The Cost Approach Often Fails to Reflect Market Conditions
In a previous post, we talked about the basics of the cost approach and mentioned that it is one of the three approaches accepted by North Carolina courts as being relevant to determining the fair market value of real property and business personal property for property tax purposes. If you are back for an appraisal theorist’s breakdown of each element, you’ve come to the wrong place. What we will try to do is discuss who uses the cost approach and what North Carolina law says about it.
The usual suspects for using the cost approach are the taxing jurisdictions. By both statute and necessity, taxing jurisdictions conduct mass appraisals. G.S. 105-317(b)(1) requires each taxing jurisdiction to create and adopt a “Uniform schedule of values, standards, and rules” to use in its mass appraisal. While some taxing jurisdictions commit resources to developing mass data tables based in income and expense data or sales data, all taxing jurisdictions spend most of their time gathering mounds of cost data and boiling it down into cost and depreciation tables for various property types. The ultimate results are assessments based largely on the cost-approach.
This is not a problem for the large percentage of properties. Most cost data available is for residential properties, and the taxing jurisdictions therefore do an admirable job estimating the values of residential properties. This shows when the taxing jurisdictions test random assessments against actual sales that have occurred close in time to the relevant valuation date in what are known as "sales ratio studies."
A problem tends to arise, however, when taxing jurisdictions attempt to utilize the cost approach to value industrial and commercial properties.
In commercial and industrial properties, you are more likely to find functional obsolescence (technology, industry or social norms, or legal evolutions require different building features) and economic obsolescence (production of product has moved overseas, demand for product has declined, the property no longer fits the use of the neighborhood, etc.). The cost approach becomes decreasingly accurate when these factors are in play, because it is extraordinary difficult to estimate the value loss due to multiple items of obsolescence. This is particularly so when trying to do it on a mass appraisal basis. The Courts have taken note. More specifically, the Supreme Court recognized this shortfall in Greens of Pine Glen (.pdf), in which it held that the cost approach is “better suited for valuing specialty property or newly developed property and is often used when no other method will yield a realistic result.” Likewise, in Belk-Broome (.pdf), the Court of Appeals recognized that:
“the modern appraisal practice is to use the cost approach as a secondary approach because cost may not effectively reflect market conditions.”
The issue of which valuation approach is most appropriate for valuing a specific property continuously presents itself in property tax appeals. Those challenging assessments in North Carolina should be asking their taxing jurisdictions which approach was used to develop the assessment. If it can be shown that the approach was contrary to the cornerstone cases above, and those discussed in upcoming posts about the income capitalization approach and the sales comparison approach, that could go a long way to winning the case.
Image Copyright Willie Duffin. This work is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic License.