Q: What is an Opinion of Value?
-Connie M., Retail Plaza Owner
A: Part 1 of this four-part response outlining the methods of valuing commercial real estate examined the Direct Comparison method in order to create an Opinion of Value. Another common technique that informs an agent’s estimate is the Cost Approach. This method is a logical, proven analysis of replacement costs that takes into account both value and depreciation.
The Cost Approach can be described in five simple yet thorough steps that result in a property estimate, as is illustrated by this Ontario Real Estate Association flow-chart:
Land valuation can be one of the most complex calculations. One method of evaluating sites is known by several names: abstraction, allocation, and extraction. Each refers to the technique of subtracting the value of structures and any tangible improvements from the total value of the property in order to determine land value.
The principle of surplus productivity is employed by another technique, the land residual> method. The principle being that surplus income, after subtracting costs such as labour, and capital outlay, is then attributed to the land, thus setting its value through this capitalization process. This method is particularly useful in evaluating properties that are readily adaptable as income producing properties.
Emphasizing objective value, the Cost Approach determines value over cost. In accounting for structural and land improvements, for instance, four criteria must be met to assign the cost (or more) of an improvement as its value. The improvement must: be new, represent the property’s highest and best use, not be affected by obsolescence, and have an anticipated return from the improvement that justifies its original cost.
The Cost Approachtakes into account both objective and subjective value. Typically, the number-crunching that creates the calculations are objective, whereas site valuation, which is also a crucial step, is based on the more subjective data that is comparative analysis.
Unique and special purpose properties can often only be evaluated using the Cost Approach method, due to the lack of comparable sales. Agents calculate replacement costs per square foot using current market rates and materials. Both straightforward replacement and the more complex reproduction costs are considered when calculating depreciation. As a general rule, the age of the structure being valued determines the adequacy of the method. Newer structures can be more accurately estimated using reproduction costs, whereas older structures must rely more on replacement costs in order to determine current market value.
Depreciation and Obsolescence
Depreciation can be defined as the loss in value, or diminished utility, due to any physical cause. Factors may include the normal deteriorations of aging, as well as functional obsolescence, should a property become outdated, undermining its viability in the marketplace. In the Cost Approach, accrued depreciation is calculated to determine value.
Diminished utility, or accrued depreciation, can be caused by a wide variety of factors, and reflects the difference between reproduction cost or replacement cost of improvements, and the present worth of those improvements. Some factors that depreciate property are worth rectifying, and some are not, or cannot be upgraded. Therefore, both curable and incurable depreciation must each taken into account.
Obsolescence can occur from both internal and external factors, thereby diminishing a properties desirability or utility, and so its value. For instance, new technology may render a property functionally obsolete. Urban planning or trends may alter the desirability of location.
Depreciation is determined through careful cost and use analyses, and then subtracted from the estimated site value to arrive at an informed Opinion of Value using the Cost Approach.
Over the following two weeks, we’ll discuss the Income Approach. First, we’ll examine the direct capitalization technique used to determine property value, followed by the conclusion to our Opinions of Value series, examining yield capitalization.