LM 2122: Land Valuation

Terans Gunawardhana
Senior Lecturer
University of Sri Jayewardenepura
Session 10: Cost Approach/
Depreciated Replacement Cost
(DRC)
3 Cost Approach/ Contractor’s Method
 An approach that provides an indication of value using
the economic principle that a buyer will pay no more for
an asset than the cost to obtain an asset of equal utility,
whether by purchase or construction.
 Within the wide range of properties which exist there are
some which are designed and used for special purpose
to meet specific requirements and which are outside the
general range of commercial and residential properties.
 Typical examples are temples, churches, town halls,
schools, public libraries, refineries, hospitals, prisons,
schools, courts, airports, railway buildings, universities
and other similar properties which perform non-
profitable community functions and are not normally
bought and sold in the market.
4 Cont…

 In nearly all cases such properties are built by the

authority or organization responsible for the provision of
the special service or use and commonly there is no
alternative body which requires the property.
 In such cases there are no sales in the market and thus
no comparable on which to base a valuation.
 Indeed, such properties are rarely sold and, when they
are, they generally need to be replaced by alternative
premises which have to be newly built since alternatives
rarely exist.
5 Cont…
 Valuation of the existing use of specialized properties such as
religious properties (Temples, Kovils, Churches, Mosques) are
sometimes required for compulsory purchase and
compensation. As a result, the price required by a body
owning such properties is the cost of providing equivalent
alternative accommodation.

 The cost of provision is basically the price of an alternative

site and the cost of erection of the buildings.

 The price for the site will be based on the value of

comparable sites whilst the cost of erection is derived from
prevailing building costs.
6 Cont…

There are three inputs to the method, namely:

1. the site value of a specialised property;

2. the cost of the buildings and site improvements
of a specialised property; and
3. assessing depreciation.
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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 for an existing specialised building where there
is no market evidence. The approach is therefore to find the answer to
three questions:

1. How much would a willing buyer pay for a similar site suitable for a
modern
equivalent asset?
2. How much would it cost to build that modern equivalent building?
3. How much should the cost at 2 be written down to reflect the fact
that the
actual building is not brand new i.e. to assess depreciation?
8
Replacement cost = Rs 2,500,000
Annual depreciation rate (100/25) = 4%
deduct accumulated depreciation at
10th year = 10 years at 4% = 40% = Rs1,000,000
DRC at 10th year Rs1,500,000

The main criticism is that depreciation will rarely follow a straight

line.
 Cont…
9
 A major issue arises in the calculation of depreciation. In the case of
newly erected buildings there may be no need to make any
adjustment. In other cases, the valuer is seeking to assess how much
less a hypothetical buyer would wish to pay for the actual building,
with all its warts, than for a modern equivalent building suitable for
the same use and purpose of the existing building.

 There are three types of depreciation, “physical deterioration,

functional obsolescence and economic obsolescence”.
 Briefly, physical deterioration refers to wear and tear; functional
obsolescence is concerned with the design or specification; and
economic obsolescence relates to factors outside the building
which can be affecting demand for goods and services produced
by the asset.
10 Depreciation Calculation
 Straight Line Depreciation: This method is probably the most used
and assumes that the same amount is allowed for depreciation for
each year of the asset’s life.

 The reducing balance method of depreciation assumes a constant

percentage rate of depreciation from the reducing base. This is the
least preferred approach.

 S-curve approach :This approach is felt to be the most realistic, as

the S-curve represents the way an asset is likely to depreciate. It can
reasonably be assumed that most assets depreciate slowly in the
early years of the asset’s life, depreciate faster in the middle years,
and then depreciation slows down in the latter years.
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Thank you!