What is Cost Approach?
The Cost Approach is a real estate appraisal method that estimates a property’s valuation based on the cost to replace or reconstruct the property, minus accumulated depreciation.
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How Does the Cost Approach Appraisal Work?
The cost approach is among one of the three main approaches used in practice to appraise the value of real estate properties.
The two other valuation methods frequently used are the income approach and the sales comparison approach. Contrary to the other approaches, the cost approach is far less reliant on the active real estate market (and any data on comparable assets).
Simply put, the cost approach estimates the value of a property based on the total cost expected to be incurred under the hypothetical pretense that the property was destroyed and needed to be reconstructed.
Therefore, the cost approach estimates the value of a property based on the value of the underlying land on which the property was constructed, the replacement (or reproduction) cost, and the accumulated depreciation of the improvements.
Briefly put, the question answered here is, “How much would it cost in total to reconstruct and rebuild the property from the ground up?”
The utility of the cost approach method stands out among the three main appraisal methods for properties when there is no (or very limited) market data on comparable properties. Hence, the cost approach is often the only viable option available in such instances.
The premise of the cost approach, or “replacement cost,” is the principle of substitution, which states that no rational investor should pay more for a property than the cost of constructing an equivalent substitute.
Estimating the property cost in this case is essentially determining the total spending required to rebuild the property from the ground up, which is then compared to the current asking price:
- Replacement Cost < Asking Price → Current Pricing is Potentially Reasonable
- Replacement Cost > Asking Price → Current Pricing is NOT Reasonable
How to Calculate Property Value with the Cost Approach
The steps to appraise the value of a property using the cost approach method are as follows.
- Estimate Land Value → Estimate the value of the land by analyzing recent sale data on comparable, vacant land parcels. Based on the characteristics of the subject project, discretionary adjustments most likely must be applied to factor in the differences.
- Estimate Replacement Cost of Improvements → Estimate the cost to reconstruct the property and improvements, inclusive of direct and indirect costs such as materials, labor, construction, contractor fees, permits, administrative fees, financing costs, professional fees, insurance, etc. Most often, either the square foot method or the unit-in-place method is used here.
- Estimate Accumulated Depreciation → Estimate the depreciation expense, which pertains to the losses in property value from age, wear and tear, deterioration in building components, functional obsolescence, and external obsolescence.
- Calculate Sum of Land Value and Depreciated Improvement Cost → The implied property value under the cost approach method equals the estimated land value, net of the accumulated depreciation cost tied to the improvements.
