Cost Approach in Real Estate
When working in real estate, especially as an agent, it’s critical to understand how real estate valuation works. Keeping that in mind, we’ve broken down the cost approach, one of the three most prevalent ways of valuation. You can learn more about the cost approach method, what it is, how it’s calculated, and when it’s best utilized throughout our article.
What are the 3 Approaches to Value?
There are three different main approaches that appraisers use while they make an appraisal. They are:
- Market Data Approach, which is also commonly called the sales comparison approach
- Cost Approach, also referred to as summation
- Income Approach, which is also known as capitalization
Each of these approaches are used in different situations depending on the type of property. The cost approach is best for figuring the replacement cost of a home and takes it a step further by factoring in the value of the land.
What is the Cost Approach?
The cost approach is a real estate appraisal method that determines how much a property would cost to replace it, subtracting depreciation. The method is based on the concept that a property’s price should be determined by the value of the land plus the cost of building on it (subtracting the depreciation cost).
It is the only form of real estate appraisal that does not use the active market to establish a property’s value.
Rather than basing the value on other comparable properties, the cost method to valuation essentially based the worth on how much it would cost to rebuild it if it were destroyed, so the replacement cost. This strategy assumes that buyers will not pay more for a building than they would if they had to cover the current price of developing a comparable structure.
The contractor’s valuation method is another name for the cost approach valuation method. The cost strategy is suited for properties with distinctive components, such as churches or schools. Furthermore, because the renovations were recently constructed, it is simple to estimate the cost of building for a new or identical property.
What is the Cost Approach Formula?
The formula for determining the cost approach appraisal is quite simple.
Replacement cost (cost new) – depreciation + land value = total value
To solve this equation, you need to:
- Calculate the cost of replacing or reproducing the improvement (structure of the property).
- Calculate the improvement’s total depreciation (accrued depreciation).
- Subtract depreciation from the cost of reproduction or replacement.
- The total of all estimated depreciation is called accrued depreciation.
- Separately calculate the land value.
- Add the structure’s depreciation cost to the land value.
As a result, you will have the estimated value of the real estate property.
How to Use the Cost Approach
As discussed before, various aspects go into cost approach calculations. The first thing appraisers must do is find the value of the land in its rawest form. Most appraisers will employ a procedure similar to the sales comparison approach to find this information. Put simply the appraiser will look at other previously sold property plots in the same market and use that as a land value baseline.
Replacement Cost (Cost New)
After appraisers determine how much the land is worth, appraisers need step is to find the replacement cost. In general, the current cost of constructing a similar property while following current building rules and utilizing existing construction materials is referred to as cost new.
There are four methods for estimating new cost:
- The comparative unit method occurs when costs are calculated using a lump-sum estimate per square foot.
- The cost segregation method occurs when instead of looking at the total expenses, you split them into components based on the construction materials used. The roof, the framing, and the plumbing, for example, would all be independent components.
- The unit-in-place method further deconstructs these expenses by examining the individual elements that make up each project component. When calculating the roof’s construction, the expenses of the roof joists and decking plates would be taken into account. Overhead and labor costs are factored into the cost of each component in this manner.
- The quantity survey method is similar to how contractors construct bids in that it focuses on the anticipated cost of each component. A percentage is added to account for overhead and profit once the base cost has been calculated.
After the land value, and cost new is found, appraisers will estimate deprecation. The three types or forms of deprecation are Functional Obsolescence, Economic Obsolescence, and Physical Deterioration.
While computing depreciated value, all three of these factors must be considered. Appraisers can calculate depreciation using one of the three ways shown below:
- The appraiser will use the age-life technique to consider the property’s total age, effective age, and the expected remaining lifespan of any renovations. In this scenario, the property’s effective age reflects the state of the property and its current market position.
- The appraiser will use the breakdown approach to identify and quantify each type of depreciation. Then they would sum them up to get a total depreciation valuation.
- The method of market extraction employs similar sales to calculate an acceptable depreciation rate for the relevant property.
Cost Approach Real World Examples
The cost approach is used in many different scenarios. In some cases, the only way to establish the worth of exclusive-use structures such as libraries, schools, and churches is to use the cost approach. The same school of thought applies to commercial properties, and newer construction.
In any form, the cost approach is considered reliable when used on newer buildings and not reliable with older buildings. Determining how much it would cost to replace an old building is more difficult because you have to factor in extra things like inflation. Remember, what it cost to build a building 100 years ago is much different from what it would cost today.
Fun fact, insurance appraisers typically utilize the cost approach when underwriting homeowners’ policies or reviewing claims because only the value of improvements is insurable, and land value is separate from the total value of the property.
Cost Approach Problem Example
Here’s an example of what you may see on the real estate exam:
An appraiser used comparables to decide that a similar plot of land is worth $30,000 while attempting to value a property. He then utilizes the comparative unit method to calculate that the cost of rebuilding a 3,000 square foot home would be $25 per square foot. At the same time, he calculated a depreciation percentage of 25% using the market extraction approach. What is the property value?
Property value = 30,000 + ($25 x 3,000) – (25% ($25 x 3,000))
= 30,000 + 75,000 – 18,750
Following the calculations mentioned above, we can determine that the property value is worth $86,250.
What to Know as a Real Estate Agent
As a real estate agent, you will need to know how these variations of the cost approach can apply to your real estate properties. By using valuation methods like comparable sales to estimate cost, your market pricing for a property will be right in line. Whether a residential or commercial property, this real estate valuation method is essential across the board.
The cost approach can indicate an overheated market if a cost approach appraisal comes in below market pricing. Regular evaluations over market pricing, on the other hand, may show a purchasing opportunity.
In many cases, the cost approach is the most accurate method for an appraiser to assess the value of a property without having to compare it to an active market.
What to Know for the Real Estate Exam
When it comes time for exam day, keep in mind the cost approach. Remember, the cost approach is a real estate appraisal method that determines how much a property would cost to replace it, subtracting depreciation. The cost approach is considered reliable when used on newer buildings and not reliable with older buildings. The formula is: Replacement cost (cost new) – depreciation + land value = total value. With this knowledge, you should be able to succeed with your exam!
Still confused? For a quick simple recap, watch our Cost Approach video featured in our Daily Real Estate Vocab Series: