Which of the following is are included in accrued depreciation when applying the cost approach to valuation?

The following are excerpts from the IAAO’s book Property Appraisal and Assessment Administration.

In appraisal, accrued depreciation is the loss in value from reproduction or replacement cost new due to all causes except depletion, as of the date of appraisal. This differs from accounting depreciation, which is the difference between the original cost and current book value of an item. Accrued depreciation is measured as of the appraisal date and applies only to improvements. Accrued depreciation reflects the demand side of the market. The cost of construction represents the supply side of the market. Cost and value are most similar when improvements are new and represent highest and best use.

As improvements age, they suffer physical deterioration and obsolescence and, as a result, lose value relative to newer structures. This loss in value is caused by a perceived diminished utility for the property on the part of potential buyers. The true measure of depreciation, then, is the effect on marketability and sales prices. The appraiser estimates depreciation (loss in value) by analyzing the market and subtracts depreciation from replacement cost new to estimate the market value of improvements. Only items included in replacement cost new can be depreciated.

There are three types of depreciation. Physical deterioration, is the loss in value due to wear and tear and the forces of nature. Functional obsolescence is loss in value due to inability of the structure to perform adequately the function for which it is used, as of the appraisal date. This results from changes in demand, design, and technology and can take the form of deficiency (for example, only one bathroom), need for modernization (for example, outmoded kitchen), or superadequacy (for example, overly high ceilings). Economic obsolescence, also called locational or external obsolescence, is loss in value as a result of impairment in utility and desirability caused by factors outside the property’s boundaries. It may be the result of inadequate public services, lack of parking facilities in a retail business district, narrow streets and heavy traffic in a residential neighborhood, or proximity to inharmonious industrial and commercial land use.

Please direct questions to the St. James Parish Assessor’s Office.

Updated: 11/23/2011

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Finite Mathematics and Applied Calculus

Costenoble/Waner

The cost approach is a real estate valuation method that estimates the price a buyer should pay for a piece of property is equal the cost to build an equivalent building. In the cost approach, the property's value is equal to the cost of land, plus total costs of construction, less depreciation. It yields the most accurate market value for when a property is new than through alternative methods.

The cost approach is one of three valuation methods for real estate; the others being the income approach and the comparable approach.

• The cost approach to real estate valuation considers the value should equal the total cost to build an equivalent structure.
• The cost approach considers the cost of land, plus costs of construction, less depreciation.
• The cost approach is considered less reliable than other real estate valuation methods, but can be useful in certain cases such as when evaluating new construction or a unique home with few comparables.

Instead of focusing on the prices other, similar homes in the area are selling for, or a property’s ability to generate income, the coast approach method values real estate by calculating how much the building would cost today if it were destroyed and needed to be replaced from start to finish. It also factors in how much the land is worth and makes deductions for any loss in value, otherwise known as its depreciation.

The logic behind the cost approach is that it makes little sense for buyers to pay more for a property than what it would cost to build from scratch. 

There are two main types of cost approach appraisals:

1. Reproduction method: This version considers what a replica of the property would cost to be built and gives attention to the use of original materials.
2. Replacement method. In this case, it is assumed that the new structure has the same function but with newer materials, utilizing current construction methods and updated design.

When all estimates have been gathered, the cost approach is calculated in the following way:

cost – depreciation + land worth = value of the property.

The cost approach can be less reliable than the income and comparable methodologies in practice. It requires certain assumptions, including taking for granted that there is enough available land for the buyer to build an identical property.

Moreover, if comparable vacant land is not available, the value must be estimated, which makes the appraisal less accurate. The lack of similar building materials also reduces the accuracy of the appraisal and increases room for subjectivity. Calculating depreciation on older property is not straightforward and easily measurable, either.

Despite these limitations, there are a few cases where the cost approach can be useful and even necessary. Valuing the various components of real estate separately is especially helpful when dealing with property that is new or differs from others in unique ways.

The cost approach is required and sometimes is the only way to determine the value of exclusive-use buildings, such as libraries, schools or churches. These resources generate little income and are not often marketed, which invalidates the income and comparable approaches.

The cost approach is often used for new construction, too. Construction lenders require cost approach appraisals because any market value or income value is dependent upon project standards and completion. Projects are reappraised at various stages of construction to enable the release of funds for the next stage of completion.

Insurance appraisals tend to use the cost approach when underwriting homeowners' policies or considering claims because only the value of improvements is insurable and land value is separated from the total value of the property. The choice between depreciated value and full replacement or reproduction value is the determining factor for the evaluation.

Finally, the cost approach is occasionally relied on to value commercial property, such as office buildings, retail stores, and hotels. The income approach is the main method used here, although a cost approach may be implemented when design, construction, functional utility or grade of materials require individual adjustments.

Most residential appraisals do not use the cost approach. Instead, sales comparisons usually drive market valuations of these types of properties.

When a cost approach appraisal comes in below market pricing, it can be a sign of an overheated market. Conversely, regular evaluations above market pricing may signal a buying opportunity.

An exception is if the property is under-improved or over-improved for its neighborhood. In this case, an accurate estimation of the value of improvements adds to the precision of the determination of value, which is not possible using only the comparable approach.