If the business next door is destroying your property, they may have to replace your property. One way to determine what they’ll actually pay you in damages is the “cost approach.” Instead of comparing the value of your property to other similar properties in the neighborhood — which is the sales comparison approach which I discussed in my last blog — the offending business may have pay you enough money to buy you a new house, or at least to fix the damage they’ve caused you.
The basic tenet of the cost approach is that the value of a property, once damaged or impaired by a compensable event, is equal to the cost of rebuilding, repairing, and restoring the property to its undamaged and pre-impaired condition. To calculate a property value using this approach, one must estimate the value of land, the replacement cost of building on the land, and the applicable level of depreciation. In essence, the formula for calculating damages for a ruined property must yield a value that would restore the claimant to an unruined property of equal condition and utility.
Like the sales comparison approach, the cost approach relies on the principle of substitution, holding that the replacement value of a property should be no greater than the cost of comparable land and improvements. The cost approach, however, focuses on cost, not sales, and it targets the cost of the constituent parts of the property, not the property as a whole.
Suppose that a nuclear mishap at a local power plant has contaminated a farmer’s land and rendered his home uninhabitable and his grain silo unusable. Applying the cost approach, we would estimate each cost associated with replacing the property, as follows:
Step One. Estimate the value of the land (without improvements).
Step Two. Estimate the construction cost of the buildings.
Step Three. Determine the depreciation in value of the buildings.
Step Four. Estimate any other replacement costs.
Step Five. Estimate any incidental and consequential costs.
Step Six. Add all the estimated costs; then subtract the depreciation amount.
Damages = Land + Buildings + Other replacement costs, incidental and consequential losses – Loss due to depreciation
In the case of a nuclear mishap, the cost approach may, in fact, require much more data, rendering the six steps above an oversimplification. For example, it may be impossible to rebuild on the site of the farmer’s land or anywhere nearby. Even if the farmer could safely return to this property, there may be cleanup costs, engineering studies, laboratory analysis, site inspections, and regulatory compliance costs, all before the property can be restored or reoccupied. The value of the farmer’s crops, livestock, grain storage, and other assets would also necessarily need to be assessed.
What if an office building were rendered unusable by the nuclear mishap? A proper expansion of the cost approach might take into consideration any number of incidental and consequential costs, such as:
- Tenant relocation costs
- Customer and client notification costs
- Special insurance endorsements
- Moving costs
- Special advertising costs
- Additional property management or security costs
- Lease modification and other legal costs
- Additional operating expenses
- Lost tenant and extended vacancy costs
- Furniture, fixable, and equipment (sometimes listed as FF&E)
Not only is it important to account for all of the replacement costs, but it is necessary to recognize all preexisting circumstances that may have reduced the value of the damaged property before the damage was done. For example, a homeowner claiming damages for total loss of his home should not enjoy 100% replacement costs if the home was in disrepair, or had a nonfunctional heating system or a defective roof.
Let’s consider a factually detailed property claim arising from a flood. Assume that Helen Homeowner has a two-story, four-bedroom Colonial-style home in the Oak Village section of town. The home and the adjacent storage shed on the property were destroyed in a flash flood when a cement infrastructure collapsed, breaching a dam on the local riverfront and flooding all of Helen’s land. Helen’s home is 10 years old, and it spans 2,300 square feet. The roof, which has a 20-year guarantee, was severely damaged before the flood. According to contractors, the roof will cost $7,500 to replace. Sheds can be rebuilt for $2,200. The typical life of a home in Oak Village is 40 years. Local vacant lots in Oak Village sell for $25,000. The cost of moving Helen and her salvageable belongings is $3,500.
To apply the cost approach to this factual scenario, let’s return to the original six-step process, this time accounting for the additional information known to us.
The first step is to estimate the value of Helen’s land (without improvements). Vacant lots sell for $25,000; so this will be our first cost.
The second step is to estimate the construction cost of Helen’s home. If we were to build Helen’s home from scratch – a brand new home – the cost would be equal to the square footage multiplied by the builder’s estimate of $75 per square foot.
2,300 square feet x $75 = $172,500
So the reconstruction costs for Helen’s home will be $172,500.
The third step is to determine the depreciation in value of the property. First we must consider the physical deterioration of the home, specifically the roof. Helen’s property was already 10 years old when the flood occurred, and the roof carries a 20-year guarantee. Therefore, she is entitled to only 50% of the replacement cost of the roof. The roof will cost $7,500 to replace; therefore, we will deduct $3,750.
As for the depreciated value of the home, we will look at the age of the home and its projected life. The home is 10 years old, and it has a projected life of 40 years. Therefore, even before the flood, the home had lost one-fourth (10/40) of its full value. We will thus subtract 25% of the construction cost $172,500.
$172,500 x 25% = $43,125
As our fourth step, we must look at any other replacement costs. The shed on Helen’s property will cost $2,200 to replace.
Our fifth step is to account for any incidental and consequential costs. In this case, Helen will incur $3,500 in moving expenses.
Our final step is to add all of the costs and to subtract the depreciation costs.
$25,000 (land) + $172,500 (home) + $2,200 (shed) + $3,500 (moving expenses) -$43,125 (depreciation of home) – $3,750 (roof) = $156,325
The value of the property claim – that is, the adjusted damages to be paid to Helen Homeowner – is $156,325.