Cost Approach Valuation Ch4 PDF

Unit Four: Cost Approach Bahir Dar University Institute of Land Administration Department of Land Administration and Surveying Habtamu Bishaw Asres (PhD) February, 2016 1  Unit IV: Cost Approach 4.1 Introduction  Th...

Unit Four: Cost Approach Bahir Dar University Institute of Land Administration Department of Land Administration and Surveying Habtamu Bishaw Asres (PhD) February, 2016 1  Unit IV: Cost Approach 4.1 Introduction  The cost approach is a set of procedures through which a value indication is derived for a property by estimating the current cost to construct a reproduction of or replacement for the existing structure plus any profit or incentive, deducting depreciation from the total cost and adding the estimated sit/land value.  Under this approach the property is valued as a function of what it would cost to buy the land and construct the buildings.  There would also be allowances made for depreciation.  This approach historically has been known as the summation approach. 2  4.2 Assumptions, Applicability and Limitations of Cost Approach  The cost approach is based on the assumptions of the principle of substitution  It is also based on the assumption that the replacement cost normally sets the upper limit of value provided that the improvement is new and represents the highest and best use of land.  It is further based on the assumption that a newly constructed building has more advantages over existing buildings.  The cost approach assumes that cost (including entrepreneurial profit) equals value.  It may be useful for certain valuation problems which separate estimates of the value of the land and 3 improvements of a property (e.g insurance purpose).  Con’t….  The cost approach is more applicable and reliable for new buildings than for old buildings.  The cost approach is more applicable to valuation problems where market data is lacking for the income or comparison approach.  Church, mosques, museums, public buildings and other special purposes buildings are usually appraised using the cost approach since the other approaches are inapplicable because of the lack of market data. 4  Con’t…..  One of the difficulty in the cost approach is in deciding whether cost and market value are likely to be approximately equal. The cost approach is relevant only when this condition is fulfilled. In order to fulfill this condition, the subject property must represent highest and best use.  The second difficulty is based on the method of calculating depreciation, particularly physical and functional depreciation. 5 4.3 Procedure/Steps in Cost Approach 1. Estimates the value of land or site. 2. Selection of cost basis: reproduction cost, replacement cost, historical cost 3. Estimate the total cost new of the improvement as of the valuation date 4. Estimate depreciation 5. Subtract the total estimated depreciation from the cost new of the improvements to arrive at the depreciated cost of the improvements 6. Add the land value and site value improvement to the total depreciated cost of improvements 7. Market value using the cost approach 6  Reproduction and Replacement Costs  The cost to construct an improvement on the effective date of valuation may be developed as the estimated reproduction cost or replacement of the improvement.  The theoretical base for the cost approach is reproduction cost, but replacement cost is commonly used because it may be easier to obtain and reduce the complexity of depreciation analysis  Reproduction cost is the estimated cost to construct, as of the effective date valuation, an exact duplicate or replica of the building being appraised in so far as possible using the same materials, standards, design, lay out, quality of workmanship, embodying all the deficiencies, super adequacies and obsolescence of 7 the subject building.  Con’t….  Replacement cost is the estimated cost to construct, as of the effective date of valuation, a building with utility equivalent to the building being appraised using contemporary materials, current construction standards, design and layout.  Replacement cost figure is usually lower and may provide better indication of the existing structure’s contribution to value.  Estimating reproduction cost may be complicated because the improvement may include materials that are now unavailable and construction standards may have changed.  However, reproduction cost usually provides a basis 8 for measuring depreciation from all causes when such measurement is necessary.  Cost estimates  valuers must consider direct (hard) costs and indirect (soft) costs in order to develop cost estimates of a building.  Both types of costs are essential to a reliable cost estimates. Direct costs:  the costs of material and labor as well as the contractors profit required to construct the improvement on the effective date of valuation.  The overhead and profit of the general contractor and various sub contractors are part of the usual construction contract and thus are included in the direct costs in the cost estimate. 9   Direct costs include costs of :  Building permits  Materials, products, and equipment  Labor used in construction  Equipment used in construction  Security used during construction  Constructors shake and temporary fence  Material storage facilities  Power line installation and utility costs  Contractor's profit and overhead including job supervision, coordination and management, workers compensation, fire, liability 10  Indirect Costs  Indirect costs are expenditures or allowances that are necessary for construction but are not part of the construction contract.  Indirect costs include costs of :  Architectural and engineering fees  valuation, consulting, accounting and legal fees  The cost of carrying out the investment in land and contract payments  The cost of carrying the investment in the property after construction is complete but before stabilization is achieved.  Marketing costs, sales commission, any applicable holding costs to achieve stabilized occupancy in a normal market 11  Administrative expenses of the developer  Entrepreneurial Profit  When the direct and in direct costs of developing a property are used to provide an indication of value, the valuer must include the economic reward sufficient to induce an entrepreneur to incur the risk associated with a building project.  Entrepreneurial profit refers to a market derived estimate of what the entrepreneur expects to receive for his or her contribution, i.e the value of entrepreneurial services. 12  Depreciation  Depreciation is the difference between what an improvement costs and the value of the improvement on the effective date of valuation.  Depreciation can be estimated by comparing the cost new of an improvement and the value of the improvement on a sale property.  Depreciation can be broken down into three types:  Physical deterioration  Functional obsolescence  External obsolescence 13  Physical Deterioration  It is the loss in the value of an improvement because of wear and tear or the passage of time.  This type of depreciation is found in all properties with improvements that are not new. Functional Obsolescence  It is the result of incompatibility with current market requirements.  In other words, this type of depreciation is the loss in value due to a problem with the utility of certain property improvements.  Nearly, all improved properties have some functional obsolescence after a few years. 14  External Obsolescence  It is the loss in the value of the improvements due to outside sources (negative externality) such as a busy interstate highway or a contaminated site.  The loss in value due to external forces will usually also cause the property to have a lower value. 15 4.4 Building Cost Estimates  To apply the cost approach to value, a valuer must prepare an estimate of the cost of the improvements as of the effective date of valuation.  Such an estimate can be prepared by an valuer who understands  construction plans  specifications  materials, and  techniques and can access a variety of data sources or computer programs available for this purpose.  Alternatively, the work can be done with the assistance of the expert cost estimators. 16  Cost Data Sources  Construction contracts for buildings similar to the building being appraised provide a primary source of comparable cost data.  Some valuers maintain comprehensive files of current cost data, including current costs for completed houses, apartments, hotels, office buildings, retail buildings, and industrial buildings.  These costs can provide a basis for calculating the cost to construct an existing or proposed building. 17   There are four primary methods used by valuers to estimate the construction cost.  These are:  Comparative (Square foot) method  Quantity survey method  Unit- in- place method  Trended historical cost (index) method 18  a) Comparative (Square foot) method  It is the most commonly used method of estimating building cost  This method assumes that there are numerous similar buildings that can be grouped by design, type and quality of construction  Replacement cost factors can be obtained by developing average unit costs from known construction costs of new buildings in each group.  The valuer can identify costs of similar structures adjusting those costs for differences in marketing conditions, location and physical characteristics in comparison to the subject property. 19  Cost derivation  Although there are several methods used by valuers to derive costs, deriving cost from sales and publications are common. Cost derivation from sales  It can be derived is by comparing with similar new construction in the area.  In its simplest form, the process starts with the sales price of the property, subtracting the value of the lot, and then divide this figure by the square footage of the improvements. 20  Cost derivation from publications  In cases where actual cost data cannot be available from the comparable sales, valuers rely on published data sources to estimate building costs.  In using published data sources, the appropriate base rate should be selected according to  the size and  quality of construction of the subject property.  The base figure is then adjusted for such matters as roofing materials, subflooring, foundation and built in appliances to get an adjusted cost per square foot. 21  b). Quantity Survey Method/Bill of Quantity Method  It is the most comprehensive and accurate method of estimating building cost, which will more often be applied by a contractor or professional cost estimator than valuer.  A quantity reflects both the quantity and quality of all materials used in the construction of improvements and all categories of labor required.  It is an item by item inventory of all costs, including contactors profit.  It is the most accurate method if it is done by the quantity surveyor. 22 Con’t….  Unit cost are applied to those figures to arrive at a total cost estimate for material and labor, then the contractor adds a margin for contingencies, overhead and profit.  Example: The following two tables summarize a general contractor’s cost break down (direct and indirect costs) for an apartment building which has 149,000 birr site value. Determine the value of the property assuming that the entrepreneurial profit is 15% of the sum of direct costs, indirect cost and site value. 23  Building cost component Cost Direct Cost Foundation 23,000 Frame 191,000 Floor structure 223,000 Floor cover 96,000 Exterior walls 647,000 Interior walls 433,000 Electrical system 59,000 Electrical fixtures 28,000 HVAC 242,000 Roof structure 205,000 Ceilings 79,000 Painting 18,000 Plumbing system 65,000 On site improvements and landscaping 1,205,000 Permits and fees 290,000 24 Total direct costs 3,804,000  Indirect costs Architectural/ engineering services 304,000 Survey 8,000 Toxic assessment 5,000 Construction loan interest 188,954 valuations 16,000 Legal 25,000 Development consultants 148,000 Total indirect costs 694,954 25  Select this paragraph to edit Total improvement costs (direct costs plus indirect costs) 4,498,954 Entrepreneurial profit (15% of total improvement cost and site value) 697,193 Total improvement cost new 5,196,147 Site Value 149,000 Total value indication by the cost approach 5,345,147 26  c) Unit-in –Place Method  It is a simplification of the quantity survey method.  It finds the sum of the cost of installed materials using convenient units of measurement such as the cost to install foundation, roof, plumbing, wiring, heating and exterior wall and etc.  The cost of building each unit would be specified with the sum of the units representing the total cost of each building.  This method is also very detailed next to quantity survey method and needs sophisticated estimating skills. 27   This method is especially suited for industrial buildings since they vary greatly in size, shape, height.  In the unit in place method, units of measure may vary according to the standardized costs for each component as installed.  For example: Floor covering may be counted to a square yard base and interior partition on a linear foot base.  Common sources of unit in place cost data are standard cost tables such as those published in the board approved cost guide. 28   Example: Suppose the building has square and rectangular parts. The floor of the building costs 8.25 birr per sq.ft., the roof costs 16.5 birr per sq,ft., and the wall costs 275 birr per linear foot. Notice that both the square building and the rectangular building have 10,000 sq.ft. but the square building has only 400 linear feet for walls while the rectangular building has 500 linear feet of walls. Consider how this would affect Square the construction cost Rectangular building for each building. Building Floor @8.25 82,500 82,500 Roof @ 16.5 165,000 165,000 Walls (400 X275) 110,000 Walls 137,500 (500X275) Cost 357,500 385,000 29   Given these different costs, its effect on the cost per square foot becomes: Square building Rectangular building Total cost 357,500 Total cost 385,000 Sq.ft. 10,000 Sq.ft 10,000 Cost/sq.ft. 35.75 br/sq.ft Cost/sq.ft. 38.5 br/sq,ft 30  d) Trended Historical Cost or Index Method  Cost index trending may be used to convert historical data into a current cost estimate.  Cost indexes are published as part of a cost manual.  The index approach is used in a situation when the original construction of the existing improvement is already known.  It is most commonly used in the case of unique buildings.  The further away the date of construction, the less accurate the estimate will be.  To trended historical cost into current cost, the current cost index should be divided by the historical cost index and the result should be multiplied by the 31 historical cost.  Example: Suppose the contract cost for constructing a building in January 2004 was 1,000,000 birr. The index for January 2004 is 285.1 and the current index is 327.3 as it is obtained from the cost manual. Determine the current cost of the subject building using the trended historical cost or index method.  The current cost of the subject building is: (327.3/285.1)=1.148 1.148 X 1,000,000 birr= 1,148,000 birr  In other words, a building that cost Birr 1,000,000 in 2004 would cost about Birr 1,148,000 today. 32  4.5 Estimation of Depreciation  Depreciation may thought of as the difference between the present value of the worn or outmoded subject property and the present value of the, newly built, modern property of equivalent utility.  There are three causes/types of depreciation  Physical deterioration  Functional obsolescence  External obsolescence 33 A. Physical Deterioration  It is a loss in value due to use or forces of nature. It is the most obvious cause of depreciation.  Buildings will ultimately wear out due to the physical forces of nature working to destroy them.  Examples of physical deterioration are Peeling paint, Flood damage, Metal fatigue etc.  Proper maintenance can slow a building’s rate of physical deterioration.  Physical deterioration can be classified as  curable and  incurable deterioration 34  Curable physical deterioration or deferred maintenance occurs when the value added by the a repair equals or exceeds the cost to cure the defects.  It applies to items in need of immediate repair on the effective date of valuation.  Some examples:  Broken windows  Carpet need immediate replacement  A hole in an interior partition etc 35  Con’t….  Incurable physical deterioration occurs when the value added by the repair is less than the cost to cure the defects as of the valuation date, i.e., it is not economically feasible to repair the item.  Incurable physical deterioration can be either be short lived or long lived.  Short lived items are those items that are not ready to be replaced on the date of valuation.  Unlike the curable depreciation that needs to replaced immediately, short lived items have generally not reached the end of their total useful life and are not completely depreciated. 36  Con’t….  Short lived components of the improvement are components that typically have useful life shorter than the remaining economic life of the entire building.  Example: A roof may have an expected economic life of 20 years while the building may last for 50 years.  Long lived item is an item that is not treated as deferred maintenance or short lived item.  It is a building component which has an expected physical life that is equal to or greater than the remaining economic life of the property. 37  Long lived item is not normally replaced except under extraordinary circumstance, i.e., if a foundation wall is damaged.  B. Functional Obsolescence  Functional obsolescence is a loss in utility and value due to a reduction in the desirability of the property.  It can be caused by the factors inherent to the property. This form of obsolescence may be attributable to  changes in tastes and preferences with in the market place  change in building techniques or technology  poor original design that is deficient or excessive when compared to the current market standards 38  Con’t….  The following are the factors that could lead to functional obsolescence.  Excessive floor space: includes floor areas that are not used or required for current or future operation  Inappropriate building layout, and disjointed production flow: Poor laid out buildings nay be the cause of extra operating costs in human power, transportation and machine etc.  Excessive operating costs: factors such as  excessive windows and openings,  poor insulation  inadequate heating system and interior building services may generate excessive operating costs.  Excessive height 39  Con’t….  Excessive or superior construction: a building may have originally been designed for certain roof loading, floor loading which no longer form part of the production process.  Inferior materials or construction: lack of quality in construction may lead to inefficiencies.  Change in property use: a manufacturing facility can require special services and designs to ensure that employees have safe and comfortable working area.  If it is changed into warehouse, these special facilities may add nothing to the current property use.  Poor lightning or poor installation of other services 40  C. External Obsolescence  External obsolescence /economic obsolescence is a loss in value caused by the negative influences of the subject property.  It can also be caused by regional factors, such as problems experienced by local industries.  In addition to these, it can be caused by national factors such as when a recession or depression affects property value.  It can be either temporary (e.g., an oversupplied market) or permanent (e.g., proximity to an area where there is environmental disaster) 41  Con’t… The following are the factors that could lead to external obsolescence.  Technological change: availability of new competitive properties  Change in attractiveness of the location  Change in government restrictions and regulations: change in restriction of the amount of pollutant permitted in manufacturing.  Physical site restriction: if expansion is not possible due to physical restriction  Change in sources of supply: a steel mill may have been located close to an ore deposit to save on transportation costs. If the ore supply runs out, the mill may suffer from the problem of external obsolescence. 42 Basic concepts in Estimating Depreciation  Economic life refers to the period of time over which an improvement or a component thereof contributes to the property value from the time it is new.  Useful life refers to the period of time over which an improvement or a component thereof actually performs the function it was designed to perform.  Remaining economic life is the period of time from the valuation date that an improvement or a component thereof can be expected to continue to contribute to a property's value.  Remaining useful life is the estimated period of time from the actual age of an improvement to the end of the improvement’s useful life. 43   Actual age/historical age /chronological age/ is the actual number of years since building construction was completed.  Effective age refers to the age of an improvement as reflected by its actual condition and utility on the date of valuation. It is based on the valuers judgment and interpretation of market perceptions.  If one building is better maintained than other buildings in its market area, the effective age of that building may be less than its actual age.  Effective age is the difference between total economic life and remaining economic life.  Lack of proper maintenance can also increase the effective age to more than the historical age or 44 chronological age of the building.  Methods of Estimating Depreciation A. Market extraction method B. Age - life method C. Breakdown method 45  A. Market Extraction Method  The market extraction method (also called the market or comparable sales data method) is the only method that uses comparable sales data to estimate depreciation.  This method requires  sales price,  site value and,  accurate estimate of cost new of properties that are highly comparable to the subject property and the cost of improvement new of the subject. 46  Con’t….  The market extraction method includes the following steps: 1. Identify and verify sales of similar/comparable properties 2. Adjust the comparable sales. Adjustment for market condition is not required since depreciation is estimated at the time of sale. 3. Determine the depreciated value of improvement (Property value- land/site value) 4. Calculate RCN 5. Determine total depreciation (RCN- depreciated value of improvement) 6. Convert each estimate of total depreciation into percentages by dividing each estimate of total depreciation by the cost new of each comparable sale. This rate is applied to the subject property’s cost to derive the estimate the subject’s total depreciation. 47  Con’t…. Example 1:  Suppose that a comparable property was sold for 350,000 birr and the site value appropriate for this comparable was estimated at 100,000 birr. The cost to build the property new today is estimated at 300,000 birr. The effective age of the property is 10 years old. Estimate the total depreciation of the subject property which has an effective age of 15 years old and its cost of improvement is 280,000 birr at the date of valuation based on this information. 48  Solution Sales price of the comparable --------------------------- 350,000 Less: Estimated site/land value ------------------------ 100,000 Depreciated cost of improvement ----------------------- 250,000 Cost of improvement new ------------------------------- 300,000 Less: Depreciated cost of improvement ---------------- 250,000 Total depreciation ----------------------------------- ------ 50,000 Rate of depreciation 49 (Total depreciation ÷ Cost of improvement) X 100 (50,000 ÷ 300,000)X 100= 16.7 % Annual depreciation of comparable is 16.7% ÷ 10= 1.67 %  Con’t….  Since the effective age of the building is 15 years, the depreciation rate is 1.67% X 15 years= 25.05 %  The total depreciation of the subject property is 0.251 X 280,000 birr= 70,280 birr Applicability and Limitations  When sales data is plentiful, the market extraction method provides a reliable and convincing estimate of depreciation.  The comparable properties should have similar physical, functional and external characteristics as the subject. 50 B. Age - Life Method  It is a quick and easy method  Effective age and economic life of the property are applied Depreciation = Effective age X Total cost of the property Total Economic life 51  Example: Suppose that a residence property has an actual age of 15 years, an estimated effective age of 10 years and a remaining economic life of 40 years. The replacement cost new of the property is 500,000 birr. Estimate total depreciation of the property and its depreciated replacement cost based on the above given. Total depreciation = (10/50) X 500,000 birr = 100,000 birr Depreciated replacement cost = 500,000 -100,000 birr = 400,000 birr 52  Applicability and Limitation  It is simple, and easy to understand  However, it has the following limitations.  It assumes that every building depreciates on a straight line basis over the course of its economic life.  This method, like the market extraction method, doesn’t segregate depreciation into its various components and difficult to apply.  It doesn’t recognize the difference between short lived and long lived items of physical deterioration. 53 C. Breakdown Method  It is the most comprehensive and detailed method of estimating depreciation.  It breaks down total depreciation into three categories: physical, functional and external, and then breaks down each of them further into subheadings:  Physical deterioration  Curable – deferred maintenance  Incurable – short lived  Incurable – long lived 54  Steps in Breakdown method 1. Identify each component cost and total cost new; classify as short- or long-lived 2. Estimate cost of deferred maintenance (curable physical deterioration) 3. Estimate cost of curable functional obsolescence 4. Estimate incurable physical deterioration on short-lived items 5. Estimate long-lived incurable physical deterioration 6. Estimate cost of incurable functional obsolescence 7. Estimate external obsolescence 8. Add up total depreciation and estimate property value 55 Example. Curable and Incurable physical deterioration A store building has 21,500 sq.ft, 2 refrigerated warehouse , 5 loading docks. The building age is 18 years and the expected physical life is 60 years. The current reproduction cost of the structure is 40 birr per square foot. The market shows that the building repairs required 1,200 birr loading repair cost and 1,700 birr refrigeration equipment. The replacement cost, effective age and life expectancy of the remaining items are given below. Determine the amount of total physical depreciation of the property given the assumption that there is no functional or external obsolescence? 56  Short lived items Replacement Effective Life cost new age expectancy Roof covering 15,000 18 20 Insulation 6,500 3 15 Plumbing 4,100 18 25 HVAC 4,700 1 20 Loading docks 6,000 2 15 Refrigeration Equip. 4,400 6 10 57  Curable physical deterioration Items Replacem Cost to Depreciation Remaining ent cost cure replacement new cost new Loading 6,000 1,200 1,200 4,800 docks Refrigeratio 4,400 1,700 1,700 2,700 n equip. Total curable physical 2,900 birr depreciation 58  Incurable physical deterioration short-lived items Items Cost New Effecti Physic Ratio Depreciatio (Remaining) ve age al age n Roof 15,000 18 20 90 % 13,500 covering Insulation 6,500 3 15 20 % 1,300 Plumbing 4,100 18 25 72% 2,952 HVAC 4,700 1 20 5% 235 Loading 4,800 2 15 13.3% 640 docks Refrigerati 2,700 6 10 60% 1,620 on Equip. Totals 37,800 20,247 59  Physical deterioration long-lived items Total reproduction cost (40 x 21,500)------------------------ 860,000 Less: Reproduction costs of Curable items --------------------------------------------- 2,900 Other short-lived incurable items ------------------ --- -- 37,800 Reproduction cost long-lived items -------------------------- 819,300 Expected economic life: 60 years Effective age : 18 years Long lived incurable depreciation (18/60) x 819,300 ----- - 245,790 60  Depreciation summary – breakdown method Total curable ---------------------------------- 2,900 Total short-lived incurable ------------------ 20, 247 Total long-lived incurable ------------------- 245,790 Functional obsolescence --------------------- 0 External obsolescence ------------------------ 0 Total physical depreciation ----------- 268,937 61  2. Estimating Functional Obsolescence Curable Functional Obsolescence  There are three types of curable functional obsolescence:  Curable – deficiency requiring addition  Curable – deficiency requiring replacement /modernization  Curable – super adequacy that is economically feasible to cure 62  Deficiency Requiring Addition  This type of functional obsolescence is characterized by lack of an item in the subject improvement that would typically be found in comparable improvement and that would be economically feasible to add.  Depreciation in this case is measured by how much the cost of the addition exceeds the cost of the item if it had been installed during the construction of improvement – this is called the “excess cost to cure”. 63  Example  Suppose the subject is a three story office building that has no elevator in a market that demands an elevator. The cost of the elevator if installed new when built was 50,000 birr, but the cost to install it today is 150,000 birr. Similar property with same problem sold for 160,000 birr less than properties with elevators. Calculate the curable functional obsolescence?  The cost to install today minus the cost of the elevator if installed new when it was built gives us the amount of depreciation.  Thus, depreciation for functional obsolescence is 150,0000 birr – 50,000= 100,000 birr 64  Deficiency Requiring Replacement/Modernization  This type of functional obsolescence involves a property component needing replacement where the obsolescence is curable.  A deficiency requiring replacement or modernization is included in the estimate of cost new. Depreciation=Reproduction cost less: any physical deterioration of the item already charged, Plus: the cost to remove the existing item less: any salvage value of the replaced item, plus: the cost to install the new item Less: Cost if installed new 65  Example:  Suppose that an office building has an outdated air conditioning system that does not meet market standards and needs to be retrofitted. The reproduction cost of the existing air conditioning system is 8,000 birr and the item is 25% deteriorated. The cost to remove the existing air conditioning system is 4,500 birr, the salvage value of the equipment is 3,000 birr, the current cost of installing an appropriate air conditioning system is 12,000 birr. If the correct air conditioning system had been installed as part of new construction, the cost would have been 10,000 birr. Estimate the depreciation for functional obsolescence. 66  Depreciation can be calculated as: The cost of existing item ---------------------------------- 8,000 Less: physical depreciation (0.25 x 8,000) --------------------------------------- 2,000 Plus: Cost to cure (4,500 -3000 +12,000) -------------- 13,500 Less: Cost if installed new --------------------------------- 10,000 Depreciation for functional obsolescence --------------- 9,500 birr 67  Curable functional obsolescence caused by Super adequacy  It applies to structures that are over built, meaning that the market will not pay more for the extra costs which were involved in constructing them.  An example might be the case where an owner has installed an extra large storage tank in the basement, more than what the market would expect and when selling the home finds that no one will pay for this extra cost. 68  Example:  Suppose the subject property had an exterior stairway to a third floor that was never constructed in other similar properties. The original cost of the stairway was 1,500 birr and it has depreciated at a rate of 33%. Removing the stairway needs a cost of 300 birr for the carpenter. There is no salvage value for the old stair. Given this information, calculate the depreciation for the functional obsolescence. Depreciation of functional obso. = 1,500 – (.33x1500) + 300 = 1,500 – 495 +300 = 1,305 birr 69  Incurable Functional Obsolescence  There are two types of incurable functional obsolescence.  These are:  Deficiency that is not economically feasible to cure.  Super adequacy which is not economically feasible to cure. Incurable Deficiency  An incurable deficiency is a property lacking a major component which is not cost effective to fix it.  Depreciation is measured by the loss in value attributable to the deficiency. 70   The best place to measure the loss is the market where sales and rent can be compared.  The loss in value attributable to deficiency can be measured in two ways. These are: 1. Capitalization of the net income loss 2. Analysis of comparable sales with some containing the deficiency and others not containing it. 71  Example 1. Estimating incurable functional obsolescence by capitalizing rent loss  Suppose that the subject property with duplex units without a garage rents for 100 birr per month per unit less than a similar property with a garage. There is no enough land to add the garage for the subject property. The capitalization rate is 12%. Determine the amount of the incurable functional obsolescence given the above information.  Annual rent loss : 100 birr X 2X 12= 2,400 birr  2,400 birr capitalized at a rate of 12%= 2,400 ÷0.12= 20,000 birr  The incurable functional obsolescence is 20,000 birr. 72  Incurable super adequacy  It refers to unwanted extra costs which do not add to value.  An example might be where an owner has constructed a house with extra large foundation walls, more than what the market would expect, when selling the house finds no one will pay for the extra cost.  The cost to cure, which is the removal of the extra large footage, is not warranted or is impossible because it would be prohibitively expensive and likely to damage the structure of the house.  Thus, the extra cost of constructing the super adequacy must be removed from the reproduction 73 cost new of the house.  Example:  Suppose that a house has an extra large foundation which costs 100,000 birr and its physical depreciation is 30%. It is not economically feasible to cure it. Determine the incurable functional obsolescence. Extra cost of foundation --------------------- 100,000 birr Less: Physical Depreciation ----------------- 30,000 birr (0.3 X100,000 birr) The extra cost to be removed --------------- 70,000 birr  Thus, the incurable functional obsolescence related to super adequacy is 70,000 birr. 74 3. External Obsolescence  This type of depreciation is outside the property itself.  It can be either temporary (e.g., an oversupplied market) or permanent (e.g., proximity to an environmental disaster).  External factors frequently affect both the land and building component’s of the property value. 75   External obsolescence can be quantified using different methods but the two mostly used methods of measuring external obsolescence are:  Capitalization of income loss and  Market comparison 76  Capitalization of income loss  It is the most common method to determine the effect of external obsolescence.  With appropriate income information, external obsolescence can be quantified by capitalizing the loss in income. Example 1:  Assume the market indicates that a house next to a gasoline station rents for 10 birr less than the other houses. The gross rent multiplier (GRM) for the neighborhood is 130. The land –to- improvement ratio in this neighborhood typically shows that the ratio of land is 0.15 and the ratio of improvement is 0.85. Estimate the external obsolescence. 77  The total rent loss (GRM 130 X 10 birr) ------------ 1,300 Loss allocated to land (1,300 X 0.15) ----------------- 195 Loss allocated to improvement ------------------------- 1,105 birr  The external obsolescence is 1,105 birr since it should be reduced from the cost new.  The remaining 195 birr, which is accounted for the land, would have been considered during making adjustment to the land value. 78  Layout of Cost Approach Value of land/site -------------------------------------------- xxx Plus: Replacement cost new of improvements ---------- --- xx Less: All forms of depreciation ------------------------------ xx Plus: Entrepreneurial profit --------------------------------- xx Equals: Market value ---------------------------------------- xxx 79 Advantage of the cost approach  People can understand it easily.  It is often the best approach in the valuation of special purpose properties and properties that are not frequently exchanged in the market.  It is the best approach if the purpose is for insurance purpose.  There is relative ease in cost calculation.  It can often be a convincing test of value for new construction. 80  Disadvantage of cost approach  It is difficult to accurately estimate accrued depreciation , and as buildings get older the possibility of error becomes greater.  It relies on the assumption that cost equals value, which is not always true.  It is possible to get different answers from different cost estimates.  It usually does not incorporate the income generating potential of the asset.  It doesn’t take into account the factors of risk and uncertainty associated with realizing the economic benefit. 81  Thank you!!!! 82