Current Issues in Real Estate Appraisal

You might have seen one of many home improvement shows where the hosts usually do a “reveal” at the end of the show. They announce that the $75,000 “reno” costs have increased the value of the house by that much if not thousands more. It sounds reasonable, and when said with some authority, seems pretty convincing. However in most cases, these pronouncements turn out to be inaccurate and misleading- here’s why:

In real estate appraisal, the relationship between cost (the total dollar expenditure to develop an improvement) and value (an opinion of the worth of a property at a given time in accordance with a specific definition of value) has been extensively studied and is the basis for the Cost Approach to Valuation, one of the three different methods used by real estate appraisers to estimate the value of a property.  The Cost Approach is based on the economic belief (called the Theory of Substitution) that informed buyers will not pay any more for a product than they would for the cost of producing a similar product that has the same level of utility. According to the Dictionary of Real Estate Appraisal, the Cost approach “is a set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including an entrepreneurial incentive, deducting depreciation from the total cost, and adding the estimated land value”.  The Cost Approach has its most utility in valuating properties that are relatively new and represent the highest and best use. Based upon the Theory of Substitution, it should be reasonable to expect that the Cost Approach should provide an indication of value close to the cost of a remodeling project. Sadly, this hardly ever seems to pan-out in the real world where the value increase for the remodeling is always a fraction of its associated costs.

Every year, the Hanley Wood Company/Remodeling Magazine publishes its “Cost vs. Value Report” which directly addresses the relationship between cost and value. This report, considered the industry standard, compares the costs of the most popular remodeling projects to how much the investment will improve a home’s resale value.  The 2019 report surveyed more than 3,200 real estate professionals about returns (on investment) for 22 different types of projects in 136 US markets. As in previous years, the cost-to-value relationship indicates a lesser return for each remodeling dollar spent.  For all projects, the average overall cost-to-value ratio stands at 66.1%, only slightly ahead of last year, and below the decade-high of 71.2% in 2014.  According to the authors of the study, factors that influenced the ratio for this year included rising material costs, the regions surveyed and the “curb appeal” of the projects surveyed. The average payback nationwide for the 22 projects ranges from as high as 123.8 percent for a garage door replacement in the Pacific Region to as low as 45.0% for an upscale master suite addition in the Mid-Atlantic Region.

So what’s going on here?  Why isn’t value a direct reflection of cost for remodeling projects when the Cost Approach is commonly utilized everyday by real estate appraisal professionals to estimate property value. The answer lies in two other theories that impact value.  One is the Theory of Contribution and the other is the Theory of Decreasing (and Increasing) Returns. The Theory of Contribution states that a particular item or feature of a home is only worth what it actually contributes in value to that piece of property.  Thus, if a four-bedroom home is not desirable, putting an addition onto a house to add a fifth bedroom doesn’t increase the value of the home that much. The owner of the house may want or need a fifth bedroom, but he shouldn’t expect it to add significantly to the value of the home when it’s sold.  Strictly speaking, the value of a whole property is not the sum of the independently determined values of the components.  The second theory, the Theory of Decreasing (and Increasing) Returns states that beyond a certain point, the added value of an additional feature, addition, repair, etc., is less than the actual cost of the item.   In other words, you can add too much to a property and not be able to increase the price enough to recoup the money invested. The impact of these two theories minimizes the applicability of the Cost Approach in valuing component additions to property such as remodeling projects. Whereas the Cost Approach is a useful and defensible approach in estimating whole property value, its utility in estimating the incremental increases in property value from component additions or replacements such as occurs in remodeling is somewhat limited.

In litigation matters, having the correct understanding of the relationship between cost and value in remodeling or other partial improvement replacement or addition has proven to be very valuable. For example, in a lawsuit where my client represented a builder being sued by a homeowner for construction defects, I was able to demonstrate a lesser contributory value of remodeling improvements than claimed by the Plaintiff. I calculated the reproductive costs of the improvements and then applied the latest Cost vs Value factor for the type of project and region in question.

In summary, the Cost Approach, one of the three different methods used by real estate appraisers to estimate the value of a property, is utilized effectively when valuing an entire property. Its usefulness comes into question, however, when the contributory value of each component is examined.  Nationwide studies have demonstrated that, for remodeling projects, cost rarely equals value, no matter what is claimed on popular remodeling television shows.

This article has been written by Donald Garfinkel, MAI-Rose Valley Appraisal Associates, LLC. for the benefit of his clients and potential clients. Rose Valley Appraisal Associates, LLC disclaims all liability and responsibility for any representation, warranty, statement, opinions or information made in this article.

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