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DAHLEN & DWYER, INC. THE COST APPROACH TO VALUE This portion of the appraisal process analyzes the value of the property through the contribution of the physical members: the land, the building and other improvements to the property. Among the basic real estate principles reflected in this approach is the principle of substitution, which states, in part, that no person will pay more for a property than the amount at which he can obtain a substitute of equal desirability and utility through purchase of a site and construction of a building without undue delay. The first step in the Cost Approach is to estimate the land value component. The land is appraised as though vacant and available for development at its highest and best use. This analysis recognizes that in some cases the existing improvements do not develop the site to its highest and best use. The second step involves the estimate of the cost to construction the basic improvements in today's market. The appraiser recognizes two forms of cost - reproduction cost and replacement cost. Reproduction cost reflects the cost of creating a replica of the improvements on the basis of current prices, using the same or closely similar materials. Replacement cost reflects the cost of creating improvements having the same or equivalent utility on the basis of current prices using current standards of material and design. In most cases, the measure of cost is the reproduction cost. However, in some cases identical materials are not available or construction methods have changed, which makes the reproduction cost difficult to estimate. In those cases, replacement cost is utilized. In this appraisal, reproduction cost is utilized. In order to reflect the value of the improvements in their present condition, accrued depreciation must be analyzed and deducted. In real estate, depreciation results from one or more of three main sources. These main types of depreciation are known as physical deterioration, functional obsolescence and external obsolescence. Physical depreciation is usually considered to be a loss in value of the building due to age or from other sources which cause the building to wear out. Functional obsolescence is loss of value in the building due to layout, design or use of materials. External obsolescence is a loss in value of the total real estate caused by factors outside the property itself, such as proximity to noxious properties/influence or economic forces which affect supply/demand relationships in the market. Deducting the accrued depreciation from the reproduction cost new results in the depreciated value of the improvements. The remaining step in the Cost Approach is the addition of the land value to the depreciated value of the improvements to arrive at an indicated value for the subject property. It is important to note that cost does not necessarily create value. Value can only be created when certain economic demands have been satisfied. 19