Editor’s Note: Who would have guessed that the Cost Approach would stir such emotions among appraisers nationwide? WRE received a sizable and emotional response to Cost Approach: Why Sidestepping it Can be Costly (WRE Online, Vol. 9).
Significant Change to Cost Handbook
by Marcos Campos, MAI, SRA
A small change was made on page two of the Marshall & Swift Residential Cost Handbook with the March 2008 updates. This could have big implications for residential appraisers.
The change comes under the heading INCLUDED IN THE COSTS. Item 6 was removed. What had been Item 7 is moved up to Item 6. Item 6 used to say: “Prorated amount of real estate commission in large tract development.”
Many of us believe the figure for real estate commissions to be around five percent. This is the typical amount for a large tract development in our market (Seattle, Wash.). In a discussion with Ed Martinez, Tech Support Manager at Marshall & Swift, he notes that the actual amount of real estate commissions in their cost figures is so small that it is not significant. The issue is one of semantics. What is the meaning of “real estate commissions”? Most appraisers assume a figure of five percent (plus or minus) for this item; we do this without asking what Marshall & Swift intends it to mean mathematically.
[Editor’s Note: Ed Martinez, Tech Support Manager of Marshall & Swift, says, “The phrase prorated amount of real estate commission in large tract development was confusing to some, so it was eliminated. This prorated amount was a marketing/commission cost in large developments for general sales offices with staffed sales representatives and covered the overhead to maintain the sales force. However, it was sometimes misinterpreted as the standard broker’s commission on the sale of a house, which is not the case. Number 7 in the NOT INCLUDED IN COSTS list states that broker’s commissions are not included in the costs. We hope this clarifies the details of our decision to omit the phrase prorated amount of the real estate commission in large tract development from the INCLUDED IN THE COSTS list. Please see the sheet What the Costs Contain (WorkingRE.com Sidebar). The costs in the Residential Cost Handbook have never included broker’s commissions on the sale of a home.”]
To be fair to the Marshall & Swift Residential Cost Handbook, there are many indications that the amount of real estate commissions included in their costs is insignificant. On pages D-8 and D-9, that list the “Percentage Breakdown of Base Costs,” they do not mention real estate commissions. On page D-17, where it gives an example of what to remove from the costs to get down to what an insurance company would have to pay to replace a damaged building, it does not mention real estate commissions as an item to exclude from the costs- that is, these commissions are not included in the first place.
When completing a Cost Approach in an appraisal to arrive at an indication of market value, the appraiser ought to make sure they account for typical real estate commissions. The cost manual is not covering them. If you are using the Marshall & Swift Square Foot Appraisal Form 1007, you need to add these (along with other items) on line 32 as a miscellaneous cost.
As appraisers we need to add quite a few additional costs to the figures from the Handbook: neighborhood profit margins, broker/real estate agent fees, mitigation fees for schools, parks, etc., plus any other fees you have noted that are not included in your costs from Marshall & Swift. These additional costs need to be included as part of the value of a new house when using the Cost Approach just as they are included in the sales comparison approach; they are part of market value. The easiest way I have found to do this is in a “lump sum” method with a “neighborhood” multiplier derived from cost new comparables.
The Appraisal Institute’s new residential courses talk about adding entrepreneurial incentive in the Cost Approach to help make up the deficiency between what Marshall & Swift Residential Cost Handbook figures show as the cost of a new home and the value of a new home using the Cost Approach. The Appraisal Institute has always recommended using cost new comparables as a good source for cost new support for your subject property. In practice, appraisers rarely take the time to do that since it is faster to just use the Marshall & Swift Residential Cost Handbook. Now I think it is more important than ever to use cost new comparables to derive a credible estimate of market value for the subject from the Cost Approach.
My process for extracting a neighborhood multiplier from the market is to take sales of new houses near the subject property and do a detailed Marshall & Swift cost analysis on each one (I have my own spreadsheet for this). Then I observe how far above or below the actual sales price is from the cost handbook figures and bring them to the sales price using a custom neighborhood multiplier. I then reconcile the multipliers from these cost new comparables into a multiplier for the subject in the Cost Approach. After applying my custom neighborhood multiplier, the result from the Cost Approach is a realistic indicator of market value. Over the past 15+ years the range from different neighborhoods around Seattle has been 0.95 to 1.50.