Cost Approach Appraisal Real Estate Guide

What Is Cost Approach Appraisal?

The cost approach appraisal method is a valuation method based on the idea that a property should be priced based 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? 

Key Components of Cost Approach Appraisal

1. Replacement or Reproduction Cost

• Replacement Cost: The cost to build a similar structure using modern materials and construction techniques.
• Reproduction Cost: The cost to build an exact replica of the existing structure using the same materials and methods.

2. Depreciation

Depreciation accounts for the loss in value from physical deterioration, functional obsolescence, and external factors. It can be categorized as:

• Physical Deterioration: Wear and tear from usage and aging.
• Functional Obsolescence: Loss in value due to outdated design or features.
• External Obsolescence: Loss in value due to external factors, such as changes in the neighborhood or economy.

3. Land Value

The value of the land on which the property is located, determined independently of the building itself.

Cost Approach Appraisal Formula

Property Value = Land Value + (Cost New - Accumulated Depreciation)

Here's a detailed break down of the cost approach appraisal formula for determining the value of a property:

1. Cost New
2. Depreciation
3. Land Value

1. Cost New

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.

2. Depreciation

There are three different forms of appreciation to be considered when using the Cost Approach formula:

1. Functional Depreciation - this is a change over time in the needs or function of the property.
2. Physical Depreciation - this results from the natural aging of the property.
3. External Depreciation - this is depreciation caused by the economy or neighborhood.

3. Land Value

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.

Cost Approach Appraisal Real Estate Example

Let's consider a hypothetical example to illustrate the cost approach:

• Land Value: $100,000
• Replacement Cost of the Building: $300,000
• Depreciation: $50,000 (including physical deterioration and functional obsolescence)

Step-by-Step Calculation:

1. Land Value: $100,000
2. Replacement Cost: $300,000
3. Depreciation: $50,000

Depreciated Cost of Improvements: $300,000 (Replacement Cost) - $50,000 (Depreciation) = $250,000

Total Property Value: $250,000 (Depreciated Cost of Improvements) + $100,000 (Land Value) = $350,000

Cost Approach Appraisal Pros and Cons 

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. 

Cost Approach Appraisal Bottom Line

The cost approach is a valuable method for appraising certain types of properties, particularly those that are new, unique, or special-use. By focusing on the cost to replace or reproduce the property and accounting for depreciation, this method provides a concrete basis for determining property value. However, it is essential to consider its limitations and complement it with other approaches, such as the sales comparison and income approaches, for a comprehensive valuation.