Replacement Cost instead of Reproduction Cost

[Bob Mulder]

There are occasions, particularly when dealing with older or unusual properties, where I find the cost approach form a reproduction standpoint not very useful or reliable. I would prefer to do a replacement cost.

Does anyone out there have an example of a USPAP compliant addendum that states the reasons for doing a replacement cost rather than a reproduction cost?

Would you e-mail me that addendum?

Thanks for any help you can provide!


Bob

 

[Blue1]

Bob,

The last time I EVER had a question on a Cost Approach was......well......NEVER! Bottom line.....The investor wants to know that they can sell the home and get back their investment........in the event of default. At that point, it doesn't really matter how much it cost to build the home.

I have always thought that REPRODUCTION cost (for older homes) was completely unreliable.......some materials are not currently available. REPLACEMENT cost is equally as unreliable for the same reasons.

The ugly truth......nobody cares about the Cost Approach.......except appraisers! (And Marshall and Swift!)

 

[rtubbs]

Bob, good question. Forgetting about the older homes, what source do you use to get reproduction cost for a newer home?

 

[Pamela Crowley (Florida)]

"Reproduction" makes no sense unless the structure is within at least 10 years of actual age. Make this simple and state what it really is.

This is a sample of what I use in the Cost Approach Comments:

Subject property has an estimated remaining economic life of 50 years. Physical depreciation is based on the effective age of the dwelling, 10 years, estimated per Age/Life Method. Marshall & Swift and local builder data used to estimate "Replacement" Cost-New-Of Improvements. Please see attached building sketch for living area calculations. The Cost Approach is rounded. Personal property items are not included in the final value estimate.

I've never had anyone question this, ever. Now that I've posted it here though, Murphy will probably strike.

 

[rtubbs]

Pamela, I'm in agreement with you. My question was sort of a loaded one. In the cost approach section of the URAR, we identify the Estimated Reproduction Cost New of Improvements. Yet, the Marshall & Swift Handbook is based on replacement cost.

I believe that the URAR should be revised to show estimated replacement cost.

 

[Jo Ann Meyer Stratton]

Since Pamela kindly offered her statements, I'll offer mine as some additional thoughts.

In the cost approach on the URAR I have the two following sentences. "Replacement cost new based on Marshall & Swift (Page-----12/2001) and local information. Physical depreciation based on observed conditions." I do not make any statement regarding remaining economic life for non FHA reports. In an FHA report, I add that the subject appears to have a remaining economic life of over thirty years or less if applicable.

Then in my addendum I have the following paragraph. "See attached building sketch for exterior dimensions and area calculations. Livable area based on field measurements of outside dimensions by this appraiser. While reasonable care was excercised in the field measurements, the final square footage utilized in the report should be considered an approximation only and is not guaranteed. Interior walls are for demonstration purposes only and are not necessarily drawn to scale. (For a 2055 I don't put in interior walls, so the the last sentence gets changed to--Room locations are for demonstration purposes only and not necessarily located to scale.)

 

[Steve Owen]

These are all pretty good answers. I don't believe you have to do anything to be USPAP compliant except to state that you used the replacement cost rather than reproduction (and I always do).

My statement simply says:

The cost figures used have been obtained from the Marshall Valuation Service and the Marshall Residential Cost Handbook and are verified through local contractors who are engaged in this type of construction; Replacement rather than Reproduction Cost.

P.S. Don't pay attention to people who don't understand the economic principle of substitution, whether they are investors or appraisers. I once had an instructor try to tell me that the cost approach was not applicable if it was an older house because the form says reproduction; short response - the form does not dictate proper appraisal process.

 

[Fred]

Bob, you ask,
"Does anyone out there have an example of a USPAP compliant addendum that states the reasons for doing a replacement cost rather than a reproduction cost?"

I do not see why any special addendum is required. If you think the solution to your appraisal problem requires reproduction cost, use it. Why should it take more than one sentence to say that you used reproduction and why (anywhere in the report)? If, for some reason, it is "wrong" to use reproduction (and I am not going there), then no addenda statement can make it correct.

Steve Owen,
You mention substituion, which (I think) is a point of confusion. From what I have encountered, there seems to be two principles of substitution that involve two different amounts of money. One involves the "price" of existing commodites that offer similar utility The other involves the "cost" of manufacturing a new commodity from scratch.

 

[Verne Hebert]

Wait a minute. It is very useful. After being depreciated (in terms of physical depreciation) the remaining amount of money in the cost approach, greater than the market value as determined by the market approach, is remaining depreciation in the form of functional and external in that order.

On older and historic homes it tells you the excess amount per square foot it costs to build this house today--which most people of any level of construction education already knows, at least in concept (maybe not exact quantity).

In horse property this very evident with a significant amount of this form of depreciation noted on every assignment I have ever done.

In this case, what it tells me as a professional and consultant is to advise you the buyer, to buy a horse property.................and not build one--it is cheaper! Better value!

I was out on inspection of a couple of "castles" and this is always the terms of which I am thinking on these inspections--what is the functional and external....and thank god for the cost approach to value. IN ENGLISH, it is begging the question, "what is the limit the typical buyer will pay for a particular item (granite from Australia? hardware from France? Cedar logs, logged form steep slopes? Microwave lumber drying as opposed to kiln..and I mean special order).

The cost approach always tells you something and in unique property it tells you very important items.

I have a new office building from plans and specs I am just finishing. The cost approach is very high due to some combination of functional and/or external. I am leaving it as that----they are not paying me to break it out (beating a dead horse)----But I, in this case, know it is both from my research.


In doing review work, I see the cost approach "cheated-in" on your type of building all the time by less experienced appraisers in this area. Good appraisers will call it in review. You will almost always have a high cost approach on older homes. It must be technically completed to bring "it" in line.

 

[Steve Owen]

Steven Santora, I enjoyed your post. To clarify a little bit,

Substitution:

The Cost Approach is based on the premise that an informed purchaser will pay no more for the subject property than the cost of producing a like property with the same utility. In economics this is referred to as the principle of substitution.

In economics the principle of substitution is a relatively simple concept. (It was covered in my very first Micro class.) In English, as opposed to economics, it may be more complicated. If you "substitute" one commodity for another, such as valuing an inground sprinkler the same in one property as a deck and hot tub in another property, that is indeed a substitution, but does not exactly reflect the economic principle of substitution in valuation process. (i.e. The buyer did not make the substitution judgement, in this case the appraiser did.)

My comment was directed at appraisers and lay people who don't understand why the cost approach is a valid valuation technique. The principle of substitution also explains why the cost approach tends to deliver the high end of the range of value under normal market circumstances. (The cost approach can also be a valuable tool for indicating to those appraisers who use it that a buyers market is developing, but that is another subject.)