Replacement Cost On Cost Approach Versus Market Value

[Wayne Henry]

Replacement cost on cost approach versus market value

In general, when dealing with an older home in a non declining market, would the replacement cost in the cost approach be lower or higher than the market value in the sales comparison approach. One school of thought on this issue is why would a property cost more to replace it than it is worth. The other thought on this is replacement cost should be based on Marshall and Swift and it falls where it falls.

What are your opinions on this debated topic and what do you generally see in your market?

 

[Mr Rex]

If you handle all the forms of depreciation correctly they would be the same.

 

[Eli]

The cost approach to value is an indicator of market value when properly applied. Many considerations must be considered in the cost approach that are market based. M&S is only one indicator and segment (method) of estimating depreciated replacement costs.

For example, a survey or itemized list of replacement costs New by local builders and building suppliers would be more credible and reliable than M&S. Land value "as if vacant" is very important. The cost approach takes a long time to complete properly. It can be a very good indicator of value on new construction. The older the improvements are, the cost approach can still be a good check and balance but not usually given as much weight as the sales comparison approach or the income capitalization approach.

 

[hastalavista]

Replacement cost on cost approach versus market value

In general, when dealing with an older home in a non declining market, would the replacement cost in the cost approach be lower or higher than the market value in the sales comparison approach. One school of thought on this issue is why would a property cost more to replace it than it is worth. The other thought on this is replacement cost should be based on Marshall and Swift and it falls where it falls.

What are your opinions on this debated topic and what do you generally see in your market?

Are you mixing-up Replacement Cost (one component in the cost approach) and the indicated value by the Cost Approach (the result after considering all components in the cost approach)?

A property's market value is $X.
The Cost Approach works as follows:

Market Value = Cost - Depreciation

Cost (in the above) includes all the costs (hard & soft costs, EI and land acquisition).
Depreciation (in the above) includes all forms (physical, functional, external).

It should be evident that Replacement Cost of the improvement can exceed the market value of the subject.

MV= $200k.
RCN = $250k (assume RCN equals all hard costs and includes EI)
Land = $100k.

What is the total depreciation?

MV = Cost - Depreciation

$200k = ($250k + $100k) - $150k.

Market value is $200k but it costs $250k to replace the improvement. RCN exceeds market value.

 

[Terrel L. Shields]

In general, when dealing with an older home in a non declining market, would the replacement cost in the cost approach be lower or higher than the market value in the sales comparison approach.

I have heard instructors say that the cost approach may be "higher" than sales and sales higher than income. I don't agree.
In theory Denis and Rex are absolutely correct. Replacement cost is to replace with a building of equal utility, not a reproduction of current buildings. So the only expectation would be to apply uniformity of application - treat all your comparables in an identical way to estimate their accrued deprecation and make a judgment about where your subject accrued depreciation falls. Success will be achieved when you do that and value the land as if vacant and available for its highest and best use. This and the site improvements (sheds, sidewalks, landscaping) etc. should be close to the sales approach.

 

[Meandering]

Replacement cost on cost approach versus market value

In general, when dealing with an older home in a non declining market, would the replacement cost in the cost approach be lower or higher than the market value in the sales comparison approach. One school of thought on this issue is why would a property cost more to replace it than it is worth. The other thought on this is replacement cost should be based on Marshall and Swift and it falls where it falls.

What are your opinions on this debated topic and what do you generally see in your market?

It's the magical pretend game.

So pretend you want to buy a 20 year old house, or you could build a similar new one and pretend it has been depreciated for 20 physical years of life, or as recognized by the market, or has depreciated at varying intervals, depending upon which components you are considering. Now once you've done all that, is this imaginary house a suitable substitution for the buyer to purchase, instead of purchasing your subject property? No, because it does not exist anywhere, except in the mind of the appraiser, and you are developing the Cost Approach in pursuit of Market Value, which is, the result of the interactions of buyers and sellers. Not the imagination of appraisers. So, lets also consider that as Denis points out, this Cost Approach you are imagining as a replacement or substitute for the subject property, is not very imaginative, as there are similar new homes available in the market.

So If you have new similar homes in the market that are built and available for purchase, more than half your battle is over. All you need to do then is compute depreciation and consider if a buyer would pay the extra money for the new house, if, they did not have to suffer the 20 year depreciation, you estimated at $X. You may have a couple of great substitutes for the subject property, utilizing the Cost Approach in this manner and arriving at a supported opinion of Market Value.

However, if there are no new similar homes being built in the area, you most likely are estimating the cost to build from an index or table of costs. Now as Denis notes, Your Cost Approach must contain ALL hard and SOFT costs including EI & EP, but darn, there is also a time value to money, and we can't build them in a day. So here's where that pretend part gets pretty intense. If your imagined new house that will be a substitute for the buyer is already constructed, as of the date of valuation, you need to date check your indexed cost tables to make sure you are using costs from 6 months ago, as that's when the project should have been cost out for the build. But that 6 months is not good if this is the spring, because of winter, that construction time frame could be 9 months or longer, due to weather delays. You get the jist of it, but it is something, we can't just gloss over, because it wasn't included with your Big Book of Appraisal Adjustments. So however you chose to handle the time value of money, the construction time frame, and changes in labor, supply and costs over the time frame is up to you, but remember that it's still a SOFT cost which needs to be included. So after you get done imagining this new building, and all the hard and soft costs, you get to estimate the depreciation utilizing which ever methodology is most suited to your market, and arrive at this wonderful number. But, is that number a representation of the actions of buyers and sellers in the market place? If it does not exist, but could exist, yet has not been commission by potential buyer in the market, does it represent anything within the definition of Market Value. I would argue no, that number does not indicate market value. Now you have to step back from the magic math and determine what does that ending number represent? It aint market value, so were you engaged to estimate market value? If so, what is the market for a magic math imaginary building on a similar piece of property? Hopefully you have a defined value that can be applied to that which does not exist, anywhere but within the imagination of someone with an index.


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[Terrel L. Shields]

So pretend you want to buy a 20 year old house, or you could build a similar new one and pretend it has been depreciated for 20 physical years of life, or as recognized by the market, or has depreciated at varying intervals, depending upon which components you are considering.

All approaches rely upon proxy. The house doesn't have to sell to validate SCA, nor does it have to be leased at market rates for the income approach.