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 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.
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.
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.