What is 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.

Understanding Cost Approach

The cost approach is one of three valuation methods for real estate; the others being the income approach and the comparable approach.

Instead of focusing on the prices other, similar homes in the area are selling for, or a property’s ability to generate income, this method values real estate by calculating how much the building would cost today if it were destroyed and needed to be replaced. It also factors in how much the land is worth and makes deductions for any loss in value, otherwise known as depreciation.

The logic behind this approach is that it makes little sense for buyers to pay more for a property than what it would cost to build from scratch. 

There are two main types of cost approach appraisals:

  • Reproduction method: This approach considers that a replica of the property is built and gives attention to the duplication of original materials.
  • Replacement method. In this case, it is assumed that the new structure has the same function with newer materials, utilizing current construction methods and an updated design.

When all estimates have been gathered, the cost approach is calculated in the following way: Replacement or reproduction cost – depreciation + land worth = value of the property.

Key Takeaways

  • The cost approach valuation method recommends the price a buyer should pay for a piece of property should equal the cost to build an equivalent structure.
  • The market price for the property is equal to the cost of land, plus cost of construction, less depreciation.
  • The cost approach is considered less reliable than other real estate valuation methods but can be useful in certain cases.

Advantages and Disadvantages of Cost Approach 

The cost approach is generally considered to be less reliable than the income and comparable methodologies. It requires certain assumptions, including taking for granted that there is enough available land for the buyer to build an identical property.

Moreover, if comparable vacant land is not available, the value must be estimated, which makes the appraisal less accurate. The lack of similar building materials also reduces the accuracy of the appraisal and increases room for subjectivity. Calculating depreciation on older property is not straightforward and easily measurable, either.

Despite these limitations, there are a few cases where the cost approach can be useful and even necessary. Valuing the various components of real estate separately is especially helpful when dealing with property that is new or differs from others.

Examples of Cost Approach 

Special Use Properties

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

New Construction

The cost approach is often used for new construction, too. Construction lenders require cost approach appraisals because 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.

Insurance

Insurance appraisals tend to use the cost approach because 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

Finally, the cost approach is occasionally relied on to value commercial property, such as office buildings, retail stores, and hotels. The income approach is the main method used here, although a cost approach may be implemented when design, construction, functional utility or grade of materials require individual adjustments.

Important

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.

Special Considerations

Most residential appraisals do not use the cost approach. Instead, sales comparisons usually drive market valuations of these types of properties.

An exception is if the property is under-improved or over-improved for its neighborhood. In this case, an 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.