Depreciated Cost, a Test of Reasonableness

By

Rachel Massey, SRA, AI-RRS

Woody Fincham, SRA

and

Tim Andersen,MAI, Msc., CDEI, MAA

Originally published at http://www.appraisalbuzz.com/depreciated-cost-test-reasonableness/

With all of the clamor and excitement that Fannie Mae’s Collateral Underwriter (CU) is creating, we started working on a new article that addresses some possible solutions. In this one, we are expanding a bit on using the cost approach as a means to develop and support some adjustments. Each of the three traditional approaches to value can be used to develop a basis of analysis in any of the approaches. As such, the cost approach can be a reliable means to develop a gross living area adjustment, or lend additional support for it. While it does not work each time, has proven successful for us many times, and as such, we do urge studying it and putting it into your toolbox of solutions for supporting adjustments.

Quantitative adjustments require some type of support. CU is not changing anything regarding this premise. Appraisers are supposed to have support within the workfile for adjustments made, and then support the adjustments with commentary within the report. This is in harmony with USPAP. Many appraisers do not address specifics on the adjustments made, let alone explain how they were developed and applied. So here is one method that can be relied on as a means to support a gross living area (GLA) adjustment. Sometimes it can be used for other items.

One aspect of Collateral Underwriter (CU) that many have been discussing concerns price/SF. In the example from the CU webinar, it is stated that if an appraiser is using $15/SF for adjustments regarding gross living area (GLA) adjustments and the comparables sales indicate $200-$300/SF, then it will be probably be flagged as a higher-risk item. So part of the advantage of using this technique will help you address this with analysis. Let us look at some improved sales now that we have an idea of what site values are for the market

Comp 1 Comp 2 Comp 3 Comp 4
Price $             308,300 $           300,000 $           295,000 $           283,000
GLA                  2,414                2,308                2,468                2,310
$/SF $               127.71 $             129.98 $             119.53 $             122.51

In this data set, we have four sales. The range of price/SF is $119.53 to $129.98. The problem with price/SF is that it deals with all attributes of the property. This can be problematic because it is inclusive of the land, which can skew the usefulness of using it as a unit of comparison. Once we get part way through this article, we will start discussing residual improvement value (RIV). RIV can be an effective defense against overall price per square foot concerns. 

Simple Depreciated Cost
We are going to walk through a case study of a file that Rachel worked on recently. Obviously, some things have been changed. Some of you will notice that the data set is anything but like what we all normally see in classroom case studies. Hardly ever do we see perfect sets of data like what often seen in most case studies in an educational offering. With that said, this may not be something to use if you are starting newly in the profession. This article is written with an experienced residential appraiser in mind.

Depreciated cost can be a test of reasonableness for some adjustments, and here it is used as a basis for the gross living area adjustment, tied to sensitivity analysis. It is not meant as a means of arriving at an adjustment, but instead as either a place to start, or a second or third approach. Because each of us have used it extensively we felt it would be a great place to help some of you establish a benchmark or test of reason to use for a gross living area adjustment, in particular as the example is from the real world.

Site Value
Site value – you really need to get a handle on site values for using this approach (while you can use the depreciation factors to get to land values, having a grasp on site values is easier with land sales). Most communities have land sales, even if they are not in the immediate area. For example, this grouping of data presented here was for a property in Michigan and there have not been a great number of land sales in the immediate area over the past few years. There have been no land sales in the subject neighborhood. There were however, enough land sales from competing areas to provide some basis from an opinion of the value of the subject site as if vacant.

The following chart shows seven sites that sold and three acreage parcels:

Sale Sold date Sold price $ To Acquire DOM Size Frontage $/SF $/FF
Comp 1 (Demo) 9/17/2014 $42,050 $51,050 673 13,068 100 $3.91 $510.50
Comp 2 2/8/2013 $67,500 $67,500 52 13,580 97 $4.97 $695.88
Comp 3 9/30/2014 $70,000 $70,000 428 14,442 166 $4.85 $421.69
Comp 4 9/30/2014 $70,000 $70,000 428 16,236 164 $4.31 $426.83
Comp 5 5/31/2013 $80,000 $80,000 2688 17,424 128 $4.59 $625.00
Comp 6 6/27/2013 $71,000 $71,000 51 19,166 127 $3.70 $559.06
Comp 7 9/30/2014 $60,000 $60,000 428 20,000 100 $3.00 $600.00
Acreage Lots
Comp 8-A 2/20/2014 $75,000 $75,000 2237 43,560 148 $1.72 $506.76
Comp 9-A 4/30/2013 $65,000 $65,000 614 43,560 202 $1.49 $321.78
Comp 10-A 10/11/2013 $67,500 $67,500 131 43,560 125 $1.55 $540.00

*Note we included a couple of acreage properties because one of the improved comparable sales was an acre property and support was needed support for a site adjustment.

In the example, we see that the smaller the lot, of course, typically the higher price per square foot (SF). This is known as increasing and decreasing returns; see definition below. While there are exceptions, this is a general rule. Comparable sale-1 is a tear down property. Because the data is actual real world data, it is not perfect as we typically see in many academic examples, but it does allow a supportable conclusion to be derived.

increasing and decreasing returns
The concept that successive increments of one or more agents of production added to fixed amounts of the other agents will enhance income (in dollars, benefits, or amenities) at an increasing rate until a maximum return is reached. Then, income will decrease until the increment to value becomes increasingly less than the value of the added agent or agents; also called law of increasing returns or law of decreasing returns.[1]

With the data shown above, we can see that price/SF averages $4.19 and the range is $3.00 to $4.97/SF in this market. Front footage (FF) averages $548.42/FF and the range is $421.69 to $695.88/FF. By establishing an estimate of land value for the comparables used in the sales analysis, it helps to develop cost-derived adjustment.

Using comparable sale-1 as an example, the estimated cost looks like this:

Element SF $/SF Extension
Dwelling          2,414 $       87.85 $ 212,069.90
Basement          1,142 $       22.17 $     25,318.14
Basement Finished          1,000 $       15.00 $     15,000.00
Extras $     10,000.00
Garage            504 $       27.57 $     13,895.28
Cost New Estimate $     114.45 $ 276,283.32
Sales Price $ 308,300.00
Site Value $ (55,000.00)
Depreciated Value of Improvements (or RIV) $ 253,300.00
Minus Cost New $     22,983.32
Depreciation % 8.32%

Below, we have estimated the site value and subtracted it from each of the comparable sales. The resulting unit of comparison is much better than overall price/SF. The price /SF-RIV can be used as an indicator of the highest possible reasonable adjustment for GLA. We like this as a test of reasonableness for any adjustment made for differences in gross living area. The resulting $/SF-RIV is going to be the upper limit of how much you can adjust.

Sales Sale Price Land Value RIV GLA $/SF-RIV
Comp 1 $308,300 ($55,000) $253,300    2,414 $104.93
Comp 2 $300,000 ($60,000) $240,000    2,308 $103.99
Comp 3 $295,000 ($70,000) $225,000    2,468 $91.17
Comp 4 $283,000 ($50,000) $233,000    2,310 $100.87
What about Fireplaces and Decks, etc. is this approach right for that? Decks and other items like decks and outbuildings typically depreciate at a faster rate than the house. One would try to steer away from using this methodology with such items. We still believe that this approach can be used in measuring the top end of the adjustment range, or as a test of reasonableness, but with the caveat that the rates of depreciation may vary.Depreciated cost may offer one of the only adjustments that you need at all, if your comparable sales are all very similar. It can be difficult to support adjustments for additional features like decks and fireplaces. Sometimes those types of amenities are sometimes best dealt with using qualitative reasoning.   If you are looking at sales that all have similar external features, are of the same quality/condition as the subject it may not be required to adjust for them. These items are difficult to extract and may be summed up with qualitative reasoning. It will depend on what information you have learned about from the market.     This is an excellent area to discuss with real estate agents and ask if such features are strong considerations by buyers. It is also important to understand how the sellers are looking at such items as well.     We find that talking to both agents on a transaction can be beneficial to glean such information.     In the end, if no adjustments are supportable for such amenities, the appraiser can discuss the additional amenities present for a sale and use that in the final weighting during the reconciliation of the sales comparison approach.

We can apply these figures to the improved sales that we are using in the sales approach to get a residual improvement value (RIV). As mentioned earlier, RIV is a better indication of comparability as it allows us to compare apples to apples. It removes the land component, and other improvements not related specifically to the house itself. Just getting this far into the process with each of the comparables, and looking at the RIV/SF as a metric will assist with the concerns many are having about the CU overall price/square foot metric.

The next process is to take each sale and develop a cost approach using Marshall & Swift Residential Cost Handbook (disclaimer, huge fans here) for the appropriate quality. It is important to make adjustments for energy and foundation (bottom of the page related to the type of housing) if they apply, refinements for floor covering, heating and cooling, etc. as well as applying the quarterly multipliers to region and location. From there you should compare total cost to the depreciated remainder for an account of depreciation.

You would then do one for each of the sales in the study.

Sales Cost New RIV Total Depreciation % Depreciated Age Depreciation/yr
Comp 1 $276,283 $253,300 $22,983 8.32% 14 0.59%
Comp 2 $254,908 $240,000 $14,908 5.85% 16 0.37%
Comp 3 $264,925 $225,000 $39,925 15.07% 29 0.52%
Comp 4 $271,585 $233,000 $38,585 14.21% 20 0.71%

*Note: This type of approach utilizes all forms of depreciation. If there were cases of functional or external depreciation present for any of the comparable sales, this would need to be adjusted for as well. In this case, study, there were neither additional forms of depreciation.

This information can be valuable in terms of understanding depreciation, as well as supporting either an age or a condition adjustment (look at how sales 3 and 4, which are older houses, have much more depreciation than the newer houses overall). Since each house is depreciated between ~6 and ~15 percent, you also have supportable adjustments to make for age or condition.

You can also utilize this type of adjustment for amenities such as basements. For example, say comparable sale-1 has a finished basement that is older and not high quality. The finish costs an additional $15 per square foot rounded over and above the cost of the basement. This finish is a recreation room only and the cost new is around $15,000. The overall rate of depreciation for this property is 8.32% or $1,250(rounded). This means that logically the basement finish would now contribute about $13,750 to the property value. That may not be sufficient to stand alone, but does offer a method of support.

Additional support can be from running simple statistics such as isolating a group of sales based on some commonalities. For the following sample, we took houses in this particular market separated between houses built between 1995 and present, but excluding proposed construction. They were further narrowed to include 1,800 to 2,800 SF and no walkout basement. By doing a simple version of grouped paired analysis, we see the result was a difference between $14,843 and $15,377 between the two types, with many having bathrooms in addition to finished rooms. With an indication of $13,750 from comparable sale-1 and the paired group analysis showing a range of $14,800- $15,400, it is easy to deduce a reasonable adjustment amount.

No Walk Out # Sales Avg Price Median Price Avg GLA Med GLA Avg $/SF Median $/SF
1800-2800 SF Unfinished Basement 42 $340,559 $329,623 2392 2402 $142.37 $137.23
1800-2800 SF Finished Basement 89 $355,402 $345,000 2399 2408 $148.15 $143.27
Difference $14,843 $15,377 7 6 $5.77 $6.04

Completing a cost approach on each sale is a good exercise in terms of seeing cost in action, as well as testing depreciation. The greater the depreciation exhibited in the individual sales, the greater the difference in either condition or age, or a combination of both. So this methodology can also create support for other types of adjustments as well, such as the basement finish adjustment shown above. Many will say this takes a lot of time, and our answer is, “Yes, but it’s something that uses some commonsense and appeals to reasonableness”. We would also add that explaining this is much easier than trying to use regression analysis or find that elusive matched paired sales. Most appraisers can reasonably explain cost-based extractions to a jury or licensing board. It does not require much in the way of additional tools. Excel©, cost estimation software and appraisal software is all that is really needed.

Depreciated cost does work in many markets, so give it a try to see if it is something that will work for you. Use it in addition to some other methods of supporting adjustments. We consider it an excellent test of the reasonableness of both the value conclusion, and the elements of comparison within the value conclusion. We have each successfully used it in lending and non-lending work assignments.

Fannie Mae and CU are specifically going to target our size adjustments. In the past, many appraisers used “rules of thumb” as the basis for a size adjustment. As we are all now aware, rules of thumb do not work anymore because CU has the ability to calculate size adjustments from market sales data. The model above, while not based on CU’s sophisticated algorithm, also functions quite well in isolating the sales price of the improvements. Using this model, appraisers are able to isolate such differences within a reasonable range of values. Even more importantly, this range of values is market-derived, thus in full compliance with CU’s requirements. Be sure, too, to save all of these calculations in the workfile for future reference.   Gone are the days when we can justify out adjustments by invoking “my 30-years of appraisal experience”. Now, we must prove our adjustments. This model is one of those proofs. Finally, what we have presented here is nothing new. This well-known method has been published in numerous books and in courses. We thought presenting a “real-world” example might be helpful in showing how even without perfect results; the results can be, nonetheless, meaningful.

[1] Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010)

Advertisements

About woody22911

I am a professional assessor/real appraiser by trade; I manage a staff of 13 people. I have a bachelor of science in business admin and an associates in culinary arts. I am looking into a masters in public policy/public administration. I am also a musician, a father to three kids and I attempt to write. I have Diabetes II as a result from a condition that causes my body to produce unusually high triglycerides. I have been hospitalized with acute pancreatitis four times over the last 15 years. This particular blog is an attempt to document my successes and failures to fix the problem through nutrition and activity.

One thought on “Depreciated Cost, a Test of Reasonableness

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s