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MENDOCINO COUNTY, like other rural areas throughout the country, is full of odd and unconventional real estate. How do you figure out what these one-of-a-kind properties are worth? The cost approach, scorned by most appraisers and disliked by lenders, is often the only way. I’m a great fan of the cost approach, although it’s taken me years to figure out how to use it.
The cost approach is one of the three standard methods appraisers use to estimate value. The other two are the income approach and the sales comparison approach. The income approach is used mainly for commercial and residential income properties where value is strongly related to rents.
The sales comparison approach has been immortalized in the standard Fannie Mae/Freddie Mac Uniform Residential Appraisal Report (URAR). The form’s two legal-sized pages devote less than two inches to the cost approach. Fannie and Freddie now use even shorter “drive-by” appraisal forms which have completely eliminated the cost approach.
Real estate agents and brokers use a simplified version of the sales comparison approach when they prepare a comparative market analysis (CMA) for their clients. Rural agents know that a standard CMA can be useless for some types of real estate. Because of this uncertainty about value, many rural properties are listed too high, sit on the market too long and don’t sell.
In Mendocino County, the best comparable sales are often old, far away and quite different from the property being appraised. Compared to urban areas with cookie-cutter tract homes, we have a relatively low volume and wide variety of sales. Many rural properties are unique, not frequently bought and sold, or simply defy comparison. Even in urban areas, the cost approach is the only way to appraise special-use properties such as churches, schools and libraries.
Economic Theory
Understanding the cost approach requires learning some new meanings for old words. Cost, price and value are good examples. Cost refers to construction and development costs, price refers to listing and selling prices, and value is always an estimate or opinion.
The cost approach reflects market behavior because buyers and sellers relate value to cost. The economic principle of substitution holds that a well-informed buyer will not pay more for a property than the cost to buy a similar piece of land and construct a similar building. Buyers often do some kind of cost analysis when making the decision to buy or build. Developers usually do a cost analysis before they decide to begin a new project.
The cost approach forces you to think about real estate as having two separate parts – land and improvements. Land value is based on its highest and best use as if vacant. The value of the improvements is determined by how they contribute to (or in some cases reduce) the value of the land. For example, an old house on a commercial lot reduces value because the buyer has to demolish the house to build a new office building.
The cost approach pulls out the components of real estate value – land, replacement costs, depreciation and entrepreneurial incentive – and then adds them up. These are the modern descendants of the four agents of production identified by the classical economists of the 1700s and 1800s – land, labor, capital, and coordination.
Land
Unimproved land sales are common in rural areas and provide a good basis for estimating land value. Without bare land sales, you have to extract land values from improved sales, which is a bit more complicated.
Many so-called bare land sales include timber, clearing and grading improvements, roads, wells, septic systems and even small cabins and outbuildings. Also, some land is dividable.
Timber
Merchantable timber can contribute to land value. The simplest way to include timber value is to use comparable land sales that have similar amounts of timber on them. Otherwise, you need a timber value estimate from a professional forester.
The forester conducts a timber cruise and estimates the gross timber harvest value after logging costs. The forester then deducts for set-asides and extra logging costs due to access, topography, water courses and other environmentally sensitive areas. He or she may also calculate the investment value of the remaining timber stand.
However, the biggest deduction for residential timberland is something called entrepreneurial incentive, which is described below. Residential timberland buyers require a large profit to assume the management and risk involved with a timber harvest. In other words, they are willing to pay only a fraction of the potential timber harvest value. Some buyers require a potential 200 percent return on their investment.
Excess Land
Excess land also contributes to overall land value. Excess land is surplus land beyond that which is needed to support the property’s highest and best use. Excess land can be dividable or undividable and may or may not have a separate highest and best use. Excess land may be any of the following.
- surplus land that is undividable
- surplus land that can be sold to an adjacent landowner through a boundary line adjustment
- underlying sub-standard parcels that can be declared separate legal lots with a Certificate of Compliance
- land that is subdividable under existing planning and zoning regulations
Like timberland, subdividable land is reduced in value by a number of up-front and on-going costs and by a large developer’s profit incentive.
Replacement Costs
The widespread use of cost manuals and computers has made the formerly complex task of estimating construction costs more simple. One time I asked my insurance agent how he estimated the replacement cost of my house. He turned to his computer, punched a few keys on his cost estimator program, and out came the number.
The most accurate way to estimate construction costs is the way most contractors do it. They use the quantity survey method, adding up all the parts and labor involved in the construction job.
A less detailed method is called the segregated cost or unit-in-place method, which uses the cost per square foot of major building components such as the foundation, frame, roof, plumbing and electrical systems.
Most appraisers use the square foot or comparative unit method, which uses an overall cost per square foot based on the occupancy type, size and quality of construction. There are several valuation services which publish paper and computerized cost manuals with monthly updates. However, the most reliable cost figures come from local contractors and building materials suppliers.
Building costs on the Mendocino Coast are relatively high because of our remote location. Nearly all construction here is custom-built, one at a time, without the usual economies of scale found in urban tract homes. We also have extra site improvement costs including clearing, grading, road-building, wells and septic systems. Buildings are built to higher specs to withstand the high rainfall, humidity and salt air. Also, many coastal residents demand custom features and quality materials in their homes.
Reproduction costs are not the same as replacement costs. Reproducing an historic building in the village of Mendocino to its original appearance, for instance, can cost more than simply replacing it with a building of equal size, quality and utility. Also, some things just can’t be reproduced, such as hand-made square nails and old growth redwood lumber.
Entrepreneurial Incentive
Entrepreneurial (or developer’s) incentive is the anticipated profit which an entrepreneur or developer will normally expect to justify the time, money and risk expended in bringing the project to completion. This is different than entrepreneurial profit, which is the actual profit the developer realizes after project completion.
This is an important concept, because the developer’s profit incentive can take a big bite out of the land value contributed by small residential timber harvests and minor subdivisions. Developer’s profit is subtracted from the value or sale price, but added to the replacement cost of the improvements.
A developer normally requires some kind of profit incentive. This is expressed as a percentage of total construction costs (normally excluding land) and is usually in the range of 10 to 15 percent for small residential projects. Larger projects usually require a smaller percentage. The developer’s incentive is not the same as the contractor’s profit, even if the developer and contractor are the same person.
Physical Depreciaton
There are three types of depreciation (also called obsolescence) – physical, functional and external depreciation. In addition, each type of depreciation is either curable or incurable. If it’s curable, the amount of depreciation is usually the cost to fix it.
As many Californians discovered in the middle 1990s, land can lose value. However, when it does it’s not called depreciation. Depreciation, by definition, applies only to improvements. The old real estate saw that “land does not depreciate” is true but misleading.
Physical depreciation includes the normal wear and tear on a building as it ages. Most physical depreciation is the incurable kind, because it’s usually too expensive or impractical to replace major building components such as the foundation, framing, plumbing and electrical systems. Another kind of physical depreciation is deferred maintenance, which is the curable kind. This includes routine painting and replacing roof and floor coverings.
For accounting and tax purposes, physical depreciation is normally calculated by the straight line method. However, for real estate purposes, depreciation follows a curve calculated by the age-life method. This is because buildings, like people, increase their life expectancy as they age.
Functional Depreciation
Functional depreciation is caused by a deficiency or over-improvement. Like physical depreciation, functional depreciation can be either the curable or incurable kind. If it’s impractical or uneconomical to correct, it’s incurable. If it can be easily corrected, it’s curable.
Common functional deficiencies include unusual floor plans and unpermitted or non-code construction. Over-improvements include houses which are unusually large or well-built for the neighborhood. In some urban neighborhoods the most common over-improvement is a swimming pool.
External Depreciation
External depreciation (sometimes called economic obsolescence) is caused by negative influences outside the property which are beyond the control of the property owner. Therefore, it’s usually incurable.
External depreciation can be caused by physical conditions such as road noise, poor access or lack of electric power. It can also be caused by economic conditions such as an oversupplied real estate market. In the case of an overheated seller’s market, external depreciation can even be positive. This is because buyers are willing to pay a premium due to a temporary imbalance of supply and demand.
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