Ch2. The Cost Approach — Replacement Cost and Depreciation

The Logic of the Cost Approach

Cost Approach: Value is estimated by calculating the cost to reproduce or replace the subject improvements at current prices, then deducting accrued depreciation, and adding site value.

Theoretical basis: The Principle of Substitution — a prudent buyer will pay no more for a property than the cost of acquiring an equally useful substitute. When a property can be replicated new, its cost sets an upper bound on value.

Cost Approach formula:
Value Indication = Reproduction/Replacement Cost New
                 - Accrued Depreciation
                 + Land Value

Best-suited property types:

Special-purpose buildings (factories, hospitals, schools, religious facilities)
Properties with few or no comparable sales
Newly constructed buildings (where cost and value tend to converge)

Replacement Cost New

Reproduction Cost New: The cost to construct an exact replica of the subject improvements using the same materials, design, and workmanship at today’s prices.

Replacement Cost New: The cost to construct an improvement of equivalent utility using current materials, design, and construction methods.

Reproduction Cost: same materials and methods — exact replica
Replacement Cost:  equivalent utility with modern methods

Appraisal practice: Replacement Cost is most commonly used
(avoids valuing functional deficiencies built into the original design)

Methods for Estimating Cost

① Quantity Survey Method:
   Itemized takeoff of all materials and labor
   → Most precise; used for large or complex projects

② Unit-in-Place Method:
   Cost per installed unit for each building component
   → Good for mid-level precision

③ Square-Foot / Comparative Method:
   Cost per square foot from comparable buildings
   → Most common in residential and routine commercial appraisals

④ Index Method:
   Historical cost × current construction cost index
   → Quick adjustment for known past costs

Accrued Depreciation

Accrued Depreciation: The total loss in value from all causes — measured as the difference between cost new and current contributory value of the improvements.

The Three Causes of Depreciation

Physical Deterioration:
- Loss from wear, age, and the elements
- Curable: deferred maintenance that is economically worth correcting
  (e.g., fresh paint, new roof covering)
- Incurable: structural decay or wear beyond economic repair
  (e.g., cracked foundation, failed HVAC system in an old building)

Functional Obsolescence:
- Loss from outmoded or inadequate design features relative to market standards
- Curable: deficiency or super-adequacy worth correcting
  (e.g., adding a second bathroom to match market expectations)
- Incurable: deficiency not worth the cost to cure
  (e.g., low ceiling heights in a modern warehouse; atypical floor plan)

External (Economic) Obsolescence:
- Loss caused by factors outside the property — always incurable
- Examples: new highway noise, proximity to an industrial facility,
  neighborhood economic decline, adverse zoning change
- Affects land value as well as improvements

Methods for Measuring Depreciation

① Straight-Line (Age-Life) Method:
   Depreciation Rate = Effective Age / Total Economic Life
   Depreciated Value Factor = 1 − Depreciation Rate

   Example: Total economic life 50 years, effective age 10 years
   Depreciation Rate = 10 / 50 = 20%
   Depreciated Value Factor = 80%

② Observed Condition (Breakdown) Method:
   Appraiser directly inspects the property and assigns
   depreciation percentages to physical, functional, and external causes
   → Reflects actual condition, not just age

③ Sales Comparison (Extracted) Method:
   Depreciation is extracted from paired sales of similar properties
   → Most market-driven; requires adequate comparable data

Calculating Depreciated Cost Value

Depreciated Cost = Replacement Cost New × (1 − Depreciation Rate)
               or = Replacement Cost New − Accrued Depreciation

Example:
Replacement Cost New: $800,000
Total Economic Life:  40 years
Effective Age:        10 years

Depreciation Rate = 10 / 40 = 25%
Depreciated Cost  = $800,000 × (1 − 0.25) = $600,000

Add land value (appraised separately) to arrive at total property value.

Land in the Cost Approach

Land is not depreciated: Land has an indefinite economic life — it is never consumed by use. Accordingly, land value is estimated separately (typically via the Sales Comparison Approach) and added to the depreciated cost of improvements.

For developed / subdivided land:
Land Value = Acquisition Cost + Development Costs + Developer's Profit
           (then tested against comparable land sales)

Key Concept Cards

Three Causes of Depreciation ★★★★★ : Physical (wear and age) · Functional (outdated design) · External (outside forces). External obsolescence is always incurable. Memory trigger: Physical · Functional · External — PFE

Straight-Line (Age-Life) Formula ★★★★★ : Depreciation Rate = Effective Age ÷ Total Economic Life. Value Factor = 1 − Rate. Memory trigger: Rate = Age ÷ Life

Reproduction Cost vs. Replacement Cost ★★★★☆ : Reproduction = identical replica (same materials). Replacement = equivalent utility (current methods). Practice uses Replacement Cost to avoid pricing in curable functional obsolescence. Memory trigger: Practice uses Replacement (modern equivalent)

Practice Quiz

Q. Replacement cost new is $1,200,000, total economic life is 40 years, effective age is 10 years. What is the depreciated cost indication?

Depreciation Rate = 10 / 40 = 25%. Depreciated Cost = $1,200,000 × 0.75 =$ 900,000.

Q. A new distribution warehouse was built nearby, causing a 20% drop in the subject property’s market rents. What type of depreciation is this?

External (Economic) Obsolescence — caused by a factor outside the property boundary. It is incurable by the property owner.

OIYO Editorial