REAL ESTATE RENOVATION DECISIONS BASED ON COST APPROACH APPRAISING PRINCIPLES Real estate renovation decisions

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1 REAL ESTATE RENOVATION DECISIONS BASED ON COST APPROACH APPRAISING PRINCIPLES Real estate renovation decisions I. PŠUNDER University of Maribor, Faculty of Civil Engineering, Maribor, Slovenia Durability of Building Materials and Components 8. (1999) Edited by M.A. Lacasse and D.J. Vanier. Institute for Research in Construction, Ottawa ON, K1A 0R6, Canada, pp National Research Council Canada 1999 Abstract In the real estate life-cycle we often encounter a problem regarding decision of renewal of the building or selling it and replacing it with similar one of equivalent utility. This decision is usually based on a deficient calculation. It considers the market value of property only, compared with its depreciated book value. The intention of this research was to quantify all variables which occur in the real estate life-cycle. The method applied is based on the theory of real estate appraising and adopted for usage for building and investment purposes. Besides the market value, physical depreciation, as well as functional and economic obsolescence of the real estate, are considered. The method gives adequate results which are often of great assistance while trying to solve the problem of renewal or selling of the real estate. This technique is a firm basis for the decision-making process of the mentioned problem. Keywords: appraising, life-cycle, real estate, reconstruction, replacement 1 Introduction It is commonly known that real estate value changes with time, but contrary to popular belief it is not necessary that the value always decreases. Experiences have shown that value of hypothetically un-obsolesced real estate (such real estate where obsolescence hypothetically does not increase with time) even increases in the longer period. Real estate is namely basis of the urban functioning of society. Therefore, with increased social and economic activities in the society, a demand for real estate in urban centers increases, and, consequently, prices of real estate also rise. The lack of spare space results in rise of prices of land. A hypothetically un-obsolesced building or its part is nowadays more expensive as a few years ago. In some cases this is true even for buildings despite clearly visible signs of physical depreciation or obsolescence.

2 The reason is that ruling prices depend on long-term increased demand for spare space in urban centers. But if we have in mind a building or its part which is maintained averagely and we subtract abrupt market oscillation caused by under- or oversupply then it is obvious that - despite of long-term capital growth of the real estate investment - value of the building depreciates. Why? Firstly, the building physically depreciates with time because of atmosphere and environment aggression. As physical depreciation we consider an adverse effect on the value caused by deterioration of condition. Physical depreciation can usually be reduced or abolished by renovation of the building. Money equivalent of the physical depreciation can be calculated and defined on the basis of invoices, catalogues, tenders, contracts, etc. By definition of size of depreciation we are seeking for an answer to the question: How much do we have to invest to abolish physical depreciation and to reset the conditions equal to a new building? Secondly, buildings tend to functional obsolescence. This is a lack of utility of the building caused by inadequate or obsolete design, structure or material. Lessening of utility has adverse influences on the value of the building. Functional obsolescence either can or cannot be abolished. In other words functional obsolescence may be curable or incurable. If we cope with curable obsolescence we can determine the equivalent sum by answering this question: How much should we invest to reach state-of-the-art standards in design and structure? Finally, by appraising the building value we cope with economic obsolescence, caused by adverse influences outside the building. Usually, economic obsolescence is incurable which means that in most cases buildings cannot be corrected or a correction is not economically feasible. 2 Value and price of a building We can now estimate value of a real estate property by estimating reproduction or replacement costs and by deducting the loss in value caused by physical deterioration, functional deficiencies, and economic obsolescence. Estimation of reproduction cost is in fact a calculation of the costs needed for the production of an exact replica of the subject building or property. Replacement costs estimation is based on the calculation of the costs of producing a building or a property with equal utility to that of the subject one. The procedure is based on the collection of invoices, catalogue prices etc. While deducting the depreciation of the value from the reproduction or replacement value, we get the estimated value of the property calculated by the usage of the cost approach. The value of the property can also be estimated by using the income approach. The idea of a income approach is that the value of the property depends on income that the subject property can potentially produce. The most accurate income approach method takes into account future stream of incomes or net cash flows received from the property. To get the value of the property, either net income or net cash flow, it has to be divided by an appropriate capitalization rate. The best way to collect data - potential gross income or potential cash inflow, and an appropriate capitalization rate - is to deduct them from market analysis.

3 A kind of income approaches are also rules-of-thumb techniques of real estate appraising. By using rules-of-thumb techniques we apprise the value of the property by multiplying potential income or cash flow with particular multiplier. These techniques are easy to understand and use. Therefore, they are often used when several income properties should be apprised in a short period of time. Data used by rules-ofthumb techniques are collected by market analysis. An additional possibility of appraising an income property is to estimate its value by using a market comparison approach. By using this method an appraiser estimates the value of the property by comparing it to similar properties that were recently sold. By considering the disparities between comparable properties and the subject one can deduct the estimated market value of the apprised property. All methods mentioned above give an estimated value of the building or property but fails to automatically tell us the price of the property. The price is the negotiated amount of money which is actually paid for the property. In the real word, despite taking into consideration all market disparity, there are differences between estimated value and the actual price (Fig. 1). The reasons for this are interpreted below. Fig. 1: The deviation of market price from the apprised value 3 Investment decisions Decision making in civil engineering and property management are (at least in Central and Eastern European countries) usually not made using the property appraising theory but simply based on real estate accountancy. That means the investors calculate depreciated book value of the real estate (purchase cost of the real estate reduced by the book depreciation) and compare it with the market value of the real estate. Basically, this approach is not wrong but it almost always lacks accuracy and is therefore inadequate for investment purposes. The supposition that

4 PC - BD = MP, (1) where PC = purchase cost, BD = book depreciation, and MP = market price, is superficial (if not even wrong). It namely results in the following. If PC - BD > MP (2) then it is, according to the equation, reasonable to renew the building. If one would sell it one would receive less money that the book value of the property. With the money we would receive from the selling we could not afford an equivalent substitute building. (Logically, this statement can also be used in the opposite case, if PC - BD < MP.) This decision is supported by the equation and logically correct. Where is the mistake? The book depreciation cannot adequately describe a real condition of the building. Therefore, by using this methodology, we make a hidden mistake. Even by a correct calculation, this decision is not right because calculation is based on wrong suppositions. 4 Solution of the problem The solution is found in the use of real estate appraising in investment decisions. Implicating earlier mentioned statements in the equation (1) we get a new equation as follows: PC - PD - FO - EO = MP, (3) where PD = physical depreciation, FO = functional obsolescence, and EO = economic obsolescence. In the equation (3) all types of depreciation and obsolescence are considered, therefore, it can be used in the well-developed real estate market without limitations. Occasionally, market value of a building oscillate from the theoretical suppositions. In such cases the equation can be used as a help while making investment decisions as follows. If PC - PD - FO - EO < MP, (4) then the reconstruction of a building is economically not reasonable. The cost of abolition of depreciation and obsolescence would exceed the cost of purchasing a nondepreciated and non-obsolete building with equal utility. Why is then a potential buyer prepared to overpay for a property? Because price of property is, above all, a matter of market liquidity. For example, a residential

5 property loan, which in Slovenia is periodically offered to young families, in a short term increases the market price of residential apartments. An opposite case is when an oversupply is present. In that case PV - PD - FO - EO > MP. (5) The equation reflects present oversupply, therefore, depreciated value exceeds market price. Such situation occur when, due to an excessive erection of buildings or due to an oversupply caused by bankruptcy or liquidation of enterprises, lower the market price of real estates. In such cases, it is not economically reasonable to sell the subject building or a part of it. It is reasonable either to renew the building or, in case of selling it, to wait for more appropriate market conditions. 5 Conclusion and summary Enterprises which deal with real property investment, maintenance and rehabilitation should, by their decisions, consider all types of depreciation and obsolescence. Investment calculations based only on book depreciation of a building lack relevant data of depreciation expanse and are therefore not suitable for investment purposes. It is much more appropriate to implement real estate appraising principles with an investment calculation. This approach gives a very clear description of building condition and is therefore very helpful in making decisions whether to renew or sell the building depending on the circumstances on the market. The only problem which still persists in this approach is difficulty of an adequate quantification of functional and economic obsolescence expanse. 6 References Airey G.J. (1998) The property investor s handbook, Wrightbooks Pty Ltd, Elsterwick. Friedman J.P., Ordway, N. (1989) Income Property Appraisal and Analysis, Prentice Hall, New Jersey. Jaffe A.J., Sirmans, C.F. (1995) Fundamentals of Real Estate Investment, Prentice Hall, New Jersey. Pšunder I. (1997) Sodobne metode vrednotenja nepremiènin (State-of-the-art methods of real-estate valuation), NepremiŁnine, Maribor (in Slovene).