Within any given real estate appraisal, there are three approaches the appraiser may utilize to develop an opinion of value; The Sales Comparison Approach, Income Approach, and Cost Approach. These “approaches” represent the analytical method for collecting, analyzing, interpreting and aggregating data, which result in the value opinion. This post is dedicated to a summary of the Cost Approach. The Cost Approach will first be explained in an easy to understand manner, specific details can be found below.
For additional questions, or to post your experiences with the Cost Approach, please use the comment section provided below.
Short Description
The Cost Approach arrives at an opinion of value by adding the land value to the depreciated value of the improvements, which is based on cost.
The Cost Approach Explained
The Cost Approach is one tool in the appraisers toolbox, which should be used under appropriate conditions. Just as a hammer would not be used to get a screw into the wall, the Cost Approach will not produce credible results in all situations.
Generally, the best and most reliable situation for utilizing the Cost Approach is on newly constructed properties operating within “Normal” market conditions. This is because estimating the correct amount of depreciation can be difficult, if not impossible to objectively identify, whereas a new building is generally perceived as having little to no depreciation, if built correctly. Additionally, in markets that are in recession or expansion, the cost to build new may be higher or lower than what buyers are willing to pay. Though External Obsolescence attempts to account for this factor, it is extremely difficult to objectively attach a percentage adjustment to a market in this stage of the real estate cycle.
As a practical matter, the Cost Approach arrives at an opinion of value based on the site value, in addition to any improvements done to the property and their corresponding cost (improvements would constitute buildings and/or site additions such as landscaping or paving). If developed correctly, this approach can account for potential deficiencies of the property, in addition to market characteristics, development fees, soft costs, cost trends (location & time) and more.
Detailed Description
The Cost Approach is devoted to an analysis of the physical value of the property; that is, the value of land, assuming it to be vacant, to which is added the depreciated value of the improvements present on the site. The latter is derived based upon an estimate of the cost of reproducing or replacing the improvements, from which must be deducted accrued depreciation in terms of physical deterioration, functional obsolescence and external obsolescence, if any.
- Physical deterioration measures the physical wearing out of the property as observed during the field inspection.
- Functional obsolescence reflects a lack of desirability by reason of layout, style or design; and
- External obsolescence denotes a loss in value from causes outside the property itself, such as the macroeconomic conditions or neighborhood trends.
Within the Cost Approach, the appraiser may elect to utilize cost estimates for either the Reproduction Cost or Replacement Cost. Only one of these approaches is utilized, which should be a result of the situation of the property (age) and needs of the client.
Reproduction vs Replacement Cost
Reproduction Cost represents an exact duplication of the property, whereby Replacement Cost represents the cost to construct a similar property. More specifically, according to the HUD/FHA Handbook:
Reproduction Cost: Exact duplicate with all deficiencies and obsolescence
Replacement Cost: Cost at current prices with equivalent utility (utility meaning “function”)
Process for Developing The Cost Approach
Like all approaches to value, the Cost Approach can follow either a linear or dynamic process of development , though it is best explained on a step by step basis (linear). Provided below is a general outline of how one can undergo the Cost Approach, utilizing the Replacement Cost method.
Step #1: Land Value: The first step in developing this approach is to estimate the value of the site, as vacant. The “as vacant” assumption is integral to the land value opinion because it does not take into account any potential cost to destroy existing improvements or to dispose of the materials. If Insurable Value is sought, these costs may be deducted. Although the land value will not be added into the equation until the last step, it is generally the first thing done within the Cost Approach.
The most common way to value the land is to find comparable sites that have sold, adjust for any differences in the transaction ranging from physical site characteristics to transactional differences such as seller financing, and analyze these comparable sites on either a per square foot or per acre basis. This is known as the Sales Comparison Approach, which is typically the most reliable way of estimating market value for land, without getting into an extensive development/feasibility analysis which may contemplate the value of the land based on its development potential. The land value will be the crutch of the entire Cost Approach, therefore, it is important to take care when determining the price per square foot (a $0.50/SF difference on a several hundred acre site may have a devastating effect on the total site value).
Hypothetical Example: The concluded value for the property’s (a hypothetical property not in existence) site is $10.00 per square foot, and the total site is 25,000 square feet. The result is:
$10.00 x 25,000 = $250,000
Site Value = $250,000
Step #2: Building Improvements: After the value of the land is determined, the cost of the buildings improvements must be generated. This is most commonly done by multiplying the various space types by their respective sizes, in square feet. Selecting the appropriate space type is typically done based on the type of construction, as this is the most pertinent to cost. If there are multiple space types, each space type total would feed into the final cost of the building improvements.
Hypothetical Example: The property (a hypothetical property not in existence) has a convenience store measuring 2,000 square feet, and a carwash measuring 1,000 square feet. The cost to construct the convenience store portion is estimated at $160.00/SF, while the cost to build the carwash portion is $130.00/SF, not including the carwash equipment. The result is:
C-Store portion – 2,000 SF x $160 = $320,000
Carwash portion – 1,000 SF x $130 = $130,000
Total Building Improvement Cost Before Depreciation = $450,000
Step #3: Site Improvements: Next, any specific site improvements done on the property must be examined. This would include things like site work (grading, utilities), landscaping, paving, or other improvements to the site that are not part of the building.
Hypothetical Example: The property (a hypothetical property not in existence) is 25,000 SF in size and has the following site improvements:
Site Work – 25,000 SF x $2.00 = $50,000
Landscaping (10% of site) – 2,500 x $6.00 = $15,000
Paving (20% of site) – 5,000 SF x $3.00 = $15,000
Total Site Improvements = $80,000
Step #4: Total Improvements (Site & Building) Before Depreciation: Simply add the Site Improvements to the Building Improvements:
Total Site Improvements = $80,000
Total Building Improvement Cost Before Depreciation = $450,000
Total Replacement Cost Before Depreciation = $530,000
Step #5: Multipliers: Current and local cost multipliers take into account fluctuations of costs through time and location. The current multiplier as of July 2010 was 1.0, which takes into account market fluctuations in pricing (cost), relative to when the initial price per unit came out. Put another way, if costs are up or down, the current multiplier will adjust for this. The local multiplier for Denver was 0.99, which takes into account the location of Denver and the relativity of distribution costs. Indirect fees can also get lumped in at this time which takes into account various land carry costs, financing fees, appraisal, attorney, etc.
Hypothetical Example: Current Multiplier of 1.0, Local Multiplier of 0.99, Indirect Fees of 1.20 (20% of costs). The result is:
1.0 x 0.99 x 1.20 = 1.188
1.188 x $530,000 (Total Improvement Cost)
= $629,640
Step #6: Deduct Depreciation: This step involves deducting for any potential depreciation on the property. This takes into account Physical Deterioration, as well as Functional and External Obsolescence (also explained in this post), which would lower the value of the entire property. Estimating depreciation is very difficult and involves a high level of skill, though it is sometimes criticized as being “subjective”, there is no other way to reconcile the fact that there may be outstanding circumstances, such as an old building, a dated floor plan that is no longer appealing, or a depressed market. Depreciation is typically estimated on a percentage basis.
Hypothetical Example: The property is relatively new, has a good floor plan, though neighborhood pricing is trending down:
Physical Depreciation = 5% – $31,482
Functional Obsolescence = 0% – $0
External Obsolescence = 5% – $31,482
Total Depreciation = 62,964
Step #7: Total Depreciated Value of Improvements: Now that the amount of depreciation has been established, it is deducted from Total Improvement Cost to arrive at the Total Depreciated Value of Improvements.
Hypothetical Example: The property is relatively new, has a good floor plan, though neighborhood pricing is trending down:
Total Replacement Cost (New) = $629,640
(LESS) Depreciation = 62,964
= $566,766
Step #8: Developers Incentive: It this point, there is a relative understanding of the raw costs to bring the project to completion. However, without a profit of some sort, a developer would not be interested in taking on the risky venture of borrowing money and constructing a building. Estimating the amount of incentive a developer would need is typically a function of the project type, location, and market timing, though is generally in the 10% to 30% range.
Hypothetical Example: Developers incentive is estimated at 15%:
Developers Incentive (15%) x Depreciated Value of Improvements ($566,766) = $85,001
Depreciated Value of Improvements PLUS Developers Incentive = $651,767
Step #9: Add Back Land Value: The last step is to add the value of the raw land into the equation. This is done as the last step due to the fact that land is not depreciated under real estate appraisal principles. Once again, this is a hypothetical example used to illustrate the Replacement Cost method:
Land Value = $250,000
PLUS Depreciated Value of Improvements w/ Developer Incentive = $651,767
Hypothetical Cost Approach Value Opinion = $901,767
Rounded = $900,000
FAQs
What is a cost approach in an appraisal? ›
The cost approach provides a value indication that is the sum of the estimated land value, plus the depreciated cost of the building and other improvements. The total cost of constructing a new building today frequently sets the upper limit of value, assuming the building is the highest and best use for the land.
What is the cost approach method in real estate? ›Cost Approach- estimates the value of real estate by calculating the cost of replacing or reproducing a structure on the land, minus depreciation, plus site value. Value derived may not equal market value.
What is an appraiser concerned with when she is using the cost approach? ›The cost approach is another method an appraiser may use to develop an opinion of value. In a nutshell, it's a breakdown of what it would cost to rebuild the property today if it were destroyed. But it's not that cut and dry-you also have to take into consideration the value of the land and deduct for any depreciation.
What does Fannie Mae say about the cost approach? ›In fact, Fannie Mae will not purchase a mortgage on a property if the cost approach is the primary or only method of valuation used. Quite simply, if there isn't enough data for the appraiser to develop a reliable opinion of value by the sales comparison approach, the mortgage will not be marketable to Fannie Mae.
Who uses cost approach in real estate? ›Share: In real estate, the cost approach appraisal method is one of the common ways appraisers calculate or estimate the value of a property.
What are the 3 types of appraisal approaches? ›- Sales comparison. This is the most common method, where appraisers value a property based on the recent selling prices of similar properties in the same neighborhood. ...
- Cost approach. ...
- Income approach.
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.
What is an advantage of cost approach? ›Cost Approach Benefits
One benefit of the cost approach is that it can help identify market status. If the building cost of a new house would be greater than the value of an existing house in an area, it's a sign the older property could be undervalued.
An appraiser, using the cost approach method would do which of the following? Use replacement cost minus depreciation. Which principle of value holds that a property can increase or decrease in value in expectation of something in the future?
Can Lender use cost approach appraisal? ›It's standard procedure for most commercial lenders to request all three approaches to value—sales comparison approach, income approach, and cost approach—be undertaken during an appraisal.
What is the formula for the cost approach? ›
The Cost Approach Formula
Property Value = Land Value + (Cost New – Accumulated Depreciation). The cost approach is based on the economic belief that informed buyers will not pay any more for a product than they would for the cost of producing a similar product that has the same level of utility.
The reporting requirement of USPAP known as the departure rule does not apply because the appraiser must always use the cost approach to value when considered applicable.
What is the first step in the cost valuation approach? ›- Estimate the value of the land imagining it vacant.
- Estimate the current cost of constructing the building and site improvements.
- Estimate the amount of depreciation of the improvements.
- Deduct the depreciation from the estimated construction costs.
When using the cost approach, an appraiser needs all of the following information, except the: capitalization rate. What is the primary purpose of professional organizations like the Appraisal Institute (AI)? Appraisers report appraisal results using one of two reporting options.
For which of these properties would an appraiser most likely choose to use the cost method of appraisal? ›The cost approach is most applicable to the appraisal of special purpose properties such as a church. The gross rent multiplier is used as a substitute for the income approach in the valuation of a single-family home. The income approach is used in the appraisal of an income-producing property.
What is another name for cost approach? ›The cost approach valuation method is sometimes referred to as the contractor's valuation method.
For which of the following properties is the cost approach most likely to be used? ›Cost approach. Cost (replacement) approach is most commonly used to appraise special purpose properties or buildings.
What is the weakness of cost approach? ›The fundamental weakness is that the Cost Approach does not reflect the supply and demand relationship in the market place because the market adjustment factor is applied to every amenity, whether or not the market reflects it.
How do you calculate property value? ›Now, the rental capacity of any comparable property should be factored in, to reach its capitalised value by multiplying its net annual income (let us assume this is Rs 55 lakhs). The difference between the two figures, i.e., Rs 35 lakhs, is the land value.
What type of value does an appraiser most commonly estimate? ›Market value is the value to a typical buyer and a typical seller. This is the MOST COMMON type of value that is estimated by appraisers.
What is the first step an appraiser takes when valuing a property using the cost approach? ›
The first step of the cost approach is calculating the cost of the building. You can do this by following either the replacement or reproduction method. The essential difference to note between these two approaches is how you determine material and building costs.
What is the difference between income approach and cost approach? ›Often, the cost approach generates the upper limit of value of a subject property. Also known also as the income capitalization approach, appraisers and valuation professionals often use the income method to accurately determine the value of any income-producing properties.
How does an appraiser determine site value when using the cost approach method quizlet? ›...
Terms in this set (63)
- estimating the reproduction or replacement cost of the improvements;
- estimating depreciation;
- estimating the value of the land.
Cost approach for Manufactured Homes
A detailed cost approach to value based on published sources and supported by market data is required for all Manufactured Home appraisals.
- Property reproduction - This method determines what an exact replica of the property would cost to build. ...
- Property replacement - This means creating a new structure with the same function using new materials, current construction methods, and modern design.
While you can't completely predict what the outcome of an appraisal will be, you have more control over it than what a CMA will conclude. A CMA and an appraisal are different processes, but both help you to get you accurate and up-to-date information about how much your home is worth.
What is total cost approach? ›Total Cost Approach. The total cost method normally consists of subtracting bid price from the actual cost of performance and adding profit to the resulting amount. This approach is heavily disfavored by the boards and courts. Wunderlich Contracting Co. v.
When an appraiser estimates cost using a cost manual which method is being used? ›When an appraiser estimates cost using a cost manual, which method is being used? of cost estimating. For example; per square foot. The cost of a structure was $300,000 when it was built 18 months ago.
Which is a situation in which the cost approach would have good applicability? ›The cost approach is most applicable in situations where the site value is not well-supported. A set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of (or replacement for) the existing structure.
When can an appraiser exclude a valuation approach? ›More often than not, what we see at VMG is that when an appraiser omits an approach it is primarily for one of two reasons: the buyer pool in the market does not analyze the worth of a property using that method, or there is not sufficient recent market data available to develop the approach.
What does Uspap state about cost? ›
Cost is a type of monetary relationship that represents the amount of money that would be required to acquire an identical property or to acquire a comparable or otherwise suitable replacement for a subject property.
What is the difference between income approach and cost approach? ›Often, the cost approach generates the upper limit of value of a subject property. Also known also as the income capitalization approach, appraisers and valuation professionals often use the income method to accurately determine the value of any income-producing properties.
How do you calculate cost approach? ›The Cost Approach Formula
Although the details are more complicated, the basic formula for valuing a property using the cost approach is: Property Value = Land Value + (Cost New – Accumulated Depreciation).
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.
When would an appraiser use the cost approach method would do which of the following? ›An appraiser, using the cost approach method would do which of the following? Use replacement cost minus depreciation. Which principle of value holds that a property can increase or decrease in value in expectation of something in the future?
What is another name for the cost approach? ›The cost approach valuation method is sometimes referred to as the contractor's valuation method.
Which approach is most widely used in the appraisal of residential properties? ›The most widely-used and accepted in residential practice is the sales comparison approach. This approach bases its opinion of value on what similar properties in the vicinity have sold for recently, with appropriate adjustments for time, acreage, living area, amenities and so on.
What is the first step in the cost valuation approach? ›The first step of the cost approach is calculating the cost of the building. You can do this by following either the replacement or reproduction method. The essential difference to note between these two approaches is how you determine material and building costs.
What is total cost approach? ›Total Cost Approach. The total cost method normally consists of subtracting bid price from the actual cost of performance and adding profit to the resulting amount. This approach is heavily disfavored by the boards and courts. Wunderlich Contracting Co. v.
When using the cost approach an appraiser needs all of the following information? ›When using the cost approach, an appraiser needs all of the following information, except the: capitalization rate. What is the primary purpose of professional organizations like the Appraisal Institute (AI)? Appraisers report appraisal results using one of two reporting options.
What type of value does an appraiser most commonly estimate? ›
Market value is the value to a typical buyer and a typical seller. This is the MOST COMMON type of value that is estimated by appraisers.
What is the weakness of cost approach? ›The fundamental weakness is that the Cost Approach does not reflect the supply and demand relationship in the market place because the market adjustment factor is applied to every amenity, whether or not the market reflects it.
For which of these properties would an appraiser most likely choose to use the cost method of appraisal? ›The cost approach is most applicable to the appraisal of special purpose properties such as a church. The gross rent multiplier is used as a substitute for the income approach in the valuation of a single-family home. The income approach is used in the appraisal of an income-producing property.
How do you calculate property value? ›Now, the rental capacity of any comparable property should be factored in, to reach its capitalised value by multiplying its net annual income (let us assume this is Rs 55 lakhs). The difference between the two figures, i.e., Rs 35 lakhs, is the land value.
For which of the following properties is the cost approach most likely to be used? ›Cost approach. Cost (replacement) approach is most commonly used to appraise special purpose properties or buildings.
How does an appraiser determine site value when using the cost approach method quizlet? ›...
Terms in this set (63)
- estimating the reproduction or replacement cost of the improvements;
- estimating depreciation;
- estimating the value of the land.
The cost approach is most applicable in situations where the site value is not well-supported. A set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of (or replacement for) the existing structure.