QUESTION: A reviewer recently got all up in my stuff about the cost approach. She told me my cost approach was “…internally inconsistent…” since the depreciation did not match either the chronological age or the effective age. But, she said, the biggest problem was that, in the One-Unit Housing Trends, I indicated the market was hot, there was an excess of demand over supply and marketing times were 30-days or less (yes! I did that!). But, in the cost approach, I did not include an entrepreneurial profit or incentive, which she said was also misrepresentation and affected the quality of the highest and best use conclusion! Just what is going on with that reviewer?! I don’t even know what she’s talking about! I got the depreciation from the published tables, just like every other appraiser. Nobody includes an entrepreneurial profit in the cost approach! I was appraising a used house! What am I missing? Are reviewers really alien life forms?!
There are two issues here, so let’s cover depreciation first, then entrepreneurial incentive. As an introduction to the answers, remember that state investigators and state appraisal boards look for internal inconsistencies (or internal incongruities) since, generally, they are easy to spot, and they are also hard to defend (usually).
Depreciation, per one definition, is the “…difference between the reproduction or replacement cost of an improvement and its market value as of the date of the appraisal[1]” (Appraising Residential Properties, 4th ed. © 2007, The Appraisal Institute, p. 283, ff). Since land cannot depreciate in the traditional sense (ibid; p. 238) [in other words, it does not wear-out, thus is never replaced], then depreciation, in all of its forms, applies solely to the improvements (ibid; p. 286). Improvements lose value since, over time, even with proper maintenance they (1) wear out physically thus, eventually, must be repaired, renovated, or replaced (i.e., razed); or (2) market preferences change, necessitating their eventual repair, renovation, or replacement. Ultimately. the improvements will wear out and an owner will eventually tear them down (or they will collapse of their own deterioration). In other words, when they no longer contribute to the value of the underlying site (since they are worn out and/or nobody likes them), it is time to raze them.
While the analytics composing the Cost Approach are generally an appraiser’s second or third choice when it comes to forming a value opinion, their greatest utility may come instead in concluding depreciation, which is part of the appraiser’s highest and best use analyses. Therefore, while their importance may be more analytical than practical, they are nevertheless important.
USPAP’s SR1-4(b)(iii), makes it clear that depreciation is an estimate of “…the difference between the cost new and the present worth of the improvements…” (2020-2021 USPAP, © 2020, The Appraisal Foundation, p. 18, ll. 522; 526, 527). By that mention as part of the 4th step in the appraisal process, then, an estimate of depreciation also becomes part of the appraisal process. Since USPAP says nothing about who completes the appraisal process, then taking depreciation from a pre-printed table is just as acceptable as calculating it yourself (assuming you conclude that pre-calculated depreciation is credible), or assigning that task to an associate or contractor.
Note that, whether you calculate depreciation yourself, or you take it from a pre-printed depreciation table (or somebody calculates it for you), none of those allocates depreciation among its three sources, which are (1) the wearing out of the improvements (physical); (2) lack of market acceptance of the improvements (functional), and (3) something external to the property affecting market desire for the property (e.g, the recession of 2008-2012 [external]). Allocation of accrued depreciation among them is difficult and, frankly, a detail most lenders do not need to know to make a mortgage loan on the property (although there is every reason to conclude the state appraisal board will not take such a benign attitude).
Relative to the reviewer’s comments about depreciation, whether the appraiser (or somebody else) extracts accrued depreciation from the market or derives it from a pre-printed table, it must still be credible in the context of the subject, its competitive market, and the appraiser’s[2] intended use of the appraisal. Consider this narrative example, then we’ll walk thru the math:
Assume the property is chronologically 35-years old, but you conclude it to be effectively 20-years old. Assume as well that, as part of the cost approach calculations you’ve indicated accrued depreciation of 25%. Based on effective age, this means the subject has depreciated 25% in 20-years, or an average[3] of 1.25% per year. To depreciate 100% at 1.25% per year means that, per these calculations. the property has an 80-year total economic life. Mathematically, this is 1/(0.25/20). Therefore, by giving the property an effective age 20-years (this is the appraiser’s judgment call, frankly, since there is no way to extract the subject’s effective age from the market), and concluding it is 25% depreciated, the appraiser is saying the property, all other things being equal, should have a total economic life of 80-years. If this is reasonable, fine; but just assume the state investigator is going to ask for supporting data for the effective 20-year age. This is what the reviewer means when she says the chronological age, the effective age, and the accrued depreciation factor do not jibe. Frankly, they do not have to jibe. But the appraiser must be able to explain – cogently and persuasively – (1) why s/he chose the effective age; and, if the actual age and effective are are far apart, (2)(i) why that distance is true, (ii) how/why it affects the subject’s marketability, and (iii) why/how it affects the subject’s market value.
As to the mention of lack of an entrepreneurial incentive, that is a more complex question, with a more complex answer. This incentive is not a component of the a costing manual since only the market bestows a profit to the entrepreneur. There is no reason to confuse a component of contractor’s overhead and profit (which is a part of any reasonable cost to construct) with entrepreneurial profit or incentive. For example, if I commissioned you to build me a house on spec, then you, the contractor, would expect to earn a profit for your expertise, etc. That is only fair. However, if I as the entrepreneur overbuilt the house for the market, or mis-timed the market and built when there was no demand for what I built, the market would not reward me with a profit for my misadventure. You the contractor would earn a profit for your efforts. But, in this case, I, as the entrepreneur, would not since the market was, in some way, out of balance.
Based on the reviewer’s remarks, the report must have indicated the market was hot, etc. When demand for housing exceeds the supply of housing is exactly the time to build a spec house. Yet, by saying there was no entrepreneurial incentive or profit in the market (which is what the report said by not including one as a component of the cost approach), the reviewer picked this up as an internal inconsistency (i.e., if the market’s so hot, why is there no new construction? No rational entrepreneur will go to the time and trouble to build when there is no excess demand for housing product). Frankly, the report’s conclusion of a hot market/no entrepreneurial profit may be true; there may not be an entrepreneurial incentive or profit in the market for any number of good reasons. But that apparent inconsistency merits an explanation which, per her remark, the report did not have. This lack of an explanation of this anomaly was the reviewer’s objection.
Many appraisers claim that, for an existing house, there is no reason to include an entrepreneurial incentive or profit since, if there ever was one at all, it was taken when the house sold new from the builder/developer to the first retail purchaser. In other words, there is only such an incentive when the house is new. This is likely true. Please note, however, that, in the analytics of the cost approach, the final value indication has its base in cost new. Why? Because you can’t build a used house. There is no other choice but to start with a new one first, then depreciate it to account for its use, as well as the market’s acceptance of the style, etc. of the improvements.
Therefore, to omit a component of entrepreneurial value or incentive from the cost approach (which begins with cost new) implies there is not one in the subject’s market as of the effective date of the appraisal. If there is not such an incentive or profit potential in that market, that absence is a prime indication of an external obsolescence factor (see e.g., the years 2008-2012). Such a statement merits a separate analysis, as well as a summary of the appraiser’s support for it as part of the report. If, indeed, there is no such incentive/profit in the market, yet the local market is increasing, there is an excess of demand over supply, and marketing times are 30 days or less, this absence is an anomaly worthy both of analysis as part of the appraisal, and then a summary of that analysis, as well as a presentation of the appraiser’s conclusions, in the report.
Therefore, the reviewer claimed there was the presence of an internal inconsistency based on what the report stated (or implied) in one of its components, versus what it stated (or implied) in another. Potentially, this is a major USPAP infraction since a board could interpret it as misrepresentation. Note that as of 1/1/2020 USPAP had a definition of misrepresentation (by reference). That definition does not allow a lack of an intent to mislead or misrepresent as a mitigating circumstance.
To sum then, the reviewer’s comment was not a result of the mere absence of an entrepreneurial incentive or profit as part of the approach. Instead the reviewer commented on it because there was no explanation in the report for this apparent inconsistency. In other words, you concluded there was not such profit/incentive, but did not explain why/how you reached that conclusion, nor why/how it affected the subject’s market value or marketability.
The reviewer’s comment as to what was/was not in the report, and its affect on the highest and best use conclusion, is also probably true. However, this blog is not the time or place to go into all of the ramifications of her claim. Nevertheless, a state investigator/state board would likely go into that depth, so you’d need to be prepared to answer those questions out of the data in the workfile.
As to your assertion the reviewer may be an alien life form, well…the truth is out there.
[1] USPAP uses different language, but uses essentially the same definition (see above).
[2] Why do appraisers think the client sets the intended use of the appraisal? Per the USPAP definition, the appraiser tells the client the only use(s) to which the appraiser assents the appraisal and report be put. Yet the boilerplate in every residential appraisal report to a GSE has the client setting the appraisal’s intended use. Is this not letting the client define the appraiser’s scope of work to the self-service of the client?
[3] There is nothing in the market to indicate depreciation follows a straight-line, which is what this assumes. However, for analytical purposes, we just assume this.
1. Once again, this is another great reminder of why we have never included the Cost Approach in the WERC (Employee Relocation) Appraisal Report, where accuracy & credibility are proven by the market in-fact, not theoretically by an appraiser’s opinion or worse yet by a reviewer’s opinion of the appraiser’s opinion of minutiae. Or worse yet by a State Licensing agency. We’ll never add a cost approach to the Relo form.
2. In a “hot” market, with rapid increases in property value, the “entrepreneurial profit” is not a separate line item but instead is to be added to the land or site value. That [Land] is where the increased value is attributed to. Not depreciation.
3. While appraisers & reviewers & licensing agencies focus on the intricacies in the cost approach, even when it is irrelevant, automation will eat away little by little at lender collateral valuation services, without even using a cost approach. Except as a possible “add-on”, backed into, and not subject to review [black box].
Craig, thank you for the explanation of why the Cost approach is never part of an ERC appraisal report. I appreciate your comments!