Question regarding Cost Approach!

[Fred]

Greg, You seem to miss the point. Santora lurks, waiting to infect

You just can't stop. In just this thread alone, I have been a poisonous fish and now a disease.

 

[Fred]

Is it a $1 incentive or a $1 profit? If he put the finished product on the market at $5 and it sold in a couple of hours to the first person who called would he think that his $1 EP was low and figure he could get $2 on the next one (EI)?

Maybe.

It may seem like a stupid question but I don't see how we can get a cost approach to yield current MV indicators unless we have a good sense of what entrepreneurs are thinking going into projects similar to the subject property. And entrepreneurs are probably at a loss when the market is moving in one direction or the other. And that's why I don't think the CA is a good methodology for residential property in anything but a stable market.

We keep plowing the same territory. There are two possibilities. You are 1) using sales to highlight (back in) to the target, or 2) you are not.
1) You come up with a cost of 100 and the comps are at 80, and your cost approach goes 100-20=80. In the context of the opening post, MS is too high and it comes out 110, then the cost approach goes 110-30=80. Suppose another appraiser uses MS and adds 10 for EI, then the cost approach goes 120-40=80. I use my Roulette Wheel, which comes out 90, and I go 90-10=80. So you tell me, what difference does the EI make?
2) Again, I would be depending on you. Develop the theory of why someone buying a house for his or her own use is an "entrepeneur" - someone "entering" a market to capture a "prize." What's the prize? Just make an empirical study showing why your theory is price predictive, and that leaving the EI out of the calculation is systematically less accurate (low I would think).

 

[Fred]

And I would argue that this is random. Far better to have a 100 homes saying something then just one.

I agree 100 comps are better than one, but that's missing the point. There is a "method" of getting EI of a market driven by EI. Get 99 more comps, and execute the method 99 more times.

So, what's the method for getting EI out of house prices in a regular old residential market? If there is one, I sure can't figure it out, and in eight years of asking here, no one has posted one - and in 100 years of appraisal literature, no one has published one. And if appraising SFR's by direct comparison, I can't figure out why I need it.

 

[timd354]

I would argue that "not out of the question" doesn't come close. In my reading of USPAP, identifying the use of the analysis is required. It may be sad that clients have a limited understanding of this, but it is even sadder that their understanding got that way and does not improve because they are working with appraisers who want 'make them as instructed' to keep the client.
A use is identified, it is usually expressed by most appraisers as something like "intended use of the cost approach is for valuation purposes only. The cost approach is not intended to be used for determining insurable value"....often there is also some sort comments regarding the SOW not being appropriate for such a use, but you undoubtedly get the idea. In my experience, the lender/clients have never come back and made the appraiser remove that or similar language language, so I guess that they must not be using the cost approach to determine insurable value despite the rumors that I have heard to the contrary....lol. :wacko:


I think there are potential "problems" both in doing it right and doing it wrong. It's just a case of what you would prefer to be saying when it hits the fan. 'It's done wrong, because the client is too stupid to understand done-right' is not a place I a willingly going to put myself.
From reading your posts, I take it that you believe that the cost approach is inherently unreliable for valuation purposes for most properties...I am not sure if it is completely unreliable for that purpose, but I will grant that, due to the problems of accurately measuring depreciation and determining the site value (in areas with few or no recent lot sales), the cost approach is of little value for valuation purposes for many, if not most, properties. However, I don't think USPAP bars an appraiser from including an approach that is of little value and then giving it little or no weight in the reconciliation....let's face it, you are not going to end up in front of the board over that.....you may end up in front of a board for other things and they may try to pile on by attacking how you did a cost approach. However, it is apparent, that for all of its problems, most appraisers accept that the cost approach has some value, and, for all of its flaws it seems to have become part of the standard practice for most lending transaactions. Thus, as long as you have documented sound reasoning for how you have done the cost approach and fully explain the problems with said approach, I don't see most boards coming down on an appraiser for including the cost approach in an appraisal report.

I have clients who have been taking reports like that from me for almost 15 years. Even if at first they have to ask what they are looking for, tell them what page it is on.

I am trying to educate my clients about the cost approach......let's just say that some clients are more able to be educated than others.

 

[Fred]

I take it that you believe that the cost approach is inherently unreliable for valuation purposes for most properties...

I don’t know if I would say unreliable, because it can just be forced into agreement with the real approach. In such an instance, I am liable to say, it wasn't even an approach. I have always tried to stick with what USPAP says. Not “necessary.” But that’s market value. It is usually necessary for insurance decisions.

If you can get the client to specify what they want insured, then you won't have to worry about disclaimers. They can’t complain effectively later, when the cost of some item was not included.

I wrote the ASB on this question, and they answered what I expected – basically that you need to get this stuff straightened out on the front end of the assignment. I wrote back saying that since the answer came to me, that I probably shouldn’t expect to see it published as a QA or FAQ, and the next response confirmed that there was intent at that time to publish it. I’ll leave it to you to read between the lines.

you may end up in front of a board for other things and they may try to pile on by attacking how you did a cost approach.

I have noticed in the brief write-ups of state sanctions, that the cost approach is attacked quite a bit. The last time there was a thread about it was around the end of last year.

I have also noticed that many appraisers do not share my “interpretation” that USPAP does not prohibit “errors,” but only prohibits “substantial errors omission and commission,” with emphasis on substantial, “that significantly affects an appraisal,” with emphasis on significant. So, while I would argue that an approach given no weight of reliance, cannot contain substantial error of commission that had a significant effect. After all, if it got no weight, it had no effect. I find some are even anxious to press their pet peeves on the vagaries of depreciation and extraction.

Despite the suggestion of one that I am a vermin on this topic, I believe the path I would suggest lead to less liability.

 

[leasedfee]

Samiboii,

Others have correctly noted that the cost approach should not come in higher than other approaches to value. The three approaches to value should reconcile -- when properly applied -- as serve as a check against each other. If one approach becomes stronger, then the marketplace will redirect capital towards that use, keeping them, again, in check.

The mis-understanding of the cost approach can result in an overstatement, particularly in declining or already depressed markets.

Consider the factors of production: land; labor; capital; management.

hard cost * See comment
+ soft costs (brokerage, const. financing interest, prof. fees, tap fees)
+ entrepreneurial incentive ** See comment
= replacement cost new
- depreciation, physical
- depreciation, functional
- depreciation, external obsolescence (fka, economic) *** See comment
= value of building
+ land value
= overall real property value

* Labor + materials + sub-contractor's profit create the many subcomponents of a building. The general contractor's profit then oversees the overall construction of the subcomponents into the whole building. The Marshall calculator includes all of these. The biggest problem with the cost approach, appears to be the vast range in quality. For example, a piece of tile can range from $0.89/SF to $40/SF; and skilled tile laborers can range from, say, $15 to $40/sf. It is extremely difficult to feel confident about the Marshall Calculator.

** Entrepreneurial incentive TO the developer (not the GC or building company). This is recognized from the "hurdle" of pulling together the concept, getting entitlements, brain damage, getting financing if the banker's recognize your reputation and skills , return on your equity capital, and the "go or no go" decision. Obviously some firms do everything from brokerage, architectural, GC, and development in one company, but the tasks and skills are separate from one another. I wouldn't allocate entrepreneurial incentive to the land, as one person does; this creates a number of economic conceptual problems.

***external obsolescence: In declining markets, ext.obs. is like a tap "turning off" or destroying value from the factors of production. It probably turns off entrepreneurial incentive first, bringing new projects to a halt, but it is not limited to just destroying entrepreneurial incentive. (The entrepreneurial profit rate doesn’t go to 0%). The external obsolescence can be determined by DCF if temporal, or direct capitalization if perpetual. For example, in some small town markets or in depressions, the capitalization of external obs. may be severe and perpetual, so no new buildings will ever constructed, as of that effective date, at least. The market won’t reward a developer for new projects. In other markets, developer’s will continue to build just to keep their companies alive, so ext.obs. is canceling out much, but not all of the ent. profit, as they struggle to make it to another day. If an appraiser uses RCN + land, and excludes the external obsolescence, this will make the cost approach “appear” to be higher than other approaches. Also, the comparable sales and/or rents may or may not have external obs. factored into them, usually depending on the point in time that those negotiations occurred.

Timothy J Lindsey, MAI

 

[Couch Potato]

Samiboii,

Others have correctly noted that the cost approach should not come in higher than other approaches to value. The three approaches to value should reconcile -- when properly applied -- as serve as a check against each other. If one approach becomes stronger, then the marketplace will redirect capital towards that use, keeping them, again, in check.

The mis-understanding of the cost approach can result in an overstatement, particularly in declining or already depressed markets.

Consider the factors of production: land; labor; capital; management.

hard cost * See comment
+ soft costs (brokerage, const. financing interest, prof. fees, tap fees)
+ entrepreneurial incentive ** See comment
= replacement cost new
- depreciation, physical
- depreciation, functional
- depreciation, external obsolescence (fka, economic) *** See comment
= value of building
+ land value
= overall real property value

* Labor + materials + sub-contractor's profit create the many subcomponents of a building. The general contractor's profit then oversees the overall construction of the subcomponents into the whole building. The Marshall calculator includes all of these. The biggest problem with the cost approach, appears to be the vast range in quality. For example, a piece of tile can range from $0.89/SF to $40/SF; and skilled tile laborers can range from, say, $15 to $40/sf. It is extremely difficult to feel confident about the Marshall Calculator.

** Entrepreneurial incentive TO the developer (not the GC or building company). This is recognized from the "hurdle" of pulling together the concept, getting entitlements, brain damage, getting financing if the banker's recognize your reputation and skills , return on your equity capital, and the "go or no go" decision. Obviously some firms do everything from brokerage, architectural, GC, and development in one company, but the tasks and skills are separate from one another. I wouldn't allocate entrepreneurial incentive to the land, as one person does; this creates a number of economic conceptual problems.

***external obsolescence: In declining markets, ext.obs. is like a tap "turning off" or destroying value from the factors of production. It probably turns off entrepreneurial incentive first, bringing new projects to a halt, but it is not limited to just destroying entrepreneurial incentive. (The entrepreneurial profit rate doesn’t go to 0%). The external obsolescence can be determined by DCF if temporal, or direct capitalization if perpetual. For example, in some small town markets or in depressions, the capitalization of external obs. may be severe and perpetual, so no new buildings will ever constructed, as of that effective date, at least. The market won’t reward a developer for new projects. In other markets, developer’s will continue to build just to keep their companies alive, so ext.obs. is canceling out much, but not all of the ent. profit, as they struggle to make it to another day. If an appraiser uses RCN + land, and excludes the external obsolescence, this will make the cost approach “appear” to be higher than other approaches. Also, the comparable sales and/or rents may or may not have external obs. factored into them, usually depending on the point in time that those negotiations occurred.

Timothy J Lindsey, MAI

In a residential appraisal one considers the cost approach in terms of constructing a single house. Rarely is that done by a "developer." Typically it is a GC building a spec house or a GC building a house under contract to an owner. The idea that some "developer" will hire a GC to build a single house is absurd. (I will grant that it is no more absurd than the idea the cost approach is necessary to any typical residential appraisal.)

 

[Joyce Potts]

Samiboii,

Others have correctly noted that the cost approach should not come in higher than other approaches to value. The three approaches to value should reconcile -- when properly applied -- as serve as a check against each other. If one approach becomes stronger, then the marketplace will redirect capital towards that use, keeping them, again, in check.

The mis-understanding of the cost approach can result in an overstatement, particularly in declining or already depressed markets.

Consider the factors of production: land; labor; capital; management.

hard cost * See comment
+ soft costs (brokerage, const. financing interest, prof. fees, tap fees)
+ entrepreneurial incentive ** See comment
= replacement cost new
- depreciation, physical
- depreciation, functional
- depreciation, external obsolescence (fka, economic) *** See comment
= value of building
+ land value
= overall real property value

* Labor + materials + sub-contractor's profit create the many subcomponents of a building. The general contractor's profit then oversees the overall construction of the subcomponents into the whole building. The Marshall calculator includes all of these. The biggest problem with the cost approach, appears to be the vast range in quality. For example, a piece of tile can range from $0.89/SF to $40/SF; and skilled tile laborers can range from, say, $15 to $40/sf. It is extremely difficult to feel confident about the Marshall Calculator.

** Entrepreneurial incentive TO the developer (not the GC or building company). This is recognized from the "hurdle" of pulling together the concept, getting entitlements, brain damage, getting financing if the banker's recognize your reputation and skills , return on your equity capital, and the "go or no go" decision. Obviously some firms do everything from brokerage, architectural, GC, and development in one company, but the tasks and skills are separate from one another. I wouldn't allocate entrepreneurial incentive to the land, as one person does; this creates a number of economic conceptual problems.

***external obsolescence: In declining markets, ext.obs. is like a tap "turning off" or destroying value from the factors of production. It probably turns off entrepreneurial incentive first, bringing new projects to a halt, but it is not limited to just destroying entrepreneurial incentive. (The entrepreneurial profit rate doesn’t go to 0%). The external obsolescence can be determined by DCF if temporal, or direct capitalization if perpetual. For example, in some small town markets or in depressions, the capitalization of external obs. may be severe and perpetual, so no new buildings will ever constructed, as of that effective date, at least. The market won’t reward a developer for new projects. In other markets, developer’s will continue to build just to keep their companies alive, so ext.obs. is canceling out much, but not all of the ent. profit, as they struggle to make it to another day. If an appraiser uses RCN + land, and excludes the external obsolescence, this will make the cost approach “appear” to be higher than other approaches. Also, the comparable sales and/or rents may or may not have external obs. factored into them, usually depending on the point in time that those negotiations occurred.

Timothy J Lindsey, MAI

Bravo, Tim!!

And that, my friends, is what doing a demo will hopefully teach you.

Try it, you just might like it.

 

[John Hassler]

Mr. Lindsey

The most pragmatic post regarding the Cost Approach I've seen on this forum. And a first post too, more please! I concur with Ms. Potts - Bravo!



Linsdey: "I wouldn't allocate entrepreneurial incentive to the land, as one person does; this creates a number of economic conceptual problems."

If you would, please expand on the "conceptual problem". How does one account for the incentive to develop a more costly piece of land? For example Lot A and Lot B both warrant the same size/quality home and Lot A has a view premium that the market will pay $100,000 more for when the homes are completed. In a dynamic market economic forces would necessitate a lot price difference of more than $100,000 to compensate the developer of Lot A for the additional outlay (else he would buy Lot B). Where would this EI be allocated if not to the land to some degree? This is very much a question not a statement. My instinct is that EI is a combination of return on capital and return on management. Thanks.

 

[John Hassler]

The idea that some "developer" will hire a GC to build a single house is absurd. (I will grant that it is no more absurd than the idea the cost approach is necessary to any typical residential appraisal.)

I'm hoping your first sentense above was a tounge-in-cheek setup for the second.