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Understanding the Cost Approach in Appraising:
Prior to being a real estate agent, I had well over 10 years of residential real estate appraisal experience, and I utilize my experience in the real estate sales profession. Most importantly, of all the three approaches to value, among the cost, sales comparison, and the income approach, for real estate agents, the sales comparison is biggest role. Why? It’s the most reliable. It’s what market is willing to pay for the property. It’s you, the buyer. Most agents don’t look at the cost other than for renovation purposes. In an appraisal, you need a feasibility study while doing these improvements, by forming an opinion of value “as is” and “and subject to completion of the improvements” of an appraisal.If you look at the cost approach, many people don’t understand the breakdown in that approach. As an experienced appraiser, I’ll give you a better explanation what we do. The cost approach is generally used and most reliable for construction procedures. What is the cost to build a home? The main reason is, there’s no depreciation on the home as opposed to others that have been existing for many years, where long and short lived components have their differences in useful lives.From an physical standpoint, the bones of the home including the foundation, the studs, floor joists, and roof trusses would last forever. Those are long lived items. Those are the backbones of the structures. Some short lived items including shingles, floor coverings or a furnace would last roughly 10 – 20 years and need replaced overtime. The physical lives of these components are not the same.
Economically, if you look to buy a home, the key factor is how long will the home last? It’s usually shorter than its physical life. It’s based on the period over which improvements can contribute to the property’s value. The more you update and renovate, the longer the home lasts.
How is the Cost Approach conducted?
In the cost approach, you’ll need the land value first. You buy land in Scottsdale, let’s say at McDowell Mountain Ranch for $100,000, that’s the land with no improvements, and no depreciation is involved. Never is there depreciation for land.Just to pretend, if the $100,000 land in McDowell Mountain Ranch in Scottsdale has a 3,500 Square feet home that cost $120 per square foot before depreciation. The home is worth $420,000, the cost new for the dwelling. By the way, the home has no basement. Not here in the valley. Plus, you have an attached 3-Car garage at 650 Square feet at $40 square foot mounts up to $24,000. So, the building total estimate of costs new for the home is $444,000. The appraisers would get these figures from Marshall and Swift.We figured out cost new for the home, but it was built in 1998. Yes, the owners have maintained the home. Physically, it’s in great shape, but needs some updating physically for interior improvements. Lets say of the total economic life of 80 years, we’ll split the home economic life from 1998 to 2012, a total of 14 years in half. The home has depreciated 7 years physically due to normal wear and tear. Physical depreciation can be cured.Functionally, the furnace and kitchen appliances were replaced, and the floor plan is still perfect for today’s living standards. There’s no functional obsolescence. Functional depreciation can be cured.
External deprecation is something that’s incurable. It happens outside the boundaries of the property, including a major highway, and flight paths of a major airport. Lets pretend this home is on a quiet street and not on a flight path, though there’s nothing fancy about the property that doesn’t back to McDowell Mountains. There’s no external obsolescence.
So, the land is worth $100,000, with home as new $444,000 minus 7 years of depreciation of the 80 years of economic life (8.75% depreciation) with a total of $38,850 of total depreciation. The depreciated cost of improvements for the dwelling is $405,150. Again, land is not factored in the depreciation.
Plus, you need the “As is” site of improvements. The driveway is $10,000, the landscaping is $15,000, and the pool is $55,000 for the total $80,000 for “As is” site of improvements.
What is the indicated value by cost approach?
Opinion of Site Value: $100,000
Dwelling: $420,000 (New)Garage: $24,000 (New)Total Estimate Cost-New for Dwelling and Garage: $444,000
Depreciation:Physical: (8.75%) $38,850Functional: $0External: $0
Total Depreciation: ($38,850)
Depreciated Cost of Improvements: $405,150
“As is” Value of Site Improvements: $80,000
Indicated Value by Cost Approach: $585,150
This is the step by step process in the cost approach, utilized in the 1004 form, the Uniform Residential Appraisal Report (URAR), and hope you have a total understanding about how the cost approach of an appraisal report works. James W. Plummer III (Jim), ScottsdaleThe post Understanding the Cost Approach in Appraising appeared first on Phoenix Real Estate.