COST METHOD

Sr IDZWAN IZUDDIN SHAH HAJI ISHAK

Registered Valuer V1088
Introduction

In the property market, there are a few types of property

that are seldom transacted;
Comparison Method could not be used in their valuations.

Another method that will give an indication of value for

these types of property is the Cost Method.

This method is suitable for the valuation of the following

properties:

Properties that are of special construction, or are unique;

Purpose-built properties which have no market or general
demand (eg: hospitals, places of worship, government
offices, stadium, etc)
Properties that are used NOT for profit motivated activities.
• Also known as :
Depreciated Replacement Cost (DRC) Method
or Contractors method.

• DRC is define as the current cost of replacing

an asset with its modern equivalent
less deductions for physical deterioration and obsolescence.

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Basis of the Method

In the cost method:

Capital value of property = value of site + value of building
Whereby, value of building = cost of construction (new) –
depreciation.

Question:
Is value = cost?
Value = f(cost + developer’s profit)
Where, developer’s profit = f(demand)
If general demand = 0, profit = 0.
Therefore, value = f (cost).
Basic Equation

Value of Land
+
Cost of + Cost of the = Building
the Site Building
as
one unit

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 Equation
Value of Site
+ Cost of Building_______
Less: Depreciation Allowance
= Value of Existing Property

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 Principles Used

Valuation using this method involves the following principles:

Principle of Substitution;
Principle of Contribution; and
Principle of Highest and Best Use
 Principle of Substitution
This is the basis of the Cost Method. According to this principle, the
maximum value of a property is set by the lowest price or cost at which
another property of equivalent utility may be acquired as at the date of
valuation.

Principle of Contribution
This principle is also used to a lesser extent in the Cost Method. This
principle states that the value of an economic good is influenced by the
amount by which the value or the net income of the economic good is
increased or decreased by the presence or absence of some additional
factor in production. The value of a component part of a property
depends upon how much it contributes to the value of the whole
property. (e.g. Investment/Profit)

Principle of Highest and Best Use

Under this principle, the value of the site is always estimated as if the
land were vacant and ready to be put to its highest and best use at the
date of valuation. This principle is applied on the calculation of the land
component of the subject property.
Determination of Land Value

The value of land/site is determined by assuming that the

subject site is vacant and ready to be developed as its highest
and best use
Based on the principle of substitution, land value is
determined using the Comparison Method that is by securing
the evidences of transaction of similar-use properties.
Cost of Construction (New)

Cost of construction (new) is:

The current cost of construction to replace the subject
building with a comparable new building; or
The current cost of construction to re-build a building which
is the same as the subject building.

In the cost method, the valuer has two choices in estimating

the cost of construction:
Replacement Cost New

The essence of this method is that the hypothetical

replacement property represents the same utility as the
subject property. This is the current cost to construct a
building that is similar to a comparable property in terms of
function and utility. Building materials, finishes, design and
layout can be according to current standards.
Reproduction Cost New
Reproduction cost new presumes that the same or a very
similar physical structure would be built. This is the current
cost to construct an exact duplicate or exact replica of a
building; that is the same in all aspects - function, utility,
design and finishes, etc.

In theory, it would be preferable to estimate replacement

cost new as the basis of calculating building value. This is
because a prospective purchaser would substitute a property
of similar utility rather than reproduce an exact replica if he
were to start over again.
In practice, it would be more accurate to base the calculation
of building value on reproduction cost new as utility cannot
be measured directly but inferred from prices and market
forces on a comparative basis.

This is because replacement cost new eliminates all

functional depreciation, leaving only physical and economic
depreciation to be measured.
Reproduction cost new enables depreciation of a replica of
the structure to be calculated based on current prices.
Cost of construction is the cost for:

Main building
Ancillary buildings (eg: guard house, external stores)
Infrastructure (eg: parking area, roads, drains)
Site improvements (eg: pavements, landscaping)
 MAIN FLOOR AREA
• Is the total area of walled-in and roofed space of the
building being the sum of each floor measured to the
external wall face of the enclosing walls or to the centre of
party walls.
• Includes areas occupied by:
i) All walls and partitions
ii) Columns, piers, stairwells, lift wells and the like
iii) Covered lift rooms, plant rooms, fuel stores and tank rooms
which are housed in a structured of a permanent nature
iv) Perimeter wall thickness and external projections
v) Internal balconies and courtyard
vi) Outbuildings which share at least one wall with the main
building
 FIRST FLOOR
PLAN

SECOND FLOOR PLAN

 ANCILLARY FLOOR AREA
● Ancillary floor area includes the total area of the following:
i) Car parks
ii) Open sided balconies – with or without roof
iii) Terraces
iv) Verandahs/ footways/ walkways
v) Air-wells
vi) Porches
vii) Passages and open sided covered ways
viii) Roof gardens
ix) External staircase
x) Loading bays (service area)
xi) Patios
xii) Pergolas
xiii) Internal gardens
xiv) Canopies etc
Car garage Patio Balcony

Pergolas Terraces Car porch

 Cost of construction above is
categorised into:
Direct costs which include:
Cost of building materials and finishes (bricks, concrete, timber, tiles etc for
constructing a building)
Cost of labour (wages and salary paid to construction workers)
Site surveillance fees
Demolition and site clearance
Subcontractors’ fees
Indirect costs which include:

Professional fees (fees payable to engineers, architect,

surveyors, etc involved in construction)
Contractor’s profit (normal profit required by a contractor to
construct a building)
Contractor’s overheads
Opportunity cost of capital (interest paid by contractor on
capital incurred)
Legal fees
Valuation fees
Taxation and insurances
Selling expenses
Environmental Impact Assessment Report
Advertisement and promotions
Building permits and licensing
Factors affecting construction costs:
Type of use- whether residential, commercial, etc
Type of construction- pre-cast, in-situ, steel frames,
conventional methods, etc.
Quality of material and workmanship
Size and height
Shape/Design
Facilities such as alarm system, air-conditioning system,
building automation system (BAS), etc.
 Methods of Estimating Construction Costs

3.6.1 Q.S METHOD

This is the usual method of construction cost estimation
practiced by quantity surveyors. This method requires an in-
depth knowledge on current material costs and labour costs
as well as being skilled in local markets and manpower laws.
These estimates are done on a special kind of paper known
as estimating paper. The total costs from the relevant
estimate paper for each building structure is then added with
labour costs, professional fees, opportunity costs on capital
and contractor’s profits to obtain the final construction cost
for the whole building.
UNIT-IN-PLACE METHOD

This is a modification of the Q.S Method where the valuer breaks down the
building structure into convenient components. The determination of
construction costs through this method is done by estimating the material
costs and current wages to complete the main structure of a building, for
instance, walls, floors, roof, windows, foundation, etc. The current price for
each structure is expressed in per square metre/per square foot; multiplied
with the area/ number of unit required to complete a particular structure.
The construction cost is the total for every structure. Such total must take
into consideration opportunity cost on capital, professional fees and
contractor’s profits.
COMPARATIVE UNIT METHOD

The basis of this method is adding together all direct and indirect costs of
construction of comparable structures in the market and dividing by the
number of units in the comparable structure to arrive at current costs per
unit. Building costs are determined by comparing the costs of similar/
comparable buildings. The comparable building must be similar in terms of
date of construction, type, design as well as materials and finishes used.

Any differences between the subject building and the comparable building
must be corrected through adjustments. The adjustment process is the
same as the adjustment steps usually used in the Comparison Method.
How to determine the construction cost in Malaysia?

1. Government Agency (JKKR, CIDB)

2. Independent Society (http://www.langdonseah.com)
3.
https://www.arcadis.com/en/asia/our-perspectives/research-and-publicatio
ns/arcadis-construction-cost-handbook/
Example:

A double-storey school block was built recently at a cost of

RM105,000. The floor area of the school is 300 square
metres. The construction cost included construction cost,
labour costs, professional fees, capital costs and contractor’s
profits. After analysis, the unit cost was RM350 per square
metre (Cost/Floor Area).

Therefore, the cost to build another school that is similar but

with a floor area of 500 square metres would be:
Floor area x RM350 per square metre (+ or – any differences
between the subject property and the comparable building)
Depreciation

Depreciation is defined as the loss in value of a subject building as

compared with the cost new.

Factors causing depreciation:

Age/lifespan of the building: the older the building, the higher the
depreciation rate;
Normal wear and tear: depreciation caused by normal/daily use of a
building according to its purpose/function;
Maintenance: rate of depreciation depends on degree of maintenance or
rather, non-maintenance
Vandalism: depreciation caused by vandalism activities such as in public
buildings like schools, libraries.
Weather/environment: a structure located near the seaside may
experience a faster rate of depreciation
Insects and rodents: existence of termites may accelerate the rate of
depreciation
Construction defects/ design flaws/poor workmanship: a building with
construction defects may further accelerate the rate of depreciation
 Depreciation

Two broad categories of causes:

A. Deterioration – causes loss of utility

it is directly linked to the passage of time & unlikely
to have a relatively constant impact

B. Obsolescence – causes decline in utility

not directly linked to the passage of time & is
likely to have a variable time pattern of impact

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 Types of Depreciation

Physical Depreciation
Functional Obsolescence
Economic Obsolescence
Technology Obsolescence
 Physical Depreciation

deterioration of an asset due to age and wear & tear.

It results from use, decay and the action of the elements.

Physical depreciation is a constant factor. It begins as soon as

an asset is exposed to the action of the elements or is put
into use. (economic life )

wear and tear through use

 Functional Obsolescence

Reduction in the value due to reduction in the usefulness or

desirability of an object/Building because of an outdated
design feature

usually that cannot be easily changed

(e.g. functional capacity or efficiency of air-con, heating,

electrical services, lifts)

(e.g. floor to ceiling height, flexibility of floor and layout)

 Economic Obsolescence

Defined as a form of depreciation, or an incurable loss in

value.

caused by unfavourable conditions external to the property,

such as the local economy condition,
neighbourhood, economics of the industry, availability of
financing, loss of material and labor sources.

(changing user requirements due to changing business

practices or tastes)
(absence of complementary services eg
conference facilities)
 Technology Obsolescence
Defined as a form of depreciation, or loss in value due to
technology in the Industry and in the building automated
system, security system, and etc.
 Methods of Estimating Depreciation
Straight-Line Method/Age-Life Method
Engineering Breakdown Method
Cost to Cure Method
Market Analysis Method/Abstraction Method
 Straight Line Method

Through this method, depreciation is determined based on the age of the

subject building. The age of a building can be seen from two (2) aspects:
physical age and economic age.

The physical age is the age of the building from the date it was built until
the date it was demolished because it is not habitable anymore.

The economic age is the age of the building from the date it was
occupied until the date when its use is not optimum anymore.
Depreciation of the building is calculated using the following formula:

(PHYSICAL AGE/ECONOMIC AGE) x 100%

to arrive at a percentage of depreciation in relation to the age of the
building.
This method is best shown by the
following graph:

COST (RM)

Age of
building
 Cost Method: Main Problems
1. Value is not equated with cost
2. Adjustments for depreciation and
obsolescence are subjective and prone to
error – difficult to test
3. Judgment required re-cost of an ‘equivalent’
site (not necessary equal)

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4. Difficult to cost buildings with specialised
function or design e.g. post office
5. How long is the building life (depreciation) ?
6. How much is the value affected by the
inefficiency of the building?

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 Example: Public Library
Information
50 years old, 500 sqm of built up area
Land Size 278.7 sqm

Evidence & Judgment

Vacant commercial land value RM2,870 psm

Building Cost RM1,250 m² (same style)

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 Calculation

Cost of Site
278.7 sqm @ RM2,870 psm RM800,000

Plus

Building cost 500 m² @ RM1,250 m² = RM625,000

Less: Depreciation (based on building cost)

(50/65) x 100 76.9% RM187,500 (max Depreciation 30%)

30% Depreciation Allowance RM437,500
Value of Existing Property RM1,237,500

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Question

2017 41
 Question

Office : 1,000 square metres

Factory : 3,500 square metres

2020

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