The cost of a property should be equal to the cost of building a similar property from scratch
Written byCFI Team
The cost approach of evaluating real estate properties is based on the assumption that the cost of a property should be equal to the cost of building a similar property from scratch. The cost of building a real estate property includes the value of the underlying land and the value of site improvements and constructions, less the depreciation cost of the improvements.
The cost approach works on the assumption that it does not make sense to pay more for a property than it will cost to build an equivalent property. The cost approach valuation method is sometimes referred to as the contractor’s valuation method.
Quick Summary
- The cost approach is one of the three main methods used in calculating the value of real estate properties.
- The cost approach method is based on the assumption that a potential buyer of a property should pay a price that is equal to the cost of constructing an equivalent building.
- The market value of a real estate property is the sum of the value of the land and site improvements on the land, less any accrued depreciation.
How It Works
The cost approach is based on the logic that informed buyers will not pay more for a property than it will cost them to build to a similar property from scratch and with the same level of utility. The cost approach is appropriate for unique properties, such as churches or schools with unique components. Also, for a new property, it is easy to estimate the cost of construction since the improvements were recently built.
The formula for calculating the cost approach is as follows:
Property Value = Replacement/Reproduction Cost – Depreciation + Land Value
Since the cost approach is not based on comparable properties or the property’s ability to generate revenues, the method considers the amount that will be incurred to build a property today, assuming that the existing structure is to be destroyed and rebuilt afresh. Hence, it takes into account the value of the land where the property is built, less any loss in value.
Steps in the Cost Approach Method
The following is the process of the cost approach method of real estate valuation:
1. Estimate the reproduction or replacement cost of the structure
The step involves estimating the current cost of building the structure from scratch and the site improvements. The cost can be estimated using the following two methods:
Replacement method
The replacement method estimates the cost of constructing a building with the same utility as the structure being evaluated, using the current construction materials, standards, designs, and layouts.
Reproduction method
The reproduction method estimates the cost of constructing a duplicate of the property, using similar materials and construction practices. It also uses the designs, standards, and layouts that were in place at the time the property was constructed.
The older and more historic a property is, the higher the difference between the replacement and reproduction costs. Building a duplicate property of a historical building is more expensive than duplicating a modern home because it will cost more to buy materials and undertake site improvements.
For a newly built property, there is no major difference between the replacement and reproduction costs. For example, assume that the reproduction/replacement cost is estimated to be $1 million.
2. Estimate the depreciation of the improvements
Depreciation is the loss in value of the building and or its improvements, and it causes the difference between the value of improvements and the current contributing value of the improvements. When estimating the depreciation of the property, you should consider the physical, functional, and economic depreciation.
Physical depreciation refers to the wear and tear that occurs as the building ages, while functional depreciation occurs with the changes in consumer tastes and preferences over a period of time.
Economic depreciation results from external negative trends, such as the collapse of major employers, recession, and new negative developments (such as the construction of a sewer treatment plant in the neighborhood). In this case, let us assume that the accrued depreciation is $150,000.
3. Estimate the market value of land
The next step is to estimate the value of the land on which the property is being built. The most appropriate method of estimating the land value is the direct comparison method, where the current price of land is obtained from the value of recently sold plots of land. It is the market value that you would pay for the land today if it was vacant. In this case, let us assume that the market value of the land is $750,000.
4. Deduct accrued depreciation from the reproduction/replacement cost
After obtaining the total value of depreciation of the improvements, deduct the figure from the estimated reproduction or replacement cost obtained in step one. In our case, it is calculated as follows:
Replacement/Reproduction Cost $1,000 000
Less: Accrued Depreciation $150,000
Depreciated Cost of the Structure $850,000
5. Add the depreciated cost of the structure to the estimated value of the land
The final step is to add the depreciated cost of the structure and improvements to the estimated value of the land. The figure is obtained as follows:
Replacement/Reproduction Cost $1,000,000
Less: Accrued Depreciation $150,000
Depreciated Cost of the Structure $850,000
Add: Estimated Value of the Land $750,000
Total Value of the Real Estate Property $1,600,000
Limitations of the Cost Approach
One of the limitations of the cost approach is that it assumes that the buyer is in a position to find a vacant plot of land where to build an identical property, and that is not always the case. If there is no vacant land, the estimated value of the property will be inaccurate.
Also, an area can be fully developed, and local authorities can be restrictive on new developments, and so it will be impractical to estimate land values in that area.
Another limitation is that it will be difficult to estimate the depreciation of older properties because there are many factors to take into account. For example, construction materials used during the construction of older property may no longer be available or in use. Estimating the value of such a property allows a lot of room for subjectivity.
More Resources
CFI offers the certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
- Direct Capitalization Method
- Economic Obsolescence
- Current Income (Real Estate Investments)
- Replacement Cost
- See all valuation resources
