There has been an on-going discussion for as long as I have been in the real estate business as to why cost may not equal value. It can certainly be argued that if something costs X to build, why is in not worth X? The cost may be factual and well supported and the property owner may be willing to pay it, but the appraisal comes in lower than the cost. Why does this happen? It might be helpful to look at some definitions.
Cost is defined as: 1) The total dollar expenditure to develop an improvement(structure); applies to either reproduction of an identical improvement or replacement with a functional equivalent, not exchange (price)
2) the amount required to create, produce or obtain a property. (USPAP 2010-2011 ed.). In USPAP, the term cost is used either as a historical fact or as an appraisal estimate of current future or historic reproduction or replacement cost.
Price is defined as: The amount asked, offered, or paid for a property. Once stated, price is a fact, whether it is publicly disclosed or retained in private. Because of the financial capabilities, motivations, or special interests of a given buyer or seller, the price paid for a property may or may not have any relation to the value that might be ascribed to the property by others. (USPAP, 2010-2011 ed.)
The definition of Market Value that is used by the agencies that regulate federally insured financial institutions in the United States is: The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specific date and the passing of title from seller to buyer under all conditions whereby:
a) Buyer and seller are typically motivated;
b) Both parties are well informed or advised, acting in what they
consider their best interest;
c) A reasonable time is allowed for exposure in the open market;
d) Payment is made in terms of cash in U.S. Dollars or in terms of
financial arrangements comparable thereto; and
e) The price represents the normal consideration for the property sold
unaffected by special or creative financing or sales concessions granted
by anyone associated with the sale. ( 12C.F.R. Part 34.42(g); 55 Federal
Register 34696, August 24, 1990, as amended at 57 Federal Register
12202, April 9, 1992; 59 Federal Register 29499, June 7, 1994)
Of course, there are some classic examples as to why cost does not equal value, and some of those are image or ego buildings where there are many custom design features or special use buildings that are built for a specific tenant/owner and have costs that are not able to be fully recaptured in the market by another purchaser. These would be examples of “Functional Obsolescence” and are specific to the property itself.
Often what we find is “Economic Obsolescence” present, which is not specific to the property itself, but is caused by outside influences. With residential properties, this is established primarily from a sales comparison approach, when you can purchase a relatively new existing home for less than the cost to build new. This was very apparent during the recent recession and one of the reasons new home construction suffered as much as it did. Many newer homes were foreclosed on and could be purchased for much less than the cost new.
With commercial and industrial properties, this approach is also relevant, but one method used to measure the amount of Economic Obsolescence present is to estimate the difference between what the market rent is and what the rent would need to be in order to give a reasonable rate of return to the investor. The difference between these two rental rates is the amount of Economic Obsolescence present, that will need to be deducted from the cost new to arrive at the current market value, assuming there is not also some functional obsolescence.
For example, if the going rate for a lease on a typical 20,000 S/F industrial building is $3.50 per S/F with triple net terms and the Net Operating Income, after deducting for vacancy and credit loss, management and reserves, is $60,500, and the going Cap. rate is 9%, a value of $672,222 is indicated.
Let’s say that building cost $800,000 to build. Working backwards, this would require a Net operating income of $72,000, which would require an Gross Income of approximately $83,000, which relates to a rental rate of $4.15 per S/F of building. That may not be achievable in the market. Therefore, if we divide $3.50 by $4.15 we have a difference of approx. 15.7%, say 16% which would be the amount of Economic Obsolescence present. If we then deduct the 16% from the cost to build of $800,000 we have an indicated value of $672,000.
All of this is market driven. If rents move up through supply/demand, they will be able to support a higher cost and more building may take place, which could then lead to an over-supply and the cycle begins again. Basically Economics 101.
I hope this helps and at least gives some rational to what may be the difference between the cost of a building and its market value.
By John Meyer, SRA, GAA, John Meyer Appraisal Company