It can be helpful to work through some cost approach appraisal examples in order to better understand the concept.
Example 1
An existing property has construction costs of $85,000. The construction costs for building a similar house are estimated at $30,000 and the price of similar land is estimated at $25,000. Depreciation costs of $20,000 are estimated for the existing property. What is the valuation price of the existing property using the cost approach method?
Building Construction Cost - Depreciation of Existing Property + Cost of Land = Market Value
($85,000) - ($20,000) + ($25,000) = $90,000
The $85,000 house is actually worth $90,000 after depreciation and adding in the cost of land. A new house could be built on a similar piece of land for a total cost of $55,000. In this case, it would be cheaper to build a new house than to purchase the existing house.
Example 2
The cost approach valuation of an existing house is $95,000. A cost of $150,000 is estimated for purchasing a similar lot of nearby land and the construction of an identical house. A difference of $55,000 in favor of buying the existing house instead of building a new one elsewhere suggests the existing home might be priced below the full market value. This may indicate that the property could be purchased at a discount relative to similar homes.
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The cost approach is a method of valuing property in which the appraiser estimates the cost of building a new property that is similar in size, quality, and features to the subject property. The appraiser then deducts depreciation from the cost of the new property. Depreciation is the decrease in asset value caused by age, wear and tear, or obsolescence. Finally, the cost of the land is added to arrive at an estimate of market value. For example, the cost approach valuation for a property would be $90,000 if an appraiser estimated the building cost of the existing property to be $85,000, the depreciation to be $20,000, and the value of the land to be $25,000 ($85,000 - $20,000 + $25,000 = $90,000).
A central assumption of the cost approach to property valuation is that a person should not buy a house if the cost of building an identical one on a comparable piece of land is cheaper. Alternatively, the cost approach can also provide insights as to when real estate may be undervalued. For instance, the cost approach valuation of an existing house is $90,000 and the cost of purchasing a similar lot of land and building an identical house costs $150,000. In this scenario, the existing house might be priced significantly below market value. The cost approach to property valuation works best for things like new construction, special use properties, and properties with no recent comparable sales. Other benefits of using the cost approach for property valuation include helping buyers to learn if a house is undervalued or overvalued, getting accurate measures for replacement value, and aiding in the appraisal of the value of home improvements. Limitations include the time it takes to collect cost data and the difficulty of accurately estimating depreciation.
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Additional Info
Cost Approach Defined
Bill is shopping for a home in a new development. He's not sure if he would like to have a new house built for himself or if he should buy an existing one. What can he do to figure out how much the two options would cost? How can he determine how much he should spend on a new home to get a good deal?
The cost approach to property valuation compares the price of one piece of real estate with how much it would take to build a similar property. It is one of the three primary methods of property appraisal. Buyers work on the assumption that it doesn't make sense to pay more for a property when comparable newly built real estate costs less money. Cost approach can be calculated by the following formula:
Building Construction Cost - Depreciation of Existing Property + Cost of Land = Market Value
Cost Approach Limitations
The cost approach system has many limitations in practice. The method assumes that the buyer could find the land to build an identical property and that's not always the case. Higher cost of land on another lot might drive the price up even if building costs are reasonable. Construction costs are another vital factor. Would similar construction methods be used to build a new home in the area to those of existing homes there - or would the construction be functionally equivalent but with hidden expenses? One example of a building cost would be the material used to build walls in a new home. Do plaster walls have the same value as drywall in real world purchase prices?
Additionally, the local political or economic environment might not be friendly to new construction. The area could already be fully developed. Local planning authorities might be so restrictive that new construction is not worth the trouble. Unfortunately, these factors aren't considered in the cost approach.
Another consideration is that older property can have major depreciation. It might be difficult to accurately account for this. What if a certain construction material or method is no longer used? Sometimes making adjustments for depreciation is a challenging process. The appraiser has room for a lot of subjectivity.
Cost Approach Benefits
One benefit of the cost approach is that it can help identify market status. If the building cost of a new house would be greater than the value of an existing house in an area, it's a sign the older property could be undervalued. Likewise, if new home construction costs are cheaper than an existing property's value, the cost approach may reveal that the older property is overvalued.
The cost approach also works with other methods. If another method's accuracy is in doubt, the cost approach may give a stronger value estimate. A second or third valuation of a property offers other data points to estimate a fair market price.
The cost approach works best for new construction properties. It's especially helpful for determining the feasibility of buying land where a like property could be built near a similar existing one.
Bill considers the cost approach to property valuation in the new development. Using the cost approach formula, he determines that he would get a better deal having a new home built than buying an existing property there. Additionally, the new home would be a better long term investment because he would customize the property with modern features which increase resale value such as energy efficient windows and solar panels.
Lesson Summary
The cost approach to property valuation weighs the price of an existing property to the cost of building a similar property elsewhere. It is measured by taking the construction cost of a building, deducting the depreciation and adding the cost of the land to determine market value. Issues in determining similar property, construction costs or figuring depreciation complicate the method's practicality. For these reasons the cost approach is most effective in new construction areas when similar parcels of land are available. The cost approach method can help to measure market activity as well as supplementing other valuation methods.
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