Real Estate Appraisal: Chapter 8 Cost Approach to Value Flashcards

Real Estate Appraisal: Chapter 8 Cost Approach to Value Flashcards

External ObsolescenceDepreciation that results from causes arising outside of the property itself.It may be economic or locational.Deferred MaintenanceCurable physical deterioration.Paired Data AnalysisTo estimate the depreciation caused by a particular defect.To do this, the appraiser must be able to identify comparables that have the same defect as the subject property, and other comparables that don't have that defect.*Methods of Estimating DepreciationProperly estimating depreciation is the most difficult part of the cost approach.This is particularly true of older properties, which may suffer from several types and causes of depreciation.Simpler methods of estimating depreciation tend to rely on assumption that don't necessarily apply in every case, while more complex methods require market data that often are not available.This is one reason why the cost approach to value is considered less reliable than the sales comparison approach or the income approach.The three main methods appraisers use to estimate

depreciation: the economic age-life method, the market

extraction method, and the breakdown method.Economic Age-Life Ratio(Straight Line Method)A technique for estimating depreciation, based on the assumption that an improvement loses value at a steady rate over the course of its economic life.IncurableDepreciation that can not be remedied possible or practical.Functional ObsolescenceIn addition to physical deterioration, an improvement can suffer from depreciation that is caused by design defects.This form of depreciation is called functional obsolescence.Whether the design is defective from the start or simply becomes outdated with the passage of time, the resulting loss in value is treated as functional obsolescence.Ex. Today's market prefers energy-efficient housing, which includes insulation with a high R-value.Older housing that doesn't meet this standard may suffer a loss in value due to functional obsolescence, even though its insulation was considered standard at the time it was built. A newer house with inadequate insulation would also suffer from functional obsolescence.Design defects that cause functional obsolescence can be either deficiencies (such as inadequate insulation) or superadequacie.A superadequacy is a form of overimprovement; it's a design

feature whose cost is greater than its contribution to value.Ex. Most modern housing uses 2x4 or 2x6 framing for wall construction. A house that was built with 2x12 wall framing would probably suffer from functional obsolescence due to a superadequacy. The cost of the superadequate wall framing would more than likely exceed any resulting value increase.Like physical deterioration, functional obsolescence is either curable or incurable.The same test

applies: if the defect can be remedied at a cost that is less

than the resulting increasing in value, then it's curable; otherwise, it's incurable.Ex. Inadequate insulation in the ceiling of a house is usually a curable form of functional obsolescence, because additional insulation can be installed at a reasonable cost. A house with substandard ceiling heights, on the other hand, probably suffers from incurable functional obsolescence, since it would be prohibitively expensive to increase the height of the walls.Soft Costs(Indirect Costs)Indirect costs such as architects' fees, construction loan interest, property taxes during the development period, and real estate sales commissions.TerminologyFor purposes of appraisal, the term depreciation refers to a loss in the value of an improvement (as compared to its cost) due to any reason whatsoever.Depreciation is the difference between the market value of the improvement and its cost.The amount of depreciation that has occurred between the time the improvement was built and the effective date of the appraisal is called the accrued depreciation.The term depreciation is also widely used to refer to the amount of an asset's capital value that has been "written off" for accounting or tax purposes.This kind of depreciation, sometimes called book depreciation, has no significance from an appraisal standpoint.

Accrued DepreciationThe amount of depreciation that has occurred between the time an improvement was built and the effective date of its appraisal.Remaining Economic LifeRemaining Economic Life = Economic Life - Effective Age Breakdown Method Step 5BWhen incurable functional obsolescence s due to a superadequacy, the appraiser estimates the present value of any ongoing costs associated with the superadequacy (such as higher property taxes, insurance premiums, or utility costs).Any value contribution due to the superadequacy is then deducted.If the cost estimate (in Step 1) is for reproduction cost, the extra cost of the superadequate item (less any physical depreciation already charged) is also added to the depreciation due to incurable functional obsolescence.Reproduction Cost and Replacement CostIt's important to distinguish reproduction cost from replacement cost.Reproduction cost is the cost of creating an exact replica of the improvements, using the same materials, design, layout, and level of craftsmanship.Replacement cost is the cost of building an improvement of equal utility, but using modern materials, techniques, layout, and design.Replacement cost estimates are nearly always lower than reproduction cost estimates, because it usually costs less to build a structure using modern materials and techniques.Reproduction cost must include the cost of reproducing any features that are excessive in quality or design, known as superadequacies.Replacement cost takes into account only the cost needed to create equal utility, so superadequacies are ignored.The choice of either reproduction cost or replacement cost can affect the calculation of depreciation.When reproduction cost is the basis of the cost estimate, the appraiser must estimate depreciation from all causes.When replacement cost is used, some forms of depreciation (such as functional obsolescence due to superadequacies) are accounted for in the cost estimation step, and so they aren't included in the depreciation estimate.Effective AgeThe apparent or functional age of an improvement, based on its current condition and the current conditions in the market.Economic LifeThe length of time during which an improvement will contribute to the value of a property.Economic life ends when the improvement no longer represents the highest and best use of the property.Economic Life =Effective Age

• Remaining Economic LifeThis formula can be

rearranged.Straight Line MethodThe economic age-life method of estimating depreciation is based on the assumption that an improvement loses value at a steady rate over the course of its economic life.According to this assumption, a graph of the