CHAPTER 3

COST APPROACH
The contractor’s method
Contents
1. The concept and meaning of the method
2. General principles and foundations
3. Procedure
4. Determining the cost
5. Calculate cumulative discount
6. Limitations of the method
 1. The concept and meaning of the method

Concept:
Is determining the value of real estate based on the
cost of making a similar property as a substitute
 1. The concept and meaning of the method

Meaningful:
• Valuation of properties with little demand, rarely bought and sold on the
market
• Valuation of public properties such as schools, hospitals, city halls, libraries
and some other real estate.
• Valuation for taxation and tax rates based on construction cost and site
value.
• Valuations for insurance and mortgage purposes
• Valuation of construction in bidding or placing orders for contractors.
• Valuation for compensation (clearance...)
• To double check the valuation results of other methods.
 2. General principles and foundations

• General principles
Cost of site
Plus Cost of building
Minus The reduction of the value of the building
Value of existing real estate
 2. General principles and foundations

The basis of the method:

• Substitution
• Supply and Demand
• Balance
• Externality
• Highest and Best Use
3. Procedure

• Step 1: Estimate the value of the site of the real estate to be valued.
• Step 2: Estimate the replacement or reproduction cost of the main building
• Step 3: Estimate the total cumulative depreciation of the main building
• Step 4: Subtract the total accumulated depreciation of the construction from
the replacement or reproduction costs to obtain the present value or
depreciated replacement cost of the main building to be valued.
• Step 5: Estimate the depreciation for the sub building and the costs of other
improvements on the site and subtract it from its replacement cost to get the
discounted replacement cost of the sub building
• Step 6: Add the value of the land with the depreciated replacement cost of
the main building and the depreciated replacement cost of the sub building
to get the estimated value of the real estate to be appraised.
• Step 7: Adjust the estimated value of the target property for any individual
assets included in the costing, if necessary
4. Building Cost Estimates
4.1 The concept of replacement cost, reproduction cost of the
building (development cost of the building)
• Replacement cost of a building is the current cost to build a
modern equivalent building with a similar function and
equivalent utilities to the property being valued according to
current standards, designs and layouts.
• The reproduction cost of a building is the current cost of
constructing a building that is identical to the property being
valued, taking into account its obsolescence.
4. Building Cost Estimates
4.2 Types of costs and profits
• Direct costs: include the direct costs of creating the construction
work
• Indirect costs: are necessary costs to acquire the construction work
and put the construction work into operation and use.
• Investor's required return
• Direct costs + indirect costs + Investor's required return = Real
estate development costs
 4.2 Types of costs and profits

- Direct costs: Labor, construction materials, machinery and equipment,

electricity, water, camp, management costs of the contractor, general
costs, required profit of the main contractor, subcontractors …
- Indirect costs: Professional service costs; Appraisal fee, consulting fee,
estimation fee and legal fee; Site clearance costs; Interest; The costs of
risk insurance and construction fees; The operating costs from the
completion of the building to the time the work achieves a stable
occupancy level; Additional investment required by the user; Marketing
expenses, brokerage fees; Administrative management costs of the
developer; The costs of changing legal rights to the property…
 4.2 Types of costs and profits

• Developer's profit: is the difference between the market value of the property
after completion and steady occupancy and the total development costs.
• The developer's profit is added to the direct and indirect costs to calculate the
replacement or reproduction costs of the building.
• Depending on market conditions, a developer's profit can be estimated as a
percentage of direct or indirect costs, or direct or indirect costs plus the value
of the site...
4. Building Cost Estimates
4.3 Methods of determining costs
• Comparative-Unit Method:
This method is used to estimate the cost per area unit (VND/square
meter) by exploiting available data in the market of works similar to
the builiding to be valued, adjusted for market conditions and
specific physical differences.
4. Building Cost Estimates
4.3 Methods of determining costs
• Unit-in-Place Method (segregated cost method):
Applied to the unit cost of the number of component parts in the
structure or to the length, area or mass of these components, then
plus other costs to get development costs.
4. Building Cost Estimates
4.3 Methods of determining costs
• Quantity Survey Method:
Is the calculation of the quantity and quality of all materials used, the
quantity of all types of labor by grade and by the number of hours
required to be used in the construction of the building; Then add
other costs to get the development cost
5. Depreciation Estimates
5.1 The concept and causes of cumulative depreciation of the
building
• The concept
Cumulative depreciation is the loss in value for any reason that makes
up the difference between the replacement or reproduction costs of a
property compared to the market value of the same property at the
time of valuation.
• Reasons for depreciation:
- Physical deterioration
- Functional obsolescence
- External obsolescence
5. Depreciation Estimates
5.2 Age of the building
• Economic age
• Useful age
• Actual age
• Effective age
• Remaining economic life
• Remaining useful life
Example 1: Determining age of the construction
A building built in 2000. According to technical standards, the building will last for 50
years. The value of construction contributing to the value of real estate will gradually
decrease, it is estimated that by 2047 the value of the works will be zero dong.
In 2005, the house was upgraded, so its economic life was extended by 5 years
Conducted valuation in 2011
Solution:
The useful age of the building is 50 years.
Economic age = 2047- 2000= 47 years
Actual age = 2011- 2000= 11 years
Effective age = 11 years – 5 years = 6 years
Remaining economic life of the building = 47 years – 6 years = 41 years
5.3 Methods of calculating cumulative depreciation of the building

5.3.1. Market Extraction Method

This method sums the cumulative depreciation of the building due to all
causes.
Step 1: Investigate to determine the right properties for sale that are
comparable to the target property in terms of quantity and type of depreciation
Step 2: Make adjustments to certain factors such as rights, payment
conditions and selling conditions of comparable properties to receive the
adjusted selling price.
Step 3: Estimate the replaceable deterioration of elements that need to be
maintained and repairable functional obsolescence.
5.3 Methods of calculating cumulative depreciation of the building

5.3.1. Market Extraction Method

• Step 4: Subtract the site value from the adjusted selling price of comparable
properties at the time of sale to obtain the reduced replacement cost of the
building (present value of the building).
• Step 5: Estimate replacement/reproduction cost for each comparable
property at the time of sale.
• Step 6: Subtract the discounted building cost from the building replacement
cost to get the Cumulative depreciation. If no adjustments are made for the
curable factors, the total cumulative depreciation is drawn including all
reasons for depreciation. If there is any adjustment, the total cumulative
depreciation drawn only includes the depreciation on incurable factors
5.3 Methods of calculating cumulative depreciation of the building

5.3.1. Market Extraction Method

• Step 7: Convert the total cumulative depreciation to a percentage, or
overall depreciation rate, by dividing the total cumulative depreciation by
the replacement cost of the building. If the age of the comparable building
is equivalent to the target buildings, then harmonize the overall cumulative
depreciation rates of the comparables. Use this ratio to calculate the total
cumulative depreciation of the target property.
• Step 8: If the comparable properties have differences in age, location and
maintenance level, the annual depreciation rate should be calculated. Then
harmonize the annual depreciation rate of the comparable properties to get
the depreciation rate applicable to the target property.
 5.3.1. Market Extraction Method

Example 2: Determine the cumulative discount rate of the building, given

that the age of the work is 13 years. There is information of comparable
properties as follows Unit: million VND
Comparative Comparative Comparative
RE1 RE1 RE1
1.Selling price of real estate 1200 1500 1400
2.Land value 900 1100 1200
3. Current building value (=1-2) 300 400 200
4. Building replacement cost 400 650 600
5. Total Building depreciation (=4-3) 100 250 400
6. Overall depreciation rate (=5/4*100) 25% 38,46% 66,6%
7. Age of building, years 10 12 17
8. Annual depreciation rate 2,5% 3,205% 3,91%
Assign weights 2 3 1
 5.3.1. Market Extraction Method

• Target property's annual depreciation rate

{(2.5%x2)+(3.205% x3)+(3.91% x1)}: 6 =3.087%
• Total depreciation rate of the target property
3.087% x13 years= 40.13%
• Economic age of the target building
100/3,087=32.39 years, rounded to 32 years
 5.3.2. Economic Age-Life Method

Total Cumulative Depreciation of the Building = Effective Age / total

Economic life of the Building x replacement or reproduction cost
Implementation steps:
Step 1: Determine the total economic life of structures similar to the target
building in the market and estimate the effective age of the target building.
Step 2: Divide the effective age of the target property by the total economic
life of similar structures. This ratio is applied to the replacement or
reproduction costs of the building to estimate the total cumulative
depreciation of the building.
Step 3: Subtract the total cumulative depreciation of the building from the
replacement or reproduction cost of the building to get an estimate of the
value of the target building.
5.3.2. Economic Age-Life Method

Example 3: An enterprise is assigned the right to use a land plot of 1000m2 and a
factory of 500m2, which has been used for production for 5 years. A valuation is required
for financial statements. Given that the current cost to build the factory is 500,000
VND/m2 and the economic life of the factory is 20 years.
Solution:
• Value of land: 1000m2 x 1.6 million VND/m2= 1600 million VND
(prices are according to local market prices)
• Current cost of building a factory
500m2 x 500,000 VND/m2 = 250 million VND
• Total factory depreciation
(5/20 x100%)x 250 million VND = 62.5 million VND
• The value of the factory has been reduced
250 million VND – 62.5 million VND = 187.5 million VND
• Real estate value: 1600 million VND + 187.5 million VND = 1787.5 million VND
Limitations of the Age-Life Method and the Market Extraction Method

• These methods have assumed that the depreciation of the building is

straight-line or uniform.
• The depreciation of the different components of the building is not
determined, so it does not distinguish the cause of the depreciation
• Does not recognize the difference between short-lived and long lived
items of physical deterioration
• Based on the age ratio of the building, however, the economic life of
the building is related to the future, so it is difficult to determine
5.3.3. Breakdown Method

• Used in the analysis of the structure of the work through

the investigation and collection of information and
documents to calculate the discount of the work.
• The reasons for the price drop are classified:
– Curable
– Incurable
 5.3.3. Breakdown Method

Implementation steps:
1. Calculate all items of physical deterioration, including deferred maintenance
if present, using the appropriate techniques and then add up all the estimates
to arrive at total physical deterioration.
2. Calculate all items of functional obsolescence, again using appropriate
techniques, and add these estimates together to arrive at total functional
obsolescence.
3. Calculate external obsolescence. When external obsolescence cannot be
allocated from a lump-sum estimate, it is calculated either through analysis of
market data or by capitalization of income loss. Sometimes part of the loss in
property value is due to a decline in land value.
5.3.3. Breakdown Method

Note: When calculating the deterioration for each reasons, it is necessary to

estimate the replacement cost for the Curable elements and calculate the
deterioration for the Incurable elements.
4. Add together all physical deterioration (including the cost to cure deferred
maintenance), functional obsolescence, and external obsolescence to arrive
at an estimate of total depreciation

• The replacement cost of the building - the total cumulative deterioration of

the building = the deteriorated cost of the building
• Real estate value = deteriorated building cost + land value + renovation
value of sub- building on site
 5.3.3. Breakdown Method/ technical method

Physical Deterioration (Step 1) The following calculations can

be applied:
• Method 1: Determine the depreciation rate according to the market
method (subtract).
• Method 2: Based on the effective age and economic age of the work.
Note: Use method 1 and 2 when the real estate project has no
functional and external obsolescence.
 5.3.3. Breakdown Method/ technical method

Physical Deterioration:
• Method 3: Based on the Deterioration rate (or the remaining quality ratio) of
the main structures according to the following formula
H= (∑ni=1Hki x Tki)/∑ni=1Tki
H- Deterioration rate of construction works
Hki- Deterioration rate of structure i
Tki- The proportion of the main structure i in the total value of the building
n - number of main structures of the building
Example 4: Determining the ratio of remaining value of a
construction work: 5 years old (illustration of method 3 - step 1)

Order Main structures Remaining Rate of contribution Remaining quality

quality ratio ,% to the value of the ratio of main
building ,% structures,%
1 Foundation 95 20 19,0
2 Columns, beams 95 10 9,5
3 Wall 80 10 8,0
4 Floor 85 5 4,25
5 Ceiling 90 2 1,8
6 Stair 85 3 1,7
7 Roof 80 5 4,0
8 Door Systems 90 2 1,8
total 57 50,05

Remaining quality ratio of the building : 50,05%: 57%x 100 = 87,8%

 Estimate Functional Obsolescence (Step 2)

Based on the excess cost to be spent to repair and overcome that

backwardness compared to the cost if the design is reasonable from the
beginning.
Example 5: A building has an unreasonable design of the kitchen and
dining room system. After 1 year of use, the investment cost to repair is
VND 50 million (the cost of replacing a new kitchen is 15 million VND,
moving the wall and repairing the dining room is 35 million VND). The
cost incurred if the design is correct right from the time of construction is
30 million VND.
Thus the Functional Obsolescence is 20 million VND
 Example 6 (illustration of technical method)
A real estate to be valued has a construction age of 10 years, this is a supermarket with a
construction area of 3000 m2.
The following information is available:
• Costs:
- Direct cost is 9,850 million VND
- Indirect costs are 2,650 million VND
• Data on cumulative depreciation :
- Depreciation of Curable physical elements 52.5 million VND
- The incurable physical depreciation of the short-term elements 122.5 million VND
- The incurable physical depreciation of the long-term elements :
The observed effective age of long-term incurable elements is 5 years.
The estimated economic life is 50 years.
- Functional Obsolescence: None
- External obsolescence (near the highway) estimated at 90 million VND
The estimated land value by the comparative method is 14,000 million VND
 Example 6 (illustration of technical method)

Solution:
(1) Determining the cost of replacement of works
• Direct cost: 9,850 million VND
• Indirect costs: 2,650 million VND
• Total 12,500 million VND
• Construction replacement cost/m2 of construction
12,500 million VND: 3000 m2 = 4,166 million VND/m2
(2) Accumulated depreciation cost of curable elements
• The incurable physical depreciation : 52.5 million VND
• The incurable physical depreciation of the short-term elements: 122.5
million VND
• Total: 175.0 million VND
 Example 6 (illustration of technical method)

(3) Depreciation costs of incurable long-term elements

• Total Depreciation: 5/ 50 x100%=10%
• Total cumulative Depreciation: (12,500 million VND-175 million VND) x10% = 1232.5 million VND
(4) Total cumulative Depreciation of the building excluding external obsolescence
175 million VND + 1,232.5 million VND = 1,407.5 million VND
(5) External obsolescence is 90 million VND
Total cumulative Depreciation of the building: 1,407.5 million VND + 90 million VND = 1,497.5 million
VND
(6) Value of the building:
The cost of replacing the building is 12,500 million VND
minus: Total cumulative Depreciation of the building 1,497.5 million VND
The cost of replacing the building has been depreciated by 11,002.5 million VND
Plus: Land value 14,000.0 million VND
Real estate value 25,002.5 million VND
 6. Limitations of the cost method

• Based on market data, there are limitations like the comparative method
• Costs are not intrinsically equal to value and do not create value.
• This method uses accumulation, but the sum of many parts is not necessarily
equal to the value of the whole.
• Estimation of cumulative depreciation is often based on the subjectivity of the
appraiser, there is no unified method to calculate the cumulative depreciation.
• Applying this method requires the appraiser to be proficient in construction
techniques and experience
• This method is not valid in giving suitable predictive values. It is less acceptable
to provide effective valuations.