Valuation Methodologies: The Cost Approach

The Texas Tax Code requires, in Section 23.0101, that the chief appraiser consider each of the three standard methodologies in determining the market value of property. These methodologies include: market sales, cost, and income approach.

Previously, we discussed the sales approach in determining market value. In this article, we will look at the cost approach.

Under the cost approach, the value of a property is estimated by determining what it would cost to rebuild the property and then applying appropriate adjustments for depreciation and obsolescence. The underlying theory of the cost approach is that a buyer would not pay more for a property than it would cost to build or to acquire essentially the same property.

Section 23.011 of the Tax Code requires that the chief appraiser utilize cost data from "generally accepted sources." For most appraisal districts as well as many appraisers, this usually means using Marshall & Swift cost data for real property improvements. The chief appraiser is also required to make any appropriate adjustments for "physical, functional, or economic obsolescence."

Physical obsolescence is a loss in value for a property due to mismanagement or neglect, usually resulting in deferred maintenance. For example, if the property has not been roofed or painted in a number of years, a buyer would normally reduce his purchase price offer to take into consideration that he will have to perform these tasks upon obtaining title or very soon thereafter.

Some might consider that physical obsolescence is the same as depreciation. However, physical obsolescence and physical depreciation are actually two different considerations. A property might be depreciated based on age and condition to determine the replacement cost new less depreciation. However, a separate consideration should also be made of any deferred maintenance items or other physical obsolescence.

Functional obsolescence is a loss in value for a property due to functional inadequacies or superadequacies. These functional inadequacies typically include design factors. For example, apartment complexes constructed in the 1970s or 1980s or earlier typically included smaller units than desired by modern renters. Also, an inadequate electrical system or air conditioning system or insufficient parking would be considered a functional inadequacy. A superadequacy might be a design or construction factor that adds no true value to a purchaser. For example, a large entry hall or atrium might be pretty, but it is not really functional; a buyer looking to maximize income might view it as wasted space. Essentially, functional obsolescence is anything about the design or construction of the property that negatively affects its value.

Economic obsolescence, sometimes called external obsolescence, is a loss in value for a property due to external factors not involving the property itself. For example, a property located next to a landfill or a polluted site is going to be worth less than the same property would be located in a clean area. Market factors might also result in economic obsolescence, such as businesses closing down or moving and leaving behind a mass of "big box" stores or vacant office space with limited tenant replacement or purchaser potential.

In practice, appraisal districts are wary of each of the obsolescence factors. But even though the value loss can often be attributed to the current owner or management, the appraisal district is more likely to accept the physical obsolescence factor than the other two. This is probably because the physical obsolescence amount can often be quantified in a deferred maintenance (or cost to repair) amount.

Under the cost approach, an appraiser determines the total value of the real estate in two ways. First, she determines the land value. This is typically done under the sales approach method utilizing comparable sales of vacant tracts of land with the assumption that the property being valued is also vacant. Utilizing such sales approach, appropriate adjustments to the sales comparables would need to be made to estimate the market value of the land as vacant.

Second, the appraiser determines the value of the improvements by categorizing the type, quality, age, and size of the construction. Using cost data (such as Marshall & Swift), the appraiser determines what it would cost to reconstruct the improvements today in essentially the same form as currently exists, without any corrections of design or other problems. In other words, what would it cost to rebuild that exact same building? After making this determination, the value of the improvements is depreciated based primarily on age of the construction. This results in reconstruction cost new less depreciation.

This value should then be adjusted for any physical, functional, or economic obsolescence that affects the value of the property.

One of the problems with the cost approach is that it assumes that the value of the parts is equal to the value of the whole, and this is not always the case with real estate. Also, often appraisers give short shrift to the obsolescence factors, which can be critical in determining the true market value under a cost approach.

The cost approach is most accurate in the valuation of newly constructed properties. As a property ages, the cost approach can become more and more inaccurate as obsolescence factors become more and more important in determining value.

Nevertheless, the cost approach is often the methodology initially considered by many appraisal districts in estimating a market value for real estate.

The cost approach is also the approach most commonly used by appraisal districts and property owners in the valuation of personal property, though typically most obsolescence factors are ignored. For personal property, the individual assets are categorized into groups, such as Furniture and Fixtures, Machinery and Equipment, Vehicles, Computers, etc. The original cost and year of acquisition for each category of equipment is then determined, and a depreciation schedule is applied. This depreciation schedule will not be the same as the federal income tax depreciation schedules.

The depreciation schedules used by appraisal districts vary from district to district as far as the rate of depreciation and the life of asset categories. For example, depending on where the property is located, the same type of property might be subject to a 10-year depreciation schedule using reconstruction cost new less depreciation tables in Dallas County, a 10-year depreciation schedule using standard depreciation rates in Tarrant County, a 15-year depreciation schedule in Harris County, and an 8-year depreciation schedule with a 20 percent residual value in Bexar County.

Utilizing the "right" depreciation schedule can be important in attempting to calculate the value estimate that would be determined by a particular appraisal district. Some appraisal districts, especially the larger ones, make their depreciation schedules available online. For those that do not, the owner or consultant should request a copy of the depreciation schedule used by the particular appraisal district.

Knowing the life and depreciation rates applied to different categories of property by an appraisal district can assist the owner and consultant in resolving value disputes, by helping determine where the differences in application of the methodology exist.

If you have any questions about the contents of this article, please contact the GPD Property Tax Section at propertytax@gpd.com.