What is a 'Cost Approach'

The cost approach is a real estate valuation method that surmises that the price a buyer should pay for a piece of property should equal the cost to build an equivalent building. In cost approach appraisal, the market price for the property is equal to the cost of land plus cost of construction, less depreciation. It yields the most accurate market value when the property is new.

BREAKING DOWN 'Cost Approach'

The cost approach is one of three valuation methods for real estate; the others are the income approach and the comparable approach. The cost approach methodology requires certain assumptions, such as the availability of land. If comparable vacant land is not available, then the value must be estimated, which makes the appraisal less accurate. The lack of similar building materials also reduces the accuracy of the appraisal.

Two Main Types

There are two main types of cost approach appraisals. The reproduction method considers that a replica of the property is built and gives attention to duplication of original materials. The replacement method assumes the new structure has the same function with newer materials, utilizing current construction methods and an updated design.

Residential Real Estate

Most residential appraisals do not use the cost approach. An exception is if the property is under-improved or over-improved for its neighborhood. In this case, accurate estimation of the value of improvements adds to the precision of the determination of value, which is not possible using only the comparable approach.

Special Use Properties

The cost approach is required and sometimes the only way to determine the value of exclusive-use properties, such as libraries, schools or churches. These resources generate little income and are not often marketed, which invalidates the income and comparable approaches.

Insurance

Insurance appraisals use the cost approach, as only the value of improvements is insurable and land value is separated from the total value of the property. The choice between depreciated value and full replacement or reproduction value is the determining factor for the evaluation.

Commercial Property

A commercial real estate appraisal usually uses all three valuation techniques. The income approach is the key. However, the cost approach is included in the case that design, construction, functional utility or grade of materials require individual adjustments.

New Construction

Construction lenders require cost approach appraisals, as any market value or income value is dependent upon project standards and completion. Projects are reappraised at various stages of construction to enable the release of funds for the next stage of completion.

Verifying Market Conditions

When a cost approach appraisal comes in below market pricing, it can be a sign of an overheated market. Conversely, regular evaluations above market pricing may signal a buying opportunity.

RELATED TERMS
  1. Market Approach

    A method of determining the appraisal value of an asset based ...
  2. Sales Comparison Approach - SCA

    A real estate appraisal method that compares a piece of property ...
  3. Appraisal Approach

    A procedure for determining an asset's value. The appraisal approach ...
  4. Appraisal

    A valuation of property (ie. real estate, a business, an antique) ...
  5. Qualified Appraiser

    An individual who has earned an appraisal designation from a ...
  6. Appraised Value

    An evaluation of a property's value based on a given point in ...
Related Articles
  1. Investing

    What You Should Know About Real Estate Valuation

    Anyone involved in a real transaction can benefit from gaining a basic understanding of the different methods of real estate valuation.
  2. Investing

    Explaining the Income Approach

    The income approach is one of the three main methods that appraisers use to value property.
  3. Managing Wealth

    Real Estate Valuation: What You Should Know

    Anyone from mortgage lenders to property buyers and sellers can benefit from a basic understanding of real estate valuation.
  4. Investing

    What You Should Know About Home Appraisals

    Home appraisals are an unbiased way to determine a home's value. Here is what you need to know about obtaining one.
  5. Investing

    4 Ways To Value A Real Estate Rental Property

    Learn to evaluate real estate and get into the investment game.
  6. Managing Wealth

    The Home Appraisal: Your Key to a Successful Refinance

    When you refinance your mortgage, everything hinges on the appraisal. Here's what appraisers look at, how to make your home look as valuable as possible and ways to fight back if the valuation ...
  7. Investing

    6 Ways Homeowners Can Dispute an Absurdly Low Appraisal

    Count it as one of the most frustrating and disappointing of all real estate quandaries.
  8. Managing Wealth

    7 Ways To Increase Your Home's Appraisal Value

    When it's time to sell your home – or refinance it – it will need to be appraised. Here's how to make sure the valuation is as high as possible.
  9. Investing

    How To Value A Real Estate Investment Property

    Make sure you know what your real estate investment is worth before you sign the ownership papers.
RELATED FAQS
  1. How is market value determined in the real estate market?

    Learn how fair market value is determined during a real estate appraisal and how market values are really decided by professional ... Read Answer >>
  2. Do home appraisers use Zillow?

    When it comes to assessing a home for sale, licensed appraisers rely on detailed —and sometimes proprietary—information to ... Read Answer >>
  3. How do you calculate GDP with the income approach?

    Learn how to calculate the gross domestic product (GDP) of a country by using the income approach, which adds together all ... Read Answer >>
  4. How do you use DCF for real estate valuation?

    Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>
  5. What criteria does a property need to meet to be considered an 'investment grade' ...

    Learn what it takes for institutional investors to consider a property "investment grade," such as real estate investment ... Read Answer >>
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center