The Cost Approach to appraisal is based around the idea that a property should be priced determined on the cost of the land, plus the cost of construction, minus depreciation. It is based on the idea that a buyer or investor would likely not pay more for the property than it would cost to rebuild or reconstruct a similar property on a comparable piece of land. It is the only type of real estate appraisal method that doesn’t depend on the active market to determine the cost of a property.
The cost approach to valuation, rather than basing the value on other comparable properties, essentially bases the value on how much it would cost if it were to be destroyed and needed to be replaced. So what do home appraisers look at when using the cost approach and how does it differ from other valuation methods?
What is the Cost Approach Formula?
The formula for determining value using the cost approach is fairly simple, and is as follows:
Property Value = Land Value + (Cost New - Accumulated Depreciation).
If the cost of the lot of land that a property was built on was valued at $100,000 and the cost to build the property new was determined to be $180,000, but the property had also depreciated in value over time by $20,000, you would calculate the property value as follows:
Property Value = 100,000 + (180,000 - 20,000)
Therefore, according to the cost approach to valuation, the property would be worth $260,000
Breaking Down The Formula
There are two different definitions for Cost New: replacement cost new and reproduction cost new. Replacement cost is the current amount that it would cost to rebuild the house using current construction materials, layout, and design. Whereas reproduction cost new is defined as the cost of rebuilding the property using the same materials, design, and standards that were in place when the property was initially built. For newer buildings, there may be virtually no difference between replacement and reproduction cost. However, for older or more historical buildings, the difference can be significant.
It is also vital that appraisers consider the costs of not only building materials and construction, but other included costs such as insurance, administrative fees, and taxes. These all play a role in determining an accurate cost new for the property.
There are three different forms of appreciation to be considered when using the Cost Approach formula:
- Functional Depreciation - this is a change over time in the needs or function of the property.
- Physical Depreciation - this results from the natural aging of the property.
- External Depreciation - this is depreciation caused by the economy or neighborhood.
Many appraisers will use the Sale Comparison Approach to estimate the current value of a lot or land. Direct comparison is typically the easiest way to determine land value; the appraiser will look at similar recently sold lots of land.
The Pros and Cons of Cost Approach
Typically speaking, the cost approach method is considered to be less reliable than other methods of property appraisal. This is because it tends to make several assumptions, particularly about the land. It assumes that there is enough available land for the buyer to build an identical property, and it is also difficult to accurately estimate the value of the land if there is no other comparable land available.
However, there are some instances where the Cost Approach to Valuation might be the best method for an appraiser to use. These include:
- Insurance Appraisals - these tend to use the cost approach since the land value is separate from the overall value of the property.
- New Construction - Construction lenders tend to require Cost Approach appraisals since the market value depends on project completion.
- Special use Properties - Properties such as churches or schools may only be able to be appraised by the cost approach since there are unlikely to be other comparable properties to determine their value.
The Cost Approach to Valuation might not be the most reliable way to determine the current value of a property. Still, in many instances, it is the best way for an appraiser to accurately determine the worth of a property without having to use an active market for comparison. In instances where there is a historic building, or a special-use property, finding a comparable property on which to base the value of the subject property may not be possible, which is why the Cost Approach method can be essential.