Cost Approach

The cost approach is a process that involves estimating a property's value based on the costs associated with building a similar property from scratch. Individuals can use this approach to appraise any type of improved property. This is a reliable method for appraising unique properties, for example, schools, churches, etc.

It is based on the assumption that paying more than the amount it would cost to construct an equivalent property with the same utility level would not be rational. It focuses on computing the cost of building a similar property while considering depreciation and land value. The two methods to cost approach appraisal are reproduction and replacement.

Key Takeaways                                                               

• The cost approach definition refers to a valuation technique in which an appraiser values a property by summing up construction costs and the land value and then deducting depreciation from the result.
• Valuation experts often use this technique to appraise new and special-use properties.
• A key advantage of this valuation method is that it enables an investor or buyer to determine whether a property is overvalued or undervalued.
• This method has certain limitations. For example, gathering cost data can be time-consuming, and a buyer might be unable to purchase a plot of land to construct an equivalent property.

The cost approach definition refers to a real estate valuation technique that involves determining a property's value by estimating the cost of rebuilding an equivalent structure from start to finish. Since this method is not based on the ability of a property to generate income or comparable properties, it considers the cost one must incur to construct a property today while assuming that the existing property is demolished and rebuilt.  

The cost approach method includes more assumptions, including the availability of land. Without comparable vacant land, one must estimate the property's value. This decreases the accuracy of the appraisal. The valuation is also less accurate if similar building materials are unavailable.  

As noted above, reproduction and replacement are two methods of this approach. Let us look at them in detail.

#1 - Reproduction Method

This method estimates the cost of building a property replica, utilizing similar construction practices and building materials. Moreover, it uses layouts, standards, and designs when constructing the property.

One must note that the more historic and older a property is, the higher the gap between replacement costs and reproduction costs. Constructing a replica of historical building costs more than building a replica of a modern home, as one has to incur a higher cost to undertake site improvements and purchase raw materials.  

#2 - Replacement Method

The replacement technique involves estimating the cost incurred to construct a property with the same level of utility as the property being appraised utilizing the current building materials, designs, layouts, and standards.

Individuals can go through the following points to understand when to utilize this property valuation technique:

• Special Use Properties: This method is sometimes necessary to estimate exclusive-use buildings' value. Examples of such properties are libraries, churches, schools, etc.  
• Commercial Property: People sometimes use this technique to value hotels, retail stores, office buildings, and other commercial properties.
• New Construction: One may use this method to value newly constructed properties.
• Insurance: Insurance appraisals often use this method when considering claims or underwriting homeowners' policies. Only the improvements' value is insurable, and the land value is separate from the property's overall value.

The formula used for cost approach appraisal is as follows:

Property Value = Reproduction/Replacement Cost – Depreciation + The Value Of Land

Suppose in an attempt to formulate a property's valuation, an appraiser named David utilized comparables to estimate that the worth of an equivalent plot of land is $50,000. David then utilized the comparative unit technique to determine that the cost of reconstructing the property from scratch would be $25 per square foot for a 1,250-square-foot property. Simultaneously, David utilized the market extraction technique to determine 25% depreciation.

The calculation of the property's market value is as follows:

• Property Value = $50,000 + ($25 x 1,250) – {25% ($25 x 1,250)}
• Or, Property Value = $50,000 + $31,250 – $7812.50
• Or, Property Value = $73,437.50

Let us look at the benefits and limitations of the cost approach.

Advantages

• It helps buyers determine whether a property is overvalued or undervalued.
• This method can accurately value special-use properties and unique buildings.
• It can help insurance companies to insure a property for its full replacement value. Moreover, insurers can use the technique to appraise improvements" value.
• This technique can be reliable for valuing new properties or structures without comparable sales.

Disadvantages

• An existing building may have significant depreciation, which may make it challenging for one to compute.
• Finding and accumulating cost data can be a challenging and time-consuming task.
• A buyer might not be able to purchase a piece of land to construct a property similar to the existing one.
• One may be unable to find data regarding similar land for the subject property. This can make it challenging to estimate the value of the land.

Cost, sales comparison, and income approaches are all property valuation techniques. Unfortunately, individuals new to the world of finance often get confused when understanding these concepts. To eliminate any confusion, knowing their distinct characteristics is vital. So, let us look at the critical differences.