Here at DwellingCost.com, we have found that several common misconceptions exist regarding the Cost Approach. We thought we would try to provide clarification regarding these misconceptions.
The Cost Approach offers the appraiser a way to illustrate the factors at play when estimating market value. How the "site value" and "contributory value of the improvements" combine to make up the overall value of the property. Also, how different forms of depreciation factor into the equation. Many times in practice, after working through the Cost Approach, the appraiser may discover that certain assumptions made in the Sales Comparison Analysis should be questioned and maybe even reconsidered. Properly developed, the Cost Approach may also provide the first indication of a "runaway" market or a "declining" market. Having a thorough understanding of the Cost Approach to Value and an easy way to process it are vital components in developing the final value conclusion for the subject property. The "key" to this equation is solid, verifiable, replacement cost numbers.
The Cost Approach is a tool to help the appraiser estimate value. Don't believe it? Just read the bottom line of the cost approach on form 1004 "Indicated Value by Cost Approach." We have heard a number of appraisers who indicate that they are just fine with the Cost Approach result being 30 or 40% higher than the result of the Sales Comparison Analysis. With a couple of very rare exceptions, this isn't possible if the approach has been properly developed. It may not even be that it has been developed improperly, but that it simply has not been "completed" - as there is usually some form of depreciation that has not been accounted for - and this is really the point of the exercise; to recognize and account for any and all forms of depreciation.
Of course, upgrading or remodeling improves the condition, however, it can also have a significant effect on the quality of the improvements. Quality is based on the materials used to "finish" the interior and exterior of improvements, as much as it is based on the quality of the "bones" of the structure. We have heard appraisers say "if it's in the same tract, it's the same quality." Of course, while most times this statement is true, many times it isn't - and it is certainly not a "given." Even UAD quality definitions reference the level of "upgrades" as affecting the overall quality.
Determining the amount of deprecation present in the improvements is the appraiser's job as part of the appraisal process. Quite simply, accrued depreciation is the difference between "cost" and "value" and there is no replacement cost data provider that can determine the contributory value of improvements for you. Straight line methods of estimating Physical Depreciation have consistently been proven to be inaccurate, and what about functional or external depreciation?
Perhaps the most frustrating thing we have heard recently, is that some appraisers are increasing their Replacement Cost New numbers, in order to push their site value estimate below 30% in the mistaken belief that site value must be under 30% of market value. In most cases, Client's simply require the appraiser to comment on high "site to value" ratios and most appraisers make this a standard comment in areas where site values are typically greater than 70%. Lowering the site value to avoid making this comment (or raising it to avoid commenting on functional or external depreciation) is not only an unacceptable appraisal practice, it is also a violation of USPAP.
This common misconception comes from the belief that "effective age" is a purely "physical" concept and effective age can be estimated by "observing" the improvements. While physical deterioration factors into effective age, it is not the whole equation, especially if there is functional or external obsolescence present. The site value "is whatever it is" and improvements can only "contribute" value over and above the site value. So what are the improvements contributing, in terms of value, relative to their cost? If it's 50%, then it's 50%, and your effective age is exactly ½ of your "economic life." Once again though, the question becomes "what type of depreciation is the source of any loss in value from Replacement Cost New" (physical, functional or external)? And what is causing the loss in contributory value? If this sounds crazy and you say that external depreciation could NOT possibly contribute to effective age (you are not alone), however, open ANY appraisal textbook ever written and research "effective age" - it will answer the question definitively. Are you stating an "effective age" in the body of the report that is inconsistent with the effective age indicated by your completed cost approach? Reviewers frequently recognize the inconsistency - do you?