Appraisers use three different methods to estimate the value of a property. The income approach considers the value as the present value of future expected cash flows generated by the property. It is most accurate when valuing commercial properties with rental income in active markets. The sales comparison method relates the estimated value of the subject property to similar properties that have recently sold in the same market. This method is particularly useful when the comparable properties and the subject property are highly similar and were sold within the past few months. That means the sales comparison method also relies on an active market for similar properties.
On the other hand, the cost approach to valuation is the one method that is not dependent upon an active market for similar properties. Instead, the cost approach estimates the property value as the value of its components, the underlying land, and the depreciated value of the improvements. In this article, we’ll take a deep dive into how the cost approach to valuations works.
The Cost Approach Formula
Although the details are more complicated, the basic formula for valuing a property using the cost approach is:
The cost approach is based on the economic belief that informed buyers will not pay any more for a product than they would for the cost of producing a similar product that has the same level of utility. The cost approach to valuation is easy to use when the property is new and represents the highest and best use of the property. In this case, cost new is known because the improvements were just built. In addition, there should be a negligible amount of accumulated depreciation. Since the cost approach does not rely on comparables, it is also useful when valuing a special use property or a property with unique components.
Cost Approach: Cost New
Cost new can be defined in two different ways. Replacement cost new is the current cost to construct a building with the same utility using the current construction materials while adhering to current standards, designs, and layouts. Reproduction cost new is the current cost to construct an exact duplicate of the property with the same materials and construction practices according to the design, layout, and standards in place at the time the property was initially constructed. For relatively new properties, there is virtually no difference in replacement cost and reproduction cost. The more unique or historic a property is, however, the bigger the cost difference between reproduction and replacement cost. Building an exact replica of a historic home is much more expensive than building a new home.
When considering the costs of construction, it is important to consider both direct costs and indirect costs. Direct costs include the materials and labor costs associated with the construction. Indirect costs include costs such as taxes, administrative fees, financing costs, professional fees, and insurance. There are four main methods to estimate cost new when calculating either replacement cost or reproduction cost.
- Comparative Unit Method– Costs are based off a lump-sum estimate per square foot or per cubic foot. Costs fall into five main categories according to construction materials: heavy steel frame with exterior curtain walls, reinforced concrete frame with exterior curtain walls, reinforced concrete or masonry exterior load-being walls, frame construction exterior load-bearing walls, and prefabricated metal frame. Costs may be further broken down by quality.
- Segregated Cost Method– Rather than considering component costs in one lump sum, the segregated cost method uses average component costs based on the construction material and quality. For example, the segregated cost method would consider the cost of components such as the roof, the frame, the floor coverings, the plumbing, and the HVAC unit separately. These individual costs together estimate cost new.
- Unit-in-place Method– The unit-in-place method is similar to the segregated cost method, but breaks down each of the major components into more detailed pieces. For example, the roof structure would be one component cost with the segregated cost method. In this method, however, the roof structure would be calculated by looking at the pieces of the roof structure, such as the roof joists and decking plates. In addition, estimated costs of overhead and contractor’s profit are built into each of the cost estimates for the unit-in-place method.
- Quantity Survey Method– This is the most accurate method for estimating cost new, but it is also the most difficult and time-consuming method. The quantity survey method estimates the cost of each individual item involved in the construction of the improvements. It is similar to the way contractors compute the cost they provide as a bid estimate. There is an adjustment for overhead and profit added to the total base component cost.
Cost Approach: Depreciation
Depreciation causes the difference in value between the cost new of the improvements and the current contributing value of the improvements. The three forms of depreciation are physical, functional, and external depreciation. Physical depreciation results from normal wear and tear on the property that happens with age. Functional depreciation is the result of changes in needs or preferences over time that cause a reduction in the property’s utility. External depreciation is the result of adverse neighborhood or economic trends. There are three methods that appraisers can use to estimate depreciation.
- The Age-life Method– This method is the simplest and most common method of estimating depreciation. The appraiser estimates the total age, effective age, and remaining life of the improvements. Effective age is a function of the property’s current condition, as well as its utility and location in the current market.
- The Breakdown Method– This is the most accurate and comprehensive way to estimate all forms of depreciation. It is, however, extremely complicated and time-consuming. The breakdown method identifies each individual form of physical, functional, and external depreciation. Then, the depreciation from each individual factor is quantified and added together to calculate accumulated depreciation on the property.
- The Market Extraction Method– The market extraction method uses data from comparable sales to estimate the appropriate depreciation percentage to apply to the subject property. Appraisers find the depreciated value of the improvements on the comparable property by subtracting the land value and contributing value of the improvements from the sales price. The percent the comparable property value has depreciated is the depreciated value of the improvements divided by the cost new of those improvements. This percent is then applied to the subject property.
Cost Approach: Land Value
There are many techniques that appraisers can use to estimate land value, but all of them are essentially some form of the income approach or the sales comparison approach. Direct comparison is the most common method for estimating land value. The price of land is simply derived from recently sold plots of land. It can also be computed as a residual value using the cost approach equation for a newly constructed property, where the cost new and sales price are both known.
Cost Approach Appraisal Example
Suppose an appraiser is using the cost approach to estimate the value of a property on 1 acre of land. Sites of similar size and location sell for around $40,000. Using the comparative unit method, an appraiser finds that the cost new for a building of similar construction materials and quality is $40/sqft for a 24,000-sqft building. So, the cost new of the improvements is $960,000. The improvements have an estimated total economic life of 40 years and a remaining economic life of 30 years. The age-life method of depreciation suggests that the improvements should be depreciated by 25% since they have aged the equivalent of 10 out of 40 years. The appropriate depreciation deduction is 25% of the $960,000, which is $240,000. Using the cost approach, the appraiser estimates the final property value is $760,000.
In this article, we discussed the cost approach to valuation, which is commonly used by commercial real estate appraisers. We compared the cost approach vs the sales comparable approach and also the cost approach vs the income approach. The primary difference with the cost approach is that it does not require an active market. The cost approach determines value by adding the value of the land to the cost of a new equivalent building, then subtracting out any depreciation. We walked through how appraisers calculate cost new, depreciation, and also how land value is determined. Finally, we went through a cost approach example step by step to show how the cost approach can be used to determine property value.