What Is the Cost Approach?
The cost approach is a real estate valuation method that estimates the price a buyer should pay for a piece of property is equal the cost to build an equivalent building. In the cost approach, the property's value is equal to the cost of land, plus total costs of construction, less depreciation. It yields the most accuratemarket valuefor when a property is new than through alternative methods.
The cost approach is one of three valuation methods for real estate; the others being theincome approachand thecomparableapproach.
Key Takeaways
- The cost approach to real estate valuation considers the value should equal the total cost to build an equivalent structure.
- Thecost approach considers the cost of land, plus costs of construction, less depreciation.
- The cost approach is considered less reliable than other real estate valuation methods, but can be useful in certain cases such as when evaluating new construction or a unique home with few comparables.
Understanding Cost Approach
Instead of focusing on the prices other, similar homes in the area are selling for, or a property’s ability to generate income, the coast approach method values real estate by calculating how much the building would cost today if it were destroyed and needed to be replaced from start to finish. It also factors in how much the land is worth and makes deductions for any loss in value, otherwise known as its depreciation.
The logic behind the cost approach is that it makes little sense for buyers to pay more for a property than what it would cost to build from scratch.
There are two main types of cost approach appraisals:
- Reproduction method: This version considers what a replica of the property would cost to be built and gives attention to the use of original materials.
- Replacement method. In this case, it is assumed that the new structure has the same function but with newer materials, utilizing current construction methods and updated design.
When all estimates have been gathered, the cost approach is calculated in the following way:
cost – depreciation + land worth = value of the property.
Advantages and Disadvantages of the Cost Approach
The cost approach can be less reliable than the income and comparable methodologies in practice. It requires certain assumptions, including taking for granted that there is enough available land for the buyer to build an identical property.
Moreover, if comparable vacant land is not available, the value must be estimated, which makes the appraisal less accurate. The lack of similar building materials also reduces the accuracy of the appraisal and increases room for subjectivity. Calculating depreciation on older property is not straightforward and easily measurable, either.
Despite these limitations, there are a few cases where the cost approach can be useful and even necessary. Valuing the various components of real estate separately is especially helpful when dealing with property that is new or differs from others in unique ways.
When to Use the Cost Approach
Special Use Properties
The cost approach is required and sometimes is the only way to determine the value of exclusive-use buildings, such as libraries, schools or churches. These resources generate little income and are not often marketed, which invalidates the income and comparable approaches.
New Construction
The cost approach is often used for new construction, too. Construction lenders require cost approach appraisals because any market value or income value is dependent upon project standards and completion. Projects are reappraised at various stages of construction to enable the release of funds for the next stage of completion.
Insurance
Insurance appraisals tend to use the cost approach when underwriting homeowners' policies or considering claims because only the value of improvements is insurable and land value is separated from the total value of the property. The choice between depreciated value and full replacement or reproduction value is the determining factor for the evaluation.
Commercial Property
Finally, the cost approach is occasionally relied on to value commercial property, such as office buildings, retail stores, and hotels. The income approach is the main method used here, although a cost approach may be implemented when design, construction, functional utility or grade of materials require individual adjustments.
Special Considerations
Most residential appraisals do not use the cost approach. Instead, sales comparisons usually drive market valuations of these types of properties.
When a cost approach appraisal comes in below market pricing, it can be a sign of an overheated market. Conversely, regular evaluations above market pricing may signal a buying opportunity.
An exception is if the property is under-improved or over-improved for its neighborhood. In this case, an accurate estimation of the value of improvements adds to the precision of the determination of value, which is not possible using only the comparable approach.
