DRC Method

Information on the Depreciation Cost Replacement (DRC) method for real estate appraisal

In order to understand thoroughly the Depreciated Replacement Cost method, it is necessary to understand the general cost approach. The cost approach, which includes the Depreciated Replacement Cost method, is often used to calculate the cost of replacing special assets as well as assets that are either very rarely or not at all sold. In the case of valuations where the properties are new constructions, the cost approach, and therefore the depreciated replacement cost method, appears easier. Of course, this does not mean that the cost approach, and therefore the Depreciated Cost Replacement method, should be applied continuously, but only if there is a complete lack of market data. However, the use of the depreciated cost approach and the depreciated replacement cost method may present difficulties due to a lack of market data on construction costs and depreciation.

The depreciated replacement cost method is the most widely used method within the cost approach and it is based on the economic theory of substitution. The Depreciated Replacement Cost method, and the Depreciated Replacement Cost itself, is also based, as the cost approach, on the theory that a potential buyer is unwilling to pay more than the cost of acquiring a property of equal utility (modern equivalent). In the case of the Depreciated Replacement Cost, the valuer is asked to submit a comprehensive opinion of the market value of the land, in its present use, adding the estimated cost of constructing a similar building or buildings to the property under valuation. All the necessary work on the land on which the property examined is placed, is added to the previous sum. It is understood that the proper use of the Depreciated Replacement Cost method requires, among other things, good practical knowledge of building regulations, construction costs and safety-related regulations. When applying the Depreciated Replacement Cost method it is necessary to apply depreciation adjustments on the total replacement cost of the property under valuation in order to reflect as accurately as possible the differences of the property compared to the modern equivalent. The adjustments in the context of the depreciated replacement cost method relate to the deterioration factors, the residual economic life of the property, the adequacy and the functionality of the property, always compared to its corresponding new version.

Applying the Depreciated Replacement Cost method also requires an assessment procedure of the replacement cost. There may be cases in this process, especially for old properties, where the cost of reproducing the property under valuation requires attention; when assessing the replacement cost, in order to apply the Depreciated Replacement Cost method, all possible costs that may be incurred in constructing the modern equivalent property must be taken into account. These costs may include: delivery and transportation of materials, duties or taxes, site preparation / improvements, professional fees and others. In the Depreciated Replacement Cost method it is of great importance to calculate the necessary costs associated with site preparation and improvements. These improvements refer to any additions made to the land where the property examined is located and include additional constructions of any kind, earthworks and plants. All of these additions or improvements are considered to play an important role in the final value of the property, so much emphasis is placed on their calculation.

The depreciated replacement cost method requires, among other things, the calculation of the damages and the depreciation that may have occurred on the property under valuation. As mentioned, the Depreciated Replacement Cost method is based on the theory that the potential buyer will not spend more money on the property examined than the money he would spend for the purchase of the modern equivalent property. Assuming that the new version of the property is the ideal choice for the potential buyer, calculating the Depreciated Replacement Cost requires assessing the wear and tear. This depreciation should reflect the differences of the property compared to its new version. There are three basic types of depreciation, as mentioned in the RICS guide (2019):

1. Physical deterioration: in the depreciated replacement cost method, the natural wear and tear on the property is significant. It is the result of years of wear and tear, possibly in combination with a lack of maintenance. Particular emphasis in assessing physical deterioration, and therefore in calculating Depreciated Replacement Costs, should be given to the type of property as for some properties a degree of deterioration is acceptable and does not affect their value.
2. Functional obsolescence: applying the Depreciated Replacement Cost method requires the calculation of the depreciation related to the inability of the property to functionally meet the purpose for which it was created. The functional depreciation is connected to the Depreciated Replacement Costs as it calculates and reflects either the cost of upgrading the property or the financial consequences of the property due to its reduced functional efficiency.
3. Financial obsolescence: the Depreciated Replacement Cost method requires the calculation of the financial depreciation. In this case, the calculation of the Depreciated Replacement Cost takes into account the effects of the financial changes that are occurring in the market that are related to changes in the demand for products or services produced in the property examined.

In addition, for valuations that it is chosen to apply the Depreciated Replacement Cost method, there are three basic ways to calculate depreciation, and therefore the Depreciated Replacement Cost:

1. Straight-line depreciation method: the depreciation cost used to calculate the Depreciated Replacement Cost is distributed evenly throughout the useful life of the property under valuation.
2. Declining Balance Depreciation Method: this case, for the calculation of Depreciated Replacement Costs, is applied to properties that are newer, the faster they are damaged and depreciated. As the years go by, depreciation, used to calculate Depreciated Replacement Costs, decreases.
3. Sum of the years’ digits depreciation method: this method is also used to calculate the Depreciated Replacement Costs for properties that over the years tend to be less productive and their depreciation for calculating Depreciable Replacement Costs is changing.

The five stages of calculating the Depreciated Replacement Cost

The calculation of Depreciated Replacement Costs can be divided into several stages. In order for the valuer to reach the final Depreciated Replacement Cost, he should calculate:

• The cost of constructing the estimated property, a necessary step in calculating the depreciated replacement cost
• Additional costs (eg professional fees, site improvements), very important for calculating Depreciated Replacement Cost
• Land Value, a key factor in Calculating Depreciated Replacement Cost
• The total depreciation of the property examined, useful for calculating the Depreciated Replacement Cost
• The final Depreciated Replacement Cost

It can be seen that the final result of the above steps is the Depreciated Replacement Cost, which is also the question of the Depreciated Replacement Cost method. The input data form (DRC Estimation - Depreciated Replacement Cost method) and outputs created are based on the above steps for the final calculation of Depreciated Replacement Costs. Great significance is paid to cover all possible additional costs that may arise in replacing the property under valuation but also in calculating the value of the land, so that the final Depreciable Replacement Cost can be estimated as accurately as possible.

Basic Definitions for Understanding the Depreciated Replacement Cost Method (European Valuation Standards 2016):

• Depreciation: "The systematic distribution of the depreciable amount of a fixed asset over its useful life". A particularly important definition for understanding Depreciated Replacement Costs.
• Depreciated amount: "The cost of a fixed asset or other amount that replaces the cost, less its residual value." A particularly important definition for understanding Depreciated Replacement Costs.
• Residual Value: "The estimated amount an entity would receive from the disposing of an asset after deducting the estimated disposal costs if the asset was already at the age and condition that would be expected at the end of its useful life" .
• Useful life: "The period during which the asset is expected to be available for use by the entity".
• Depreciated Cost of Replacement: "... of a building is the cost of replacing it so that it can fulfill the functions it is used for, depreciated by age, natural wear and tear."