Unit 8 : Cost of replacement Method of

Valuation or the Contractor’s method

By : P.Mpolokang
 Objectives of the Unit
• To learn another method of valuation which
could be used in-case there is no comparable
evidence nor rentals being paid to enable the
direct comparison method or the investment
method to be used.
• To appreciate circumstances in which the cost
of replacement method is the more
appropriate method to adopt in carrying-out a
valuation.
Cost of replacement method/contractor’s
method of valuation
• The cost of replacement method is also at times referred to
as the depreciated replacement cost method (DRC). DRC is
defined as the current cost of replacing an asset with a
modern equivalent asset less deductions for physical
deterioration and all relevant forms of obsolescence and
optimisation.
• The principle behind the method is that of market
substitution. The valuer is seeking to establish what a willing
buyer negotiating with a willing seller would pay a
specialized property where there is no market evidence.
• As the cost method is based on the principle of substitution
it assumes that the market value of a new building is similar
to the cost of constructing it today. For older building
accrued depreciation is taken into account.
Questions being asked when using the
replacement cost method
• The approach seeks to answer the following
questions:
➢How much would it cost to build a modern
equivalent building?
➢How much should the modern building be written
down to reflect the fact that the actual building is
not brand new (assessment of depreciation)
➢How would a willing buyer pay for a similar site
suitable for a modern equivalent building.
 Cost of replacement method/contractor’s
method of valuation
• The method is used mainly where is no
market for the particular type of property.
The cost of replacement method of
valuation assume that the market value of a
new building is similar to the cost of
constructing it today; that is the principle of
substitution.
• For an existing property the valuer identifies
and measures the reductions in value from
today’s re-construction costs. The
reductions relate to accrued depreciation.
 Cost of replacement method/contractor’s
method of valuation cont.
• The underlying principle here is that a buyer will not pay
no more for an asset than the cost to obtain an asset of
equal utility, whether through purchase or construction.
This implies that a prudent developer would not develop
any investment property if its development costs exceed its
market value.
• The main inputs of the replacement cost method are:
➢ The cost reproducing/replacing the specialized property
➢ Assessed depreciation of the building
➢ Estimated site value
• Estimated market value using the cost method = estimated
reproduction cost (replacement cost) of the building minus
the accrued depreciation + estimated site value.
 Why does cost of production nearly
equal to value
• Market forces compel the market value of newly
constructed properties to approximate construction costs.
• When costs of construction are low, and demand for such
developments is high, developer are encouraged to develop
more properties.
• When construction costs increase, the demand for such
developments start to dwindle and developers start to
produce less and less developments until they final stop to
produce any developments when costs exceed market value
of developments being produced. Costs and value are
pressured towards each other. Cost can therefore be used
to estimate value in such instances.
 Estimating costs
• Building costs that could be estimated are:
➢ Reproduction costs – the costs to construct the building today
replicating it in exact detail, that is; including some features which
could be out-dated or using out-dated materials.
➢ Replacement costs – the costs incurred to construct a building of
equal utility to the existing building. This includes the use of modern
construction techniques, new materials, new design and represents
the cost of a building for which some out-dated aspects are
eliminated.
• In most cases, the type of cost to be estimated is the
replacement cost/value. This is because in many instances
buildings may be made of materials and construction methods
which are no longer available or are no longer permitted in
accordance with the existing building codes.
• In estimating cost, valuers tend to rely on builder’s cost figures.
Builders and more especially builder’s quantity surveyors
maintain comparative cost data on a per m2 basis for various
properties.
 Estimating costs cont.
• To properly estimate the present costs of a property, it is necessary
to determine its accrued depreciation.
• Accrued depreciation is the difference between the market value
of a building and its construction cost. The difference occurs over
time and it is attributed to the following elements:
➢ Physical deterioration – loss in value which is associated with the
property’s age, decay and maintenance or lack thereof. Older buildings
are therefore worth less than new ones of equivalent utility.
➢ Functional obsolescence – loss in value of property which is associated
with its usefulness as dictated by for example by trends, tastes and
technological advancements e.g. a new house without an en-suite in
the master bedroom would be functional obsolescent in this new age. A
new house in a high cost area which is roofed using corrugated iron
sheets would be functional obsolescent in this era.
➢ External obsolescence – loss in value due to external influences e.g.
increased noise from traffic within a neighbourhood resulting in loss of
value of real estate within the neighbourhood or increase in crime rates
affecting property values in the neighbourhood. External obsolescence
results from a deterioration in the subject property’s neighbourhood.
 Estimating the life span of a building
• In order to use the cost of replacement method it is always
necessary to know the life span of a building so as to properly
estimate its accrued depreciation.
• The method normally adopted to estimate accrued depreciation is
the straight line depreciation method. The straight line
depreciation method assumes that the same amount is allowed
for depreciation for each year of the asset’s life span.
• Using the replacement cost method the valuer has to establish the
remaining useful life of the building at the date of valuation. The
next step is to calculate the annual percentage of depreciation,
which is simply 100/total life span.
• If for example a building has a total life span of 25 years and is 10
years old; its percentage depreciation at the date of valuation
would be 100/25 * 10 = 40%. The accumulated depreciation
would therefore deducted from the cost of producing a modern
equivalent building.
 Example 1
• The replacement cost of an equivalent
modern building is P1 500 000. The subject
building whose value you are required to
estimate has an expected life span of 40 years.
At the date of valuation the building is 15
years old.
• What is the replacement value of the building
at the end of the 15th year?
 Solution

• Replacement cost P1 500 000.00

• Annual depreciation rate 100/40
• Depreciation: 100/40 * 15 37.5% 562 500.00
• Replacement cost at the end 15th year P937 500.00
• As you will note we have only estimated the replacement cost of
the building. To complete the valuation it is necessary to add the
site value.
 Example 2
• Using the cost of replacement approach, you are
required to estimate the value of lot 4964,
Gaborone given the following:
➢The area of the building is 220 m2 and building costs for
high cost houses within the area are P4000 /m2 for un-
air-conditioned space. The building’s life span is 40years.
➢The building on lot 4964 is air conditioned at a cost
equivalent to 5% of the building cost
➢The physical deterioration of the building to-date is
estimated at 2.5% of the total improvement costs on lot
4964 as the building is only 1 year old.
➢The plot measures 2215 m2 and the price for bare land
within the vicinity is P350/m2.
 Solution
• Replacement value of the house
• 220m2 * P4000/m2 = P880 000

• Improvements to the house

• Air-conditioning P880 000 * 0.05 = P44 000
P924 000
• Less depreciation
• Physical deterioration P924 000 * 0.025 = P23 100
P900 900
• Add site value
• 2215m2 * P350/m2 = P775 250
P 1 676 150
Rounded to P 1 676 000
Using replacement cost method the value of house no. 4964, Gaborone is
estimated at P1 676 000.00 and is comparable to the value arrived at using
the direct sales comparison method earlier on. A value of P1 681 000.00 was
obtained earlier on using the direct comparison method. The values are
within 10% of each other which is an acceptable range.
 Final reconciliation

• In determining the final estimate of market value, a

valuer has to consider and weigh the reliability of the
estimated value as well as the relevance of the
approach used to value the subject property.
• That is, looking at the values arrived at using the to
different methods, one needs to decide as to which
method is the most appropriate hence the value to be
adopted as the value for the subject property.
• The above implies that in real life valuation it is
necessary to use two methods in order to ensure that
one method act as check for the other.
 Types of properties which are amenable to the use of
the cost of replacement method
• The method is adopted in those cases where there are no sales
comparables nor any income that the subject property is generating.
• Properties such as churches, schools, police stations, power stations
etc which perform non-profitable community functions are the ones
most amenable to the use of the method.
• Properties similar to those listed above are rarely sold but can at one
point be required to make way for other more valuable
developments.
• When such properties have to make way for other developments, the
price required by an owner of such a property is the cost of providing
an equivalent alternative property.
• The price for such property is basically the cost of erecting an
alternative building plus the cost of an alternative site.
 Conclusion
• The cost of replacement method or the contractor’s
approach in one the methods of valuation which can
be adopted to value property.
• The method is usually adopted to value properties
which are not normally sold in the open market
and/or properties which do not generate income.
• The method is premised on the understanding that
the estimated value of a building equals its
replacement cost minus its accrued depreciation plus
the value of the site.
• In valuing a property it is always advisable to adopt
two different methods so that so that one method
acts as a check against the other method.