Cost Approach

What is a 'Cost Approach'

The cost approach is a real estate valuation method based on the concept that the price a buyer should pay for a property should not exceed what an individual would pay to build a building of equivalent value. In cost approach pricing, the market price for the property is equivalent to the cost of land plus cost of construction, less depreciation on the building and other tangible assets. The cost approach is a more accurate valuation of market value when the property is new.

BREAKING DOWN 'Cost Approach'

Cost approach is one of three popular valuation methods for real estate, along with the income approach and the sales comparables approach. The cost approach methodology requires certain assumptions, such as the availability of land. If land is not available for the project, then it is not possible to substitute the existing property for a new building project. Additionally, the method does not address whether an exactly equivalent structure must be built, or what to do if the cost of an equivalent building cannot be reasonably estimated.

How The Sales Comparison Approach Works

The sales comparison approach is the most popular method used to value residential property, and this approach compares the real estate to comparable properties that have recently sold to determine a value. This approach considers many aspects of the property, including the location’s traffic levels, noise and whether to not the property is in a cul-de-sac or on a normal street. A sales comparison considers the size of the lot, the condition of the property and the number of rooms in the property. If the property has a pool or a deck, those features are also considered as part of the valuation.

Factoring in the Income Approach

The income approach places a value on a property based on the amount of income the property can generate, so this approach is used for commercial property, such as an office building or a strip mall. Assume, for example, that a real estate firm is considering the purchase of a three-story office building in a city’s business district. The first step for this approach is to estimate the annual gross income that the property can generate, and the firm predicts a $1 million gross income, based on lease rates paid per square foot in the area. Next, the firm adjusts the total income to assume a level of average vacancy during the year, and also subtracts real estate taxes, insurance and other operating expenses from the income. The remaining net income amount is the value of the property.

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