might encounter. My issue is regardless of whether it is worthwhile or worthless, if done it still has to be done correctly. The old-timers may never change their view or may never think it is worth the effort to do correctly. Hopefully, the newer entrants into the profession, who may be in 100% agreement that it is worthless, will consider that it is necessary, if it must be done, to do it correctly.

As usual excellent response.....
Every point.....

Hypothetical question...

Suppose you're appraising a "typical tractish cookie cutter" home located in a 300 tract of homes...
No zoning issues, HBU as presently employed yada yada yada....
And you had collect what you considered to be accurate cost data and the cost approach was substantially less than the sales comps, would you give most weight to the cost approach?

 

[hastalavista]

As usual excellent response.....
Every point.....

Hypothetical question...

Suppose you're appraising a "typical tractish cookie cutter" home located in a 300 tract of homes...
No zoning issues, HBU as presently employed yada yada yada....
And you had collect what you considered to be accurate cost data and the cost approach was substantially less than the sales comps, would you give most weight to the cost approach?

Without going through 101 qualifiers, but simply assuming I considered the SCA data to be superior, then I would give most consideration to the sales comparison approach.
However, if I thought I had good data in the cost approach and good data for the SCA, I'd dig deepr in my cost approach analysis to see if I made a mistake; I'd look there first because that's where I'd suspect an error to be found.

I don't have a problem with seeing differences in the two approaches (in the cookie cutter example you give).
I have no problem if the SCA indicates $500k, and the cost approach is, say, anywhere between $475k and $525k (a 5% variance, roughly). I wouldn't bat an eye.
If the difference were 10%, I'd still run with it but I'd certainly include additional comments regarding how I reconciled the two.
If more than 10%, I'd start digging deeper. But, it is what it is. One reason could be a significant market shift (either way). An excellent example would be new construction in the fire-ravaged areas of Northern California. Even the builders cannot accurately predict how much it will cost them to build; I would expect my data (especially the cost-data form a reputable provider...the standard for our purposes, but not as good as the builder on the ground) to be pretty weak.

Does that answer your question?

 

[Michigan CG]

........."typical tractish cookie cutter" home located in a 300 tract of homes.............And you had collect what you considered to be accurate cost data and the cost approach was substantially less than the sales comps, would you give most weight to the cost approach?

If the cost approach is done correctly, especially on an easy house like that the difference will be minimal. If one has that many homes that are coolie cutter then it is easy to figure depreciation and assuming the costs are correct and the appraiser remembers to add in EP the results are going to be very close to each other.

 

[Mr Rex]

The Cost Approach is an interesting study of Cost versus Market Value. But since Cost and Value are not equal, it is at best a weak support of market value and hardly ever the best indicator of value. I like studying the variances of the various approaches but the Cost Approach as performed by most appraisers is a exercise/study model at best. I might give it more credit if it more closely mimicked the real world development of the cost approach as performed the folks that actually rely on it, the contractors that actually build stuff. As is, the "appraiser" cost approach does not mimic the typical market participant buyer and more importantly does come close to how contractors develop the "real" cost approach. Carry on Cost Approach Soldiers, Marching as to War...