I know Scott Cullen is not a big supporter of using Compounded Cost method. The argument (if I may, Scott) is that there is no support in appraisal literature or methodology for the use of this method.

I have a curious situation, though, where this method might be of use, and would like to toss it out for discussion.

I have a small community park with many large oaks, near an airport. FAA is requiring new electronic equipment that will necessitate cutting many trees to lower heights, ranging from 0 to 25% of height (80 to 110 feet tall trees). Some of the trees will tolerate the lighter levels of pruning, those needing heavier pruning may not survive longer-term. In almost all cases, future pruning will also be necessary to maintain the lower heights, and as response to new growth. Dieback and decay can be expected in some cases.

This is a heavily used public area, so safety is a major concern. But keeping the trees is also vital.

My thought was that by using a compounding method, we can project the needed funds in the future to maintain the trees, based on assumptions of the need for pruning, etc. For example, after the initial hard pruning, we can expect the need to prune at 2 years, 5 years, 8 years and 12 years. Although the level of pruning won't be as drastic at these times, we can estimate the cost. The purpose would be to determine the future cost of necessary care, so that funds can be planned or invested now.

Reply to post by Russ Carlson, on February 18, 2001 at 13:08:08:

"I know Scott Cullen is not a big supporter of using Compounded Cost method. The argument (if I may, Scott) is that there is no support in appraisal literature or methodology for the use of this method." Actually that is only part of the argument. When you really pull the exercise apart, compounding a partial replacement cost when used to estimate the present value of a complete loss is not descriptive of what is actaully experienced... maybe that's why it's not in the literature.

All that can be said of componunding is that it trends towards a $ figure bigger than the 4" replacement cost tree. And if we're appraising a 30" tree then it's trending in the right direction. But we don't know how long to compound it at what rate because we don't know what the value is supposed to be and if we knew we wouldn't need to compound to find out. Circular logic. Fatal error. This does not compute.

What you are talking about here is a completely different exercise... estimating future costs. Compounding is used for this type of exercise. This is a principal part of timber or forest land valuation. Let me repeat I said PART OF. this compounded, future cost must be subtracted from the anticipated, future revenue to get VALUE. As above, compound alone does not work for present value. Do I have to say that again?

Now, compounding is a straight-forward mathematical exercise. But it is entirely dependent on the desired result and the data inputs. If you have costs today and you want to know future costs the rate you use would be an inflation rate, NOT a nominal interest rate. The inflation rate is the nominal interest rate less the real interest rate. That's the exercise you would use if you're denominating today an award or payment to be made in the future to cover future costs. If you are looking for an award today, you would not compound. You would use the inverse exercise, discounting. You would estimate the future cost in each year it would be required (using an inflation rate). Then you would discout to PV from each yeare of incurred costs using as a discount rate a nominal investment rate. The theory is you'd get the PV award today and invest it earning a nominal, compounded interest rate and it would grow to the projected future cost just as you would need it.

There is some interesting case law on these FAA tree cuttings. If I can find it I'll post separately.

Reply to post by Scott, on February 18, 2001 at 13:08:08:

Interestingly, my employer and subsequently my own company were both located adjacent to this airport for 13 years. The discussion of history of local zoning and use includes mention of my employer's application to opereate a tree service business.

Reply to post by Russ Carlson, on February 18, 2001 at 13:08:08:

Russ,

Why don't you just get estimates from tree contractors as to the costs of doing your proposed maintenance schedule, and use that as cost of repair. How does calculating compounded interest give you a figure of tree maintenance costs in the future?

lew

Reply to post by lewbloch, on February 18, 2001 at 13:08:08:

Lew's method is very straight forward. It would save the effort of compounding forward at an inflation rate and discounting back at a nominal investment rate to get PV of an award today for future costs.

If inflation is at or near zero you are getting over paid since the invested amount will grow to something more than anticipated costs. If inflation is expected to be high and future costs will be higher the nominal interest rates will be higher too (nominal rate = real rate + inflation rate), but there's a liquidity risk in your investment.. if you lock in rate x for a term and inflation over term goes up you might come up short with a discounted award. Does it matter? The bigger the amounts are and the longer the term the greater the errors will be. For short terms and small amounts Lew's technique is probably fine.

One potential problem with "current" costs for maintenance besides inflation is if the actual work required will be greater than today. E.g. 10 trees at x size planted today cost y/year to prune and spray. But in ten years they will be 4x size and cost ~4y/year to care for. So the unit cost of y may inflate but the number of units may also increase. That's where projecting future costs on a per year basis and discounting each year separately back to PV really gives the most accurate result.

Reply to post by Scott, on February 19, 2001 at 18:35:09:

Scott's last paragraph really gets more to the heart of the problem. We can look at the trees now, and know what they need. We can reasonably estimate what may be needed in 2 or 3 years. We're starting to stretch it at 5 years, and 10 or 12 years out- Who knows? Getting estimates for now to 3 years might work, but I don't feel confident about going farther than that. As a contractor, would you offer a bid price for unspecified work to be done 12 years from now? I sure wouldn't.

What I need is figure how much to put in a trust or escrow NOW, so the costs will be covered. Ideally, there will be enough $$ at each stage for the work needed, and none left over when finished. Practically, you probalbly want a bit extra. And I can't necessarily specify when the end of term might be. At 12 years out, we may still have trees that need ongoing care. Maybe more so as decay spreads, and more removals become necessary. This is obviously much more than simple compounding. But my assignment is simply to estimate the costs, and when. Asking the local tree service is just the start.

Reply to post by Russ Carlson, on February 20, 2001 at 07:36:24:

It's up to you as "tree expert" to estimate what future, physical maintenance needs will be, year by year. Having done that you need to cost out those services. That would be done by applying an inflation factor to the most future cost you have hard commitments for.

That inflation calculation could be done by you, or maybe you delegate to a CPA or somebody else accustomed to doing it.

Once you have those projected future costs they need to be discounted back, year by year to PV as of the award date. This is a common exercise by application of a "sinking fund factor." A CPA or certified income producing property appraiser (e.g. MAI) should be able to do this or advise you.

Whether the award is truly in "escrow" or given to the damaged party is an administrative arrangement. If it's in escrow and the actual costs are low the payor could maybe get the excess back. If it's given to the damaged party they would keep any overage. They also have an incentive to do the work efficiently to get such overage. It's also their risk to invest it properly and not spend it elsewhere. Depending on the amount of award it may not be worth the admin expense to appoint an escrow agent.