Is The Cost Approach Flawed?

[Howard Klahr]

Please enlighten me how your cost approach provided any credibility to the appraised value of the report you completed where the subject was a 1,000 sf ranch and your comps were 2,000 sf colonials????

Another absurd worthless comment that is not worth addressing.

 

[Mr Rex]

I think what was meant was that you can utilize the cost approach as the basis to derive many different adjustments. It is a very useful tool to use when determining highest and best use, site value (using abstraction), effective age calculations, if a property is overbuilt relative to other properties in a neighborhood, plus many others. Oftentimes when other types of data are scarce, the cost approach can point out market changes and reactions that can be meaningful in making sense of the bigger economic picture in a particular market. Whenever possible, I develop the cost approach for my subject and all the comparables I've selected in order to test the results of other methods and adjustments that I've derived. It is just one of the many different tools that I use to perform as complete an analysis as possible on a property. Sometimes I use a simplified cost analysis tool (derived from the Craftsman Building Cost Calculator) to perform a quick cost estimate, while other times I might have to use the more in-depth Marshall Valuation System which takes more time to develop. It all depends on the property in question and the data available.

I think that there is this impression that the cost approach is inaccurate because the two most widely used sources of data don't accurately represent what actual costs are in a particular market. I don't dispute this, but even this can be overcome if you know how to localize your cost data to your market. I'm a data nut, so every six months I calibrate my cost data by observing and then adjusting for differences in the markets where I work. I do this by analyzing sales in new tract subdivisions where houses are typically built at the same quality level with mostly the same features. I use the un-adjusted cost data to estimate the cost of as many different sales as I can find in the neighborhood. From there, it is pretty easy to pull land to building ratios, calculate developers profit, and even spot potential paired sales elements. Finally, I calculate a local multiplier to apply to both the Craftsman and M&S data. It is surprising how accurate you can get once you localize your data. We also use this technique in mass appraisal all the time.

I know that for most appraisers, it's the amount of time that is required to properly develop the cost approach which is the deciding factor in its use (or non-use). The cost approach does take time to develop however it can be reduced considerably by making your own tools to streamline the process. I can perform a cost analysis for my subject and three comparables in about 10 minutes by using a spreadsheet that I made which replicates the methodology used in the Craftsman Building Cost Calculator. It's simple, easy, and fast. The real time savings however, comes from all of the other adjustments that I can automatically derive without any additional work (or added time). The effective age calculations shown in the images I've uploaded were performed automatically and didn't require any additional time since they were linked to the results generated by the cost estimator. This is only one potential adjustment which I now have support for in my workfile. There are many others. Thanks to the ability to link specific cells in my custom spreadsheets to input cells in WinTotal, I don't even have to reenter data, which saves me even more time,

To sum it all up, the cost approach might not be applicable to every assignment, but it can be an accurate and useful analysis tool that you would be foolish to discount completely out of hand without even considering its use.

As a former licensed general contractor I think I understand the Cost Approach pretty well. I take issue with MichCGs and others claims that they use the Cost Approach to "disprove" adjustments in the SCA as at best the Cost Approach can not be developed without SCA data to determine the market reaction to particular amenities aka depreciation and/or obsolescence. Mich has often been dismissive of FP adjustments, when a masonry FP may cost $15-25k while a pre-fab gas log may be $1500, and admittedly there is no market data to support a line item adjustment. Please enlighten me how your Cost Approach methodolgy is so good and done so correctly that you can determine if all the lost $12-13k is due to depreciation and/or a particular form of obsolescence when there are numerous other variables/differences that do not lend to the sacred "matched pairs" methodology. Is the Cost Approach useful? Is it able to stand on its own? Hardly ever unless new construction as it is dependent on the mother of all methods, the SCA. As such, it is a "*******" approach at best. MHO. YMMV. Again, can it be supportive? At times. Other times, as much as a mother of a murderer claiming "My baby would never do that" is acceptable defense/support...

 

[NC Appraising]

Is it flawed? Not if you know what you're doing. Like any tool, one needs to know how to use it. Many don't

http://orepeducation.org/how-to-support-and-prove-your-adjustments/ good detailed class on the cost approach.


What a pompous statement. It is flawed... Although just because it is flawed, it does not mean that it cannot be utilized to produce accurate and meaningful data and results. Is it perfect a better way to ask the question? I bet you are the type of an appraiser that thinks that the sales approach can be used in any type of residential assignment because you can always find sales....

I am only speaking of the Sq. Ft. method using the M&S book, as this is what most of my peers use.
Flawed Example:
Going back to my original example where I asked the OP to go into a older established subdivision to find a vacant lot sale. Based on my experience, if one did the extraction method to determine the site value, the site value most always resulted in a higher number when I had actual vacant site sales to compare it too. Flawed. Most of the time you do not have a lot/site sales to use. Calculating depreciation is still a guess/opinion based on facts and subjective data. Therefore, the site value from the extraction method is flawed. Sure, you are the man, so this does not apply to you because you and only you can do it correctly.


The cost approach is flawed. I still use to derive adjustments and to support the sales approach. Although for mortgage assignments I rarely develop it. They do not want it, don't care or need it. Waste of time and money when we are competing with AMCs and other jackass appraisers for bottom level fees. It's all about the sales approach. You can bust my chops for that statement, but it is the truth.

 

[NC Appraising]

As a former licensed general contractor I think I understand the Cost Approach pretty well. I take issue with MichCGs and others claims that they use the Cost Approach to "disprove" adjustments in the SCA as at best the Cost Approach can not be developed without SCA data to determine the market reaction to particular amenities aka depreciation and/or obsolescence. Mich has often been dismissive of FP adjustments, when a masonry FP may cost $15-25k while a pre-fab gas log may be $1500, and admittedly there is no market data to support a line item adjustment...

Here you go. Take it and come back with what you have learned or disagree with.
http://orepeducation.org/how-to-support-and-prove-your-adjustments/ good detailed class on the cost approach.

You could use it to determine or at least to support condition/quality adjustments. Support is the key. Something in your work file....

Flawed?
Just like the regression software guys.....trying to prove that a $65 per sqft GLA adjustment should be applied to a $221,000 home? Tract PUD with many sales to derive a GLA adjustment ($35).

I told him that a new PUD down the street are $38 a sqft difference for new homes? Heck, took two minutes to do the math on that one.

Regression guy got mad as heck and used the good ole...you have been doing it wrong for 20 years and that pull out of the air adjustment is not going to work anymore...

I told him that his $65 per sqft adjustment included more than just the difference in GLA....or was flawed.

 

[Mr Rex]

I don't think the Cost Approach is totally useless, but except for new construction it is always "backed into" methodology that is dubious at best. As Santora was famous for saying, nobody wants an appraisal, they want to know what its worth. That includes not needing to know the backed into depreciated cost.

 

[hastalavista]

It is flawed... Although just because it is flawed, it does not mean that it cannot be utilized to produce accurate and meaningful data and results.

I hear what you are saying. And (as I think you said earlier), the same can be said of all approaches (they have flaws).

Here is where I make a distinction: It isn't the methodology that is flawed; the methodology works and works correctly each and every time. It is the data that is "weak" (I wouldn't use the term "flawed", but that's me; we are saying the same thing... at least I think we are).
The approach with the higher quality data, done correctly, will always be better than the approach done with the lower quality data, done correctly.
But again, it isn't a flaw in the approach. It is a flaw (weakness) in the data.

Why is this important? (Am I trying to slice the baloney too thin?)
It is important because if we use an approach to value, we are required to...


So, I must correctly employ the methods and techniques when I use the cost approach. How that result gets baked into my value reconciliation is not a weakness of the approach (because I've completed the approach correctly) it is a weakness of the data as compared to the data available for another approach.

I can always defend my work because I use the recognized methods.
I can always defend my opinion of value because I've done that in the reconciliation.
I do not use a flawed technique; I use a recognized technique but sometimes, the data available for that technique is inferior to another approach.

(Hopefully, the above doesn't make me sound pompous! )

 

[Mr Rex]

I understand that there are times when the Cost Approach is useful and at times the only available means of developing an opinion of value. Before the licensing laws changed, I took all my CG courses and looked far and wide for a mentor. By chance, I did a refi residential appraisal for a guy that happened to be one of the only USDA CG appraisers in NC. Turns out he was also married to my aunts sister. He piqued my interest when we discussed how it was possible to develop an appraisal on volunteer fire departments and other similar properties that were the majority of USDA commercial loans etc. Of course the answer was the Cost Approach or rather the depreciated Cost Approach. We discussed his possibly co-signing for me to get my commercial hours to qulaify fo CG. Unfortunately for me(and him), he passed from cancer before we were able to collaborate, but obviously I realize that there is an inherent need for the Cost Approach, however it may very well be the weakest of the three legged support approaches unless it is the only applicable one.

 

[ucbruin]

Another absurd worthless comment that is not worth addressing.

In the example I presented, would the cost approach raise a red flag?

 

[NC Appraising]

I

(Hopefully, the above doesn't make me sound pompous! )

Ha. I could never get mad at you. You are one of the most respected appraisers on this forum. Much respect.

 

[ucbruin]

Can the cost approach provide a credible appraised value for, let's say, a 42 unit townhouse style condominium development?
And
Can the cost approach provide a credible appraised value for just 1 of the units in the 42 unit townhouse style condominium development?