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Cost approach

Definition

Where a market exists for residential, retail, commercial and industrial property there should be sufficient market evidence to
establish market value using the sales comparison or income capitalisation approaches.
The cost approach should not be used where there are market sales of comparable properties, or if the property is one for which a
cash flow approach based on business profits is more typical of buyer behaviour. This could be due to:
 the type of property not generally being sold on the open market – in which case you can use the depreciated replacement cost
(DRC) method;
 the property having development potential and there are no reasonable comparable sales – you can use the residual appraisal
method.
Where there is no market evidence, or where the property is of a specialised type, such as an oil refinery, which is not normally
bought and sold, the cost approach can be used as a surrogate valuation method. This class of property, which is rarely sold, is
generally referred to as 'specialist (specialised) property'.
The DRC method is based on the supposition that no one would pay more for an existing property than the amount it would cost to
buy an equivalent site in terms of size and location plus the cost of constructing an equivalent building. Where used for properties
other than new properties the cost figure will be written down for obsolescence. The cost in such cases will be based on the cost of a
simple substitute rather than the cost of replicating the actual building. It 'provides an indication of value using the economic
principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or
construction' (IVS Framework paragraph 62).
The approach is sometimes used as a check for a market approach valuation. The variances that can occur due to demand exceeding
supply means that on many occasions cost and market value simply cannot equate. Location can give real estate a monopoly in that
there is no other substitute parcel of land with the same potential or utility in the same location. Supply and demand push the price
(value) of the property above the value of any substitute property.
In other situations over-improvement can mean that cost will considerably exceed market value. For example, the construction on a
holiday island of an international airport of a size capable of handling 5,000 passengers an hour will be of low value compared to its
cost if the island can only accommodate 1,000 holidaymakers and residents and only needs an airport capable of handling 2
incoming and 2 outgoing flights a day.

Description
Description

The DRC method requires the valuer to consider 3 components:


 the cost or value of an equivalent parcel of land;
 the cost of constructing a replica or simple substitute building or a modern equivalent building; and
 an allowance for depreciation.
The value of the land does not depreciate and is assessed using normal market value approaches, the best of which would be direct
sales comparison of similar land being bought and sold for similar purposes.
The gross replacement cost (GRC) of the buildings is calculated using current cost figures (this part of the calculation may involve a
building cost estimator) to which is added the related costs such as:
 site works;
 architect's fees;
 building permit costs; and
 finance (interest) charges on bank borrowing to cover the costs.
If the existing building can be replaced at lower cost with a modern equivalent building, the modern equivalent cost figure is used.
The GRC has to be adjusted to reflect the hypothetical buyer's perception of the likely difference in utility between the replica new
build or modern equivalent and the actual building(s) on the site. The IVS recognise the need to account for physical deterioration,
functional or technical obsolescence, and economic or external obsolescence. Today a major factor will be depreciation arising from
the need for new buildings to have lower carbon footprints.
The allowance for depreciation is made after comparing the age, design and use of the existing building(s) with a brand new
building. A relatively new building, say less than 3 years old, for which a DRC is required is likely to show little depreciation
compared to a building used for the same purpose that is 30 years old. A historic building that is protected may also display little
depreciation.
Three approaches to depreciation are recognised:
 overall depreciation;
 straight line depreciation; and
 S curve depreciation.
An experienced valuer should be able to arrive at an overall factor. For example, a building that would cost $1,000,000 to replace
might need to be depreciated for various factors at an overall rate of 75% giving a DRC figure of $250,000.
A popular approach is to use straight line depreciation, taking account of the building's economic life and remaining useful economic
life. A 15-year-old building with an expected remaining life of 25 years and a total life of 40 years could be depreciated on a straight
line basis. The average annual rate of depreciation will be 100/40, which is 2.5% a year. The accumulated depreciation after 15 years
is 15 times 2.5%, which is 37.5% and would mean reducing $1,000,000 by $375,000 to $625,000. To this the valuer would add the
land value figure.
Buildings that are repairable and could be 100% economic again through repair could be assessed by taking the cost of remedial
work away from the GRC.
Buildings very rarely depreciate in a straight line. Typically depreciation follows an S curve. Slow at the beginning and fast at the
end of the building's life. Making a realistic, sensible and supportable adjustment for depreciation is at the heart of this method.
The DRC method is used in many states as a valuation method of last resort, only used when it is impossible to find market
evidence. The calculation is of the DRC and is a figure that can be used for certain classes of asset for the purpose of compliance
with the International Financial Reporting Standards (IFRS) or other reporting standards. As it is not based on market evidence the
final sum should be expressed as a non-market valuation.
In developing markets it can take many years for an adequate database of comparable sale prices to be established. The DRC method
is sometimes used in these markets and is seen by buyers and sellers as a surrogate for a market valuation. These markets are
problematic but any calculation based on a cost approach should be expressed in cost terms and not in exchange or market value
terms. Here the cost approach will be reconciled with the best figures obtained from one of the other market methods.
The IVS White paper on valuation in emerging markets stresses that:
 while DRC methodology is acceptable for valuations where market data is insufficient, the limitations of the value derived
must be clearly identified; and
 extra consideration is required regarding consistency of valuations where mixed/combined market and non-market data is
used.
In some situations, where a cost approach has previously been used, valuers are now turning to a profits based or cash flow approach
because such properties are now bought and sold as part of a business, often as a result of a return to private ownership from public
ownership. A market for such assets is emerging and the market comparable is based on a sustainable net profit multiplier
(sometimes known as the income and expenditure approach).
This method should only be used for specialised properties that are not normally bought or sold: it should not be used as a basis for
arriving at a 'market value' figure for secured lending. By definition such properties are not bought and sold and so could not be sold
to repay a loan in the event of lender default.

Application
The DRC method is used for hospitals, schools and other properties that are not bought and sold. It can be used as a check for values
based on other methods in developing markets where comparative methods are relying on limited market data or where the market
lacks transparency.
In many cases the actual market value may differ considerably from the value obtained using DRC. For example, a specialist
building may, when valued by DRC method show a considerable value yet if sold to any other person it may require demolition to
enable the land to be used for another purpose.
It should be stressed that DRC is a specialist method requiring particular expertise by the valuer and should not be regarded as just a
mathematical exercise, since each item must be considered separately and in the light of the valuer’s experience. Furthermore, it
assumes that the property being valued will continue to be viably used for its existing use for the foreseeable future and requires a
statement to this effect as part of the valuation report.
For further guidance on the DRC approach see RICS Red Book UKGN 2 Depreciated replacement cost method of valuation for
financial reporting.