Collateral Valuation: Credit Risk: Cost Approach for real estate
The Cost Approach is another valuation methodology for real estate. The post provides a step by step process of how the Cost approach works and presents situations where it should or should not be used. It also covers the type of data and data sources used for carrying out the analysis.
The value of the property is equal to the Cost of the Land + the Current cost of Building the structure – the Accrued Depreciation. As the equation shows this involves three steps as given below:
Step 1: Estimation of the cost of land
This involves considering what the land on its own, i.e. vacant and without any built structures on it, would cost.
Step 2: Estimation of the current cost of actually building the structure
There are two ways in which this may be estimated. One is the reproduction cost method and the other is the replacement cost method.
Reproduction cost approach involves estimating the cost of replicating the structure completely including construction methods and materials.
Replacement cost approach on the other hand involves the cost of building a similar structure but by employing modern construction methods and materials and leaving out features and materials that have become functionally obsolete in current times (e.g. oversized rooms and construction materials that would require a high level of maintenance, etc.). This is the method that is most frequently used when using the cost approach.
There are four methods of estimating the reproduction or replacement cost. These are:
- The square foot or comparison method that estimates the cost by using the costs per square foot incurred on recently developed similar properties. This cost per square foot is multiplied by the external dimensions of the concerned structure to determine the cost of the structure.
- The unit-in-place method that estimates the cost by determining the cost per unit for each component of construction such as materials, labor, overhead, profits, multiplying the cost per unit of a particular component with the number of units of that component used in the construction and then aggregating across the costs of all these components.
- The quantity-survey method that estimates the cost by carrying out a thorough itemization of each and every cost (both direct and indirect) expected in the construction, estimating each cost and then summing the individual estimates together. This method usually generates the most accurate estimates but it also tends to be the most costly approach.
- The index method starts by considering the actual cost of construction of the structure and then increases this cost by a factor that represents the percentage increase in the cost of materials, labor, etc since the structure was built. This approach is rarely used because it gives inaccurate estimates as it does not account for the specific differences between structures. It may however serve as a cross check to the estimates derived from any one of the other methods given above.
Step 3: Estimation of accrued depreciation
Depreciation in real estate appraisals refers to the loss of value of the property due from all causes, i.e. physical deterioration as well as functional and external obsolescence. Accrued depreciation is calculated as the difference between the cost of replacing the structure and the current appraisal value of the structure.
A simplified approach for calculating the depreciation is to use a straight line economic age-life method. Under this method the total estimated cost of the structure is assumed to depreciate in a linear manner at a constant rate over the life span of the structure. The annual depreciation amount is the total cost of the structure divided by the life span. The accrued depreciation would be the annual depreciation amount times the effective/ actual age of the structure.
b. Appropriate Uses
The cost approach is used for properties:
- that have had new or nearly new improvements on them or
- that are not regularly sold such as public buildings, like schools, libraries, etc
- that do not earn income such as public buildings
c. Inappropriate Uses
It is inappropriate to use this approach to value properties that have had older improvements or that suffer from substantial depreciation in its physical structure or that have a number of features with outdated or obsolete functionality.
d. Sources of Data/ Information
- For construction costs: cost estimates from quantity surveys, relevant publications, builders, contractors, etc.
- For depreciation: market research and valuation procedures
- For land values: market research and valuation procedures
We have detailed the Cost Approach to collateral valuation of real estate above. In the next post we will look at other pledged assets are valued.