When cost is the right approach
Sometimes there are no comparable sales and no rent roll. A school, church, or public building rarely sells and produces no income, and new or proposed construction has no sales history. For those, the cost approach is the right tool.
The formula is:
Land value (as if vacant) + reproduction or replacement cost new of the improvements − accrued depreciation
Depreciation is subtracted. A version of the formula that adds it overstates value, and that wrong sign is a standing distractor.
A worked cost calculation
Land is worth $80,000, cost new of the improvements is $250,000, and accrued depreciation is $40,000.
Depreciated improvement value: $250,000 − $40,000 = $210,000 Add land: $210,000 + $80,000 = $290,000
Traps: $330,000 forgets the depreciation, $210,000 omits the land, and $370,000 adds the depreciation instead of deducting it.
Straight-line depreciation
The straight-line (age-life) method spreads cost new evenly over the economic life. For a building costing $200,000 new with a 50-year life, at 10 years old:
Annual depreciation: $200,000 ÷ 50 = $4,000 Accrued depreciation: $4,000 × 10 = $40,000, the same as $200,000 × 10/50 Depreciated improvement value: $200,000 − $40,000 = $160,000
The question usually asks for the remaining value, not the $40,000 of accrued depreciation — read which one it wants.
The three kinds of depreciation
- Physical deterioration: wear, tear, and deferred maintenance.
- Functional obsolescence: a defect in the design or utility of the improvement, including a superadequacy such as an over-built pool that costs far more than buyers will pay for it.
- External (economic or locational) obsolescence: caused by something off the property, such as proximity to a freeway. It is always incurable by the owner, because no spending on the property can move the freeway.
The most common trap reverses the last two — calling the pool external and the freeway functional. Anchor on the cause: on the property is functional, off the property is external.