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Definition
Where a market exists for residential, retail, commercial and industrial property there should be sufficient market evidence to
establish market value using the sales comparison or income capitalisation approaches.
The cost approach should not be used where there are market sales of comparable properties, or if the property is one for which a
cash flow approach based on business profits is more typical of buyer behaviour. This could be due to:
the type of property not generally being sold on the open market – in which case you can use the depreciated replacement cost
(DRC) method;
the property having development potential and there are no reasonable comparable sales – you can use the residual appraisal
method.
Where there is no market evidence, or where the property is of a specialised type, such as an oil refinery, which is not normally
bought and sold, the cost approach can be used as a surrogate valuation method. This class of property, which is rarely sold, is
generally referred to as 'specialist (specialised) property'.
The DRC method is based on the supposition that no one would pay more for an existing property than the amount it would cost to
buy an equivalent site in terms of size and location plus the cost of constructing an equivalent building. Where used for properties
other than new properties the cost figure will be written down for obsolescence. The cost in such cases will be based on the cost of a
simple substitute rather than the cost of replicating the actual building. It 'provides an indication of value using the economic
principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or
construction' (IVS Framework paragraph 62).
The approach is sometimes used as a check for a market approach valuation. The variances that can occur due to demand exceeding
supply means that on many occasions cost and market value simply cannot equate. Location can give real estate a monopoly in that
there is no other substitute parcel of land with the same potential or utility in the same location. Supply and demand push the price
(value) of the property above the value of any substitute property.
In other situations over-improvement can mean that cost will considerably exceed market value. For example, the construction on a
holiday island of an international airport of a size capable of handling 5,000 passengers an hour will be of low value compared to its
cost if the island can only accommodate 1,000 holidaymakers and residents and only needs an airport capable of handling 2
incoming and 2 outgoing flights a day.
Description
Description
Application
The DRC method is used for hospitals, schools and other properties that are not bought and sold. It can be used as a check for values
based on other methods in developing markets where comparative methods are relying on limited market data or where the market
lacks transparency.
In many cases the actual market value may differ considerably from the value obtained using DRC. For example, a specialist
building may, when valued by DRC method show a considerable value yet if sold to any other person it may require demolition to
enable the land to be used for another purpose.
It should be stressed that DRC is a specialist method requiring particular expertise by the valuer and should not be regarded as just a
mathematical exercise, since each item must be considered separately and in the light of the valuer’s experience. Furthermore, it
assumes that the property being valued will continue to be viably used for its existing use for the foreseeable future and requires a
statement to this effect as part of the valuation report.
For further guidance on the DRC approach see RICS Red Book UKGN 2 Depreciated replacement cost method of valuation for
financial reporting.