Everything You Need to Know About the Cost Approach in Real Estate

By: ROS Team

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If you want to invest in real estate, it’s crucial that you understand how valuation works. In this article, we’ll decode the cost approach to real estate, as it is a commonly used method for valuation. Here is everything you need to know about the cost approach, the cost approach to value formula, and some frequently asked questions about the cost approach to real estate.

What Is the Cost Approach Method?

The cost approach appraisal method is one of the three methods used for estimating the value of the real estate. It’s often used in conjunction with the comparable approach and the income approach.

The cost approach is a method used to estimate the price of a property in which a buyer pays an amount that equals what it would cost to build an equivalent structure or to rebuild the building if it was destroyed. In the cost approach, we consider the cost of land and total construction costs minus depreciation. This approach gives buyers the most accurate market value.

On the other hand, in an income approach, income generated by a property is used to estimate the fair value of a property which is calculated by dividing the net operating income by the capitalization rate. In a comparable approach, the prices of the recently sold identical buildings in the surrounding area are compared to estimate the price of the given property.

How Does the Cost Approach to Real Estate Valuation Work?

Unlike the income method, which focuses on how much income a property can generate, or the comparable method that concentrates on the prices of similar homes in the surrounding, the cost approach method takes into account how much the building would cost today if it needed to be replaced or rebuilt from scratch.

In addition to construction costs, the cost approach also factors in the worth of the land and deducts depreciation for any loss in value.

The idea behind the cost approach is that it does not make sense for buyers to pay for a house that would cost more than what it would cost to build the same house from the ground.

There are Two Types of Cost Approach Appraisals:

Reproduction Method – According to this method, you consider how much it would cost to construct a replica of the property. Therefore, this appraisal method factors in the cost of the original building materials.

Replacement Method – In this method, the new structure is assumed to have the same function as the original structure. However, instead of factoring in the costs of the original building materials, the current cost of building materials is considered, along with an updated design.

Once you calculate all the costs, the cost approach to value formula is calculated in the following manner:

Land Worth + Cost – Depreciation = Property Value

What are the Pros and Cons of the Cost Approach?

Pros

  • The cost approach to real estate is accurate in evaluating unique and special-use buildings.
  • Cost approach does not depend on the prices of similar homes in the surroundings; instead, it only considers how much it would cost to build the house from scratch.
  • This approach factors in the deductions for any loss in value over time.

Cons

  • The cost approach may not always be accurate due to the variability of land and land value.
  • There are certain assumptions and guesswork involved in the cost approach as you have to assume the cost of the material when the property was initially built.
  • From a practical aspect, the cost approach is considered less reliable than the comparable method or income method because you have to assume certain factors, in particular the rates of the material used in construction.

What are the Limitations of the Cost Approach?

One major limitation regarding the cost approach is that it assumes there is enough land available for the buyer to build a similar home. There could be scenarios in which this is not the case. And if there is not enough land, the cost estimates may not be accurate or comparable. There may also be restrictions on new housing developments at play, in which case it won’t make sense to apply the cost approach to the value formula.

Limitations of the Cost Approach

In addition, it is often hard to estimate the depreciation of older properties because several factors come into play in terms of valuation, such as evaluating the cost of construction material used at the time of construction.

When is the Cost Approach Best Used?

1- Special Use Properties

The cost approach is often the only way to estimate the price of exclusive-use buildings. Exclusive-use buildings may include schools, libraries, or churches. Such properties are not often marketed and generate little income. That is why comparable or income approaches are not used for such properties.

2- New Construction

The cost approach happens to be very accurate for newly constructed buildings. Given the fact that income value is dependent upon project completion, lenders typically request the cost approach. Lenders also request the cost approach since construction projects are appraised at various stages of the building process and enable the release of funds based on that information.

3- Insurance

The cost approach is best used in insurance appraisals when claims or underwriting is being considered for homeowners’ policies. Insurance companies only insure the value of improvements and the worth of land is separated from the total value of the property.

4- Commercial Property

The cost approach can also estimate the value of commercial properties like hotels, retail stores, or office buildings. But the most common method used for evaluating the value of commercial properties is the income method, the cost method is also used when construction, design, or grade of materials require individual adjustments.

5- Special Considerations

Most of the time, the cost approach is not used to appraise residential properties. The cost approach is an essential indicator as evaluations of above-market pricing may indicate a buying opportunity, and below-market pricing shows an overheated market.

How to Use Cost Approach for Real Estate Valuation

Cost Approach for Real Estate Valuation

To Make Use of the Cost Approach Appraisal Method, Follow the Five Steps:

1- Estimate the Replacement/Reproduction Cost of Building the Structure

The first step is deciding whether you will need an appraisal for the replacement or reproduction of the building structure. In the replacement method, you look for ways to add a modern touch to the current building. Building an identical structure is likely to be more expensive than a modern building. Because the materials used to build the original building might not be available at the same price.

2- Estimate the Depreciation Cost of the Building Improvements

Depreciation is defined as the process of deducting the loss in value of a structure and its improvements. The older the building’s design the higher the likelihood that it has lost value. That loss of value makes a difference in the current market value and the original market value of a property. Depreciation can be functional, economic, or physical.

  • Functional depreciation means a property’s worth is reduced due to outdated features or design.
  • Physical depreciation means the building has lost value due to normal wear and tear over time.
  • Economic depreciation implies that there has been a decrease in the property’s value due to an economic factor such as a recession.

3- Estimate the Market Value of the Land

Market value means the current price a buyer would pay for the land if it is vacant. The best method to figure out market value is the sales comparison approach. In this method, you can find out the cost by comparing the prices of recently sold houses in the surrounding area.

the Market Value of the Land

4- Deduct Accrued Depreciation from the Reproduction Cost or Replacement Cost

Adding the economic, functional, and physical depreciation values will help you calculate the accrued depreciation for a property. Now deduct the accrued depreciation from the reproduction/replacement cost, which would give you the depreciated cost of the property.

5- Add the Depreciated Cost of the Structure to the Estimated Value of the Land

To calculate the cost approach appraisal, add the depreciated cost of the structure to the value of the land.

Conclusion

Although the cost approach of real estate may not be the most accurate or commonly used method. It can provide the most accurate cost calculation for a buyer. It can also be extremely useful when there are no comparable buildings nearby. Now that you know the cost approach, you can make the best use of it when considering prospective real estate purchases.