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The Basic Valuation Approaches
• Cost (or Summation) Approach
• Sales (or Market) Approach
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• Income Approach
• Valuers tend to use the approach(es) which are most appropriate to their valuation problem.
• Reconcilation
Cost Approach
• Whatisit
• Data sources
• Methods of assessing replacement cost • Depreciation
• Practical application
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What is it?
• Based on substitution & contribution principles
• The buyers outlay of capital will be influenced by the alternative cost to acquire a comparable property
• Improvements add to a property’s market value
IVS 105 (60.1)
The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved. The approach provides an indication of value by calculating the current replacement or reproduction cost of an asset and making deductions for physical deterioration and all other relevant forms of obsolescence.
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IVS 105 (60.2) When to use
• participantswouldbeabletorecreateanasset with substantially the same utility … without regulatory or legal restrictions, and the asset could be recreated quickly enough that a participant would not be willing to pay a significant premium for the ability to use the subject asset immediately
• theassetisnotdirectlyincome-generating…or market approach is unfeasible
• thebasisofvaluebeingusedisfundamentally based on replacement cost …
Steps in the Cost Approach
• Assesslandvalueasavacantsite(LV).Thisis accomplished by the market comparison approach.
• Assessthereproductionorreplacementcostofthe major improvement (RC)
• Assessaccrueddepreciation/obsolescence(DPN)
• Assessthevalueofoutbuildings&other
improvements (OI).
• MarketValue=LV+(RC-DPN)+OI
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Reproduction Cost Method
The cost of a duplicate or nearly identical structure, every physical component must be included.
Replacement Cost Method
The replacement cost is generally that of a modern equivalent asset, which is one that provides similar function and equivalent utility to the asset being valued, but which is of a current design and constructed or made using current cost- effective materials and techniques.
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Reproduction vs Replacement Cost
Subject Property
Reproduce a Replica
Replace the Utility
What costs to include
• direct costs: materials and labour.
• indirect costs: transport costs, installation costs, professional fees (design, permit, architectural, legal, etc), other fees (commissions, etc), overheads, taxes, finance costs (eg, interest on debt financing), and profit margin/entrepreneurial profit to the creator of the asset (eg, return to investors).
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Main Applications of the Cost Approach
• Value Special Use Properties
• Use as a Check Against Other Approaches
Replacement Cost Methods
• Units of Accommodation • Schedule of Quantities
• Units in Place ($ per square metre of floor, linear metre of plasterboard)
• Units of Cubic Capacity • Area Method
• Modal Rate – Multiples • Index the original cost
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Area Method
• Floor area x cost per area e.g. 100m2 x $3,000 per m2
• Quick, easy, readily understood by market
Primary Cost Variables
What Affects Construction Costs?
• Design or Use-Type
• Construction Class
• Yard Improvements
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Source of Cost Data
• Building experts (builder, developer, architect, quantity surveyor…)
• Building Economist
• QV costbuilder
• Statistics
House Cost Multiple System
• Multiples are determined by experience or expert knowledge. It can be highly subjective.
• Estimated cost of 200m2 house 200m2 x “Standard” House Rate x Multiple
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Depreciation
• In accounting practice, all capital assets except land are considered to be wasting assets, assets that decline in value over time. (Theoretical loss)
• In valuation practice, estimated loss in value as compared to a new building from any cause whatsoever (Actual loss)
Actual Depreciation
– Definition:Lossin value
– Purpose:Usedin valuations (cost approach primarily)
– Howdetermined: Cost to cure, age-life, sales data, rental loss…..
– Howapplied: Deduction from current replacement cost.
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Types of Accrued Depreciation
• PhysicalDeterioration
• FunctionalObsolescence • ExternalObsolescence
Obsolescence
• Lossinvalueduetoallothercauses – External obsolescence
• Causedbyexternalinfluencesmayaffectthedemandforgoods and services and the profitability of business entities.
– Functional and technical obsolescence
• causedbyadvancesintechnologythatcreatenewassetscapable of more efficient delivery of goods and services.
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Curable Depreciation
Cost to correct the condition or defect is less than the amount of value restored, called economically curable
Incurable Depreciation
Cost to correct the condition or defect is greater than the amount of value restored, called economically incurable
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Measuring Accrued Depreciation
• Straight-LineorAge-Life
• SalesData(Market)Method
• Cost-to-Cure(ObservedCondition) • CapitalisedIncome
Market Derived Depreciation Rate for a 50 year old house
Sale Price
Value of Improvements Replacement Cost $200,000 Depreciation = $60,000 Depreciation % = $60,000/$200,000
So: Depn = 30%/50 = .6% per annum
• Need plenty of sales
• Accuracy in deducting OI’s • Need land sales
$560,000 $420,000 $140,000
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Cost-to-Cure Method
Measures the accrued depreciation by the cost to cure or repair any observed building defects. After inspecting the premises, the appraiser tries to identify each building defect, feature, or condition that reduces value. Each is then classified as either physical, functional, or economic.
In addition, each defect must be studied to estimate whether it is economically curable or incurable. However, economic obsolescence is rarely economically curable.
Physical Deterioration
• Deferredmaintenance—curable
• Deferredmaintenance—incurable • Short-liveditems
• Long-liveditems
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Functional Obsolescence
• Curable—anaddition
• Curable—areplacementorsubstitution
• Curable—superadequacyorover-improvement • Incurable—adeficiency
• Incurable—asuperadequacy
Physical Deterioration
• StraightLine
• Diminishingvalue
• Remainingeconomiclifevsusefullife
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Obsolescence
• Marketobservation
• Consider:past,presentandfuture • Usingknowledgeandskill
• An additional annual % rate
• An additional lump sum%
• A $ deduction
Replacement Cost in Practice
• Traditional/widely used method of valuation • Accepted by the Courts
• Now commonly used as a check method
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• Costing experience is an important part of a valuer’s “tools of trade” e.g. advise on whether to build or buy
• Usefulwhenlackingsalesevidenceorinvestment approach inappropriate e.g. church, stadium
• Consistent/justifiablevaluesprovidedadequate allowance for depreciation
Weaknesses
• Somewhathypotheticalwhenconsideredinisolation • Highlyjudgmental
• Lossesvalidityasageofimprovementsincrease
• Inappropriatewhereuseisnot“Highest&BestUse” • “Costdoesnotnecessarilyequatetovalue”
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Replacement Cost Approach
Cost of House $ Attached Garage $ Terrace $ Total Main Building
Less Depreciation / Repairs = Value of Main Building
$ $________
Plus Value of Other Improvements
Paths & Drive Garage (Detached) Total Value of Imp’ts
Land Value
MARKET VALUE LAND AND BUILDINGS $ _____
Plus Chattels $ Total Market Value $
(Inclusive of GST if any)
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