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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Chapter 12
Value Theory, Highest andBest use Analysis, and the
Cost Approach
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Major Topicsj Value, Price and Cost Conceptsj M
arket Price Formation from ReservationPricesj TraditionalMethods of Valuationj Newer Approaches to Valuej Highest and Best Use Defined
j Improved or unimproved (vacant)j The Impact of Option Valuej When Cost approximates market valuej Methods to estimate cost newj Methods to estimate accrued can
depreciationj Difficulties in estimating cost new and
accrued depreciationj Replacement versus reproduction cost
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Introduction to theDetermination of Value
j Value concepts always theoretical innature
j PRICE is usually factual in nature
j Value by nature is an opinionj In the absence of a perfectly
competitive market, there can be nocertainty that the value sought is
resolutely true or unchallengeablej Cost is also factual in nature
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Definitions
j Subject Propertyj Appraisalj Costj Reservation Price or Investment
Valuej Exchange Value orMost Probable
Pricej Liquidation valuej M
arket Valuej Use Valuej Going Concern Valuej Equilibrium Value
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Price and Value Formation
j The shaded area is where actualtransactions will occur and market priceswill be formed through negotiation
j The distributions of buyers and sellersneed not be equal in size
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Methods of Valuation
j Market orSales Comparison
j Cost Approach
j Income Approach
j Statistical approaches based on multiplefactor regression models with largersamples are essentially a variation on themarket/ sales comparison approach to
value
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Starting with Site Value Based onthe Highest and Best Use
j Option Value
j Definition of Highest and Best Use (H&B Use)
The reasonably probable and legal use of
vacant land or improved property, which isphysically possible, appropriately supported,financially feasible, and that results in thehighest value as of the date of the appraisal
Site Value = Current Use value +
Future Use Value/ Option Value
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Option Value (Contd.)
j The lowest improved site values are shown aboveas surface parking lots, yet these sites are worthmore than the current use value as they have the
highest option value of any of the above uses
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Improved Site Valuej Most of the time the H&B use of a property as
improved (as currently developed) is thecurrent use
j This is because the cost of construction anddemolition being higher than the cost ofconstruction alone and also the opportunitycost of time for the conversion
New market
value with a
new building
at H&B use Existing
Building
Value
Demolition
Cost andSite Prep
Lost income
during
construction
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
The Steps in the Cost
Approach to Valuej Step 1: Estimate land value
j Step 2: Estimate the structure cost new Comparative-Unit Method
Indexed Cost Update Method Unit-in-placeMethod Quantity Survey Method
j Step 3: Estimate "lease-up" or absorptioncosts necessary to bring a new building upto normal levels of occupancy and use
j Step 4: Deduct accrued Depreciation
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
The Steps in the Cost
Approach to Value (Contd.)j Depreciation
1. Physical
2. Functional3. Location or External
j Curable Defects
j Negative Value of Incurable
Depreciation
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Simple ExampleYou are appraising a warehouse that is 5 years old and
seems to have an effective age of 5 years. The economiclife on similar bulk warehouses is 30 years since
technology is making the bulk warehouse obsolete
quickly. The warehouse has 28 foot ceilings (low by
modern standards but incurable and still useable) and it
covers 100,000 square feet sitting on a lot of 200,000square feet with just enough parking and space for truck
docking. Similar sites cost $6 per square foot for clean
land, $3 per square foot for site preparation and asphalt
paving. Similar buildings cost $40 per square foot new
including hard costs, soft costs and normal fees. What is
the value via the cost approach ignoring functional
obsolescence and assuming no external depreciation and
assuming that such a warehouse is pre-leased prior to
construction?
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Simple Example (Contd.)
Site Value = 200,000 * ($9)
for land plus prep= $1,800,000
Cost New = 100,000 * $40= $4,000,000
Accrued Depreciation= 5/30 * $4,000,000= (666,667)
Value = $5,133,333
What if the technological changes inwarehousing had made the existing warehouseobsolete for most modern warehouse users?
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Simple Example (Contd.)
Effective Age = 20 years
Accrued Depreciation= 20/30 * $4,000,000= (2,666,667)
Value = $3,133,333
j There are more complex methods ofestimating accrued depreciation
j The Component Breakdown Method
considers the wear and tear and remaininglife of each component of the property,similar to the unit in place (component)method discussed for cost new
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Another ExampleAssume once again a 100,000 square foot warehouse that is 5
years old. The economic life is 30 years. It sits on 150,000
square feet of land, enough for truck turns and docking andwith some parking. It is multi-tenant and set up for several
different tenants. There is enough parking for 100 cars in
addition to 10 truck docking doors. There is not enough land
for more parking but there is a raw land parcel next door that
could be purchased and prepped for $10 per square foot. Thecurrent level of parking required for more labor intensive
retail distribution firms suggests enough parking be added for
50 more cars. This means 11,250 more paved area at a
finished cost of $12 per square foot or $135,000 dollars beyond
the land cost. Without the additional parking half the buildingwill remain vacant. Economic life on similar bulk warehouses
is 30 years. Warehouse has 32 foot ceilings. Similar buildings
cost $50 per square foot new including hard costs, soft costs
and normal fees. Lease up costs estimated to require $60,000
in commissions/ marketing; $50,000 in capital carry costs.
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Another Example (Contd.)
Cost new of Land = 150,000 * ($10)= $1,500,000
Cost New of Bldg. = 100,000 * $50
= $5,000,000Accrued Depreciation
= 5/30 * $5,000,000= (833,333)
Lease Up and Carry Cost= $110,000
Net Cost New = $5,776,667
What is the value via the cost approach andconsidering the extra parking required?
Could we stop here?
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Another Example (Contd.)
j We could stop here and suggest the valueis roughly $5.776 million, but there is aproblem with parking relative to currentmarket requirements
j The property has a functional deficiency
of 50 parking spots and without thisparking will be worth much less then thenet cost new
j A present value of the lost rent over 25years based on 50,000 additional empty
square feet at $7.50 per square foot peryear net discounted at 10% is ~ $3.4dollars so the parking expansion is amust
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
Another Example (Contd.)
Cost new as is = $5,776,667
Less Functional Depreciation= (3,400,000) w/o pkg
AS IS Value = $2,366,667
Cost New Value with the additionalparking = $5,776,667Additional Parking Cost or FunctionalDepreciation = ($12 land+$10 prep)
*11,250 sq ft= (247,500)Total cost new and value as expanded
at the same rent = $5,529,167 value
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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner
END