The cost approach is one of the three real estate valuation methods, the other two approaches being the income approach and the sales comparison approach.
You will need to know a little bit about the cost approach for your real estate exam, so let’s dig in.
What Is the Cost Approach Method?
The cost approach estimates the price a buyer should pay for a property by equating it to the cost of building an identical property from scratch (then adding the land value).
This concept ASSUMES that the cost of a property should be more or less equal to the cost of constructing an identical building (again, plus the land value).
What is the Basis Behind Cost Approach?
Are you a beginner in the real estate industry? Or are you someone interested to become a real estate agent, appraiser or a broker?
Whatever your reason is, if you are searching for the cost approach, you are in the right place.
To fully understand the concept of the cost approach, you must first understand its logic.
Buyers would not pay more money for a property than what it would cost to build the property from the ground up.
No one would.
This information is important to a buyer.
For instance, you want to purchase a property that costs $1.5 million.
You found out that the price of constructing an equivalent property only costs $1.3 million. Would you still purchase the property or just build one from scratch?
It wouldn’t make sense for you to purchase at $1.5 million when a new one costs $200,000 less. This is the logic behind the cost approach.
When Do You Use Cost Approach?
There are five great valuation uses for the cost approach technique.
Special use properties
Special purpose or special use properties are those that have limited or specialized uses. These are
- Religious buildings
- Hospitals
- Theaters
- Museums, and the like
The cost approach is used in their market pricing because they generate little income, which invalidates other valuation methods.
New construction
Construction lenders use this approach because projects and improvements are reappraised at various stages of construction.
Insurance
The cost approach is used by insurance appraisals because only the value of improvements is insurable. Land value is not included in the total market value of the property.
Commercial Property
Although just occasionally, some rely on the cost approach when evaluating commercial properties. These are office buildings, retail stores, and hotels.
The cost approach is implemented when materials, construction, design, or even the functional utility of a commercial structure needs individual adjustments.
Market indicator
A cost approach appraisal that dives below the market price can be a sign of an overheated economy.
Fast Fact: Overheating means the economy reaches its capacity to meet all of the demands from individuals, firms, and government. [R]
On the other hand, if the appraisal is higher, then it may mean that there is a buying opportunity.
How to Use Cost Approach for Real Estate Valuation
The worth of certain real estate property is the land value plus the contributing value of site improvements and constructions.
From the sum, you will deduct the amount of depreciation of the site improvements.
To simplify that, this is the formula:
Property value = value of the land + cost of construction – depreciation
What Are the Steps in Computing for Cost Approach?
In this real estate valuation method, estimating the cost approach has five steps. These are the following:
#1 Estimate the Reproduction/Replacement Cost of Building the Structure
Reproduction and replacement costs are the two types of valuation techniques.
Reproduction Method
This technique estimates the price of constructing a replica of the property, including similar construction materials and construction practices.
The reproduction method aims to have the same utility with the structure being evaluated.
This includes using the same standards, designs, and layouts to estimate the required cost to build an equivalent building.
Replacement Method
This technique estimates the cost to build EXCEPT with upgrades.
The replacement method involves utilizing newer materials, modern construction methods, and an updated design.
This method aims for the same functions for the property being evaluated. The only difference here is that in the replacement method, there is a more modernized touch.
Some important notes…
An important thing to remember is that the older a real estate property is, the higher the difference would be between the replacement and reproduction cost.
It makes sense, doesn’t it?
Building a replica of an old building is going to be more expensive than a modern building.
That is because the materials and site improvements needed may be different from the ones available in the market now.
#2 Estimate the Depreciation Cost of the Improvements
What is Depreciation?
Depreciation is the process of deducing the loss in value of a building or structure and its improvements. [R] It is also called obsolescence.
This loss of value causes the difference between the market value of a property when it was first bought and its current income value.
What are the Forms of Depreciation?
There are three forms of depreciation
- Physical Obsolescence
- Economic Obsolescence
- Functional Obsolescence
Physical depreciation is the wear and tear of buildings over time.
Functional depreciation happens when a property’s worth reduces due to outdated design and features. [R] It is also affected by changes in consumer tastes and preferences.
Lastly, economic depreciation is the decrease in the income value of the property due to influential economic factors. [R] This can include:
- Recession
- A general decrease in real estate properties
- The collapse of major employers
- Development of properties such as a sewer treatment plant, a landfill, etc.
#3 Estimate the Market Value of the Land
The market or income value is the current amount to be paid for the land if it was vacant.
To estimate the value of the land, the best method to use is the market data approach (or more commonly referred to as the Sales Comparison Approach.
Through this approach, the price of the land is determined by comparing it to the cost of recently sold properties in the area.
#4 Deduct Accrued Depreciation From the Reproduction Cost or Replacement Cost
To get the accrued depreciation, simply add the figures of the physical, functional, and economic loss of value.
Once you deduct the accrued depreciation from the replacement/reproduction cost, you will get the depreciated cost of the structure.
#5 Add the Depreciated Cost of the Structure to the Estimated Value of the Land
To determine the final cost of the property, the value of the land is added to the depreciated cost of the structure.
This whole process will look like this:
Replacement/Reproduction Cost xxx
Less: Accrued Depreciation – xxx
Depreciation cost of structure = xxx
Add: Estimated value of the land + xxx
Total value of the real estate property = xxx
Example
Person A wants to buy a property. They want to use the cost approach technique to determine the value of the real estate.
He found out that the replacement cost is $1 million, while the accrued depreciation is $150,000.
Upon studying the market pricing, he discovered that the value of the land is $750,000. What is the total value of the real estate property Person A wants to purchase?
Replacement cost $1,000,000
Accrued Dep. ($150,000)
Depreciated cost of the structure $850,000
Estimated value of the land $750,000
TOTAL VALUE of the property $1,600,000
What are the Pros and Cons of Using the Cost Approach?
Pros
- This approach is accurate in evaluating special-use and unique buildings.
- The cost approach does not focus on the prices of similar homes. Rather, it calculates how much the building would be if it were created from scratch.
- This method factors in the worth of the land and already makes deductions for any loss in value.
Cons
- Comparable land may not always be available, which means that the appraisal may not always be accurate.
- In practice, this method is considered less reliable than the income and comparison methods.
What are the Limitations of the Cost Approach?
This method assumes that the buyer would find a vacant plot of land to construct an equivalent building. If there is no vacant land, the information about the property will be inaccurate.
Another limitation is restrictive authorities.
It may happen that an area is already fully developed, and there are strict rules on new developments. It would be impractical to estimate land values in situations such as those.
Lastly, in older property’s depreciation, the cost approach may be unreliable. Materials used in an old building may not be available anymore. Therefore, the estimated data might be subjective.
