What is cost approach?
In real estate, there are three basic methods used to value a property: market approach, income approach and the cost approach. Cost approach quotes the price of a property on the basis of the cost it would take to build a similar property from scratch.
Cost approach valuation applies the assumption that a property’s fair value can be equated to the cost of building a similar property. The costs involved would include the value of the underlying land and improvements to it. Cost approach method also factors in the depreciation on these improvements and deducts it from the overall value of the property to arrive at a more realistic price.
Types of cost approach
Cost approach can be applied on two methodologies known as reproduction and replacement methods. Under the reproduction method, an exact replica of the same property is considered with respect to construction materials, design and layout.
For example, if the property was built five years ago, to estimate its cost the valuer would consider the price of constructing a duplicate property using the materials and standards applied five years earlier.
The replacement method accounts for costs of building a similar property, but with contemporary construction materials and techniques. This does mean that if the property in question is older there is bound to be a higher difference between the reproduction and replacement cost methods. Whereas, if it is relatively modern, the costs ascertained under both the methods wouldn’t have a significant price gap.
How to calculate cost approach?
Cost approach means a summation of land value and improvement costs. From this overall value, the depreciation costs are deducted to arrive at a realistic valuation for the property in question. The approach formula is:
A cost approach example would be where property X needs to be valued but has no relevant comparable in the market. To build a similar property, the following costs may be involved:
Land value = $100,000
Improvement costs = $50,000
Depreciation = $20,000
Putting these values in the formula above, it seems that Property X can be valued $130,000.
Is the cost approach realistic?
There are several advantages and disadvantages of the cost approach valuation method. Cost approach is used for properties that do not have many comparable properties available in the market. For example, if a property is unique, there won’t be existing replicas of it in the broader market.
The cost approach operates on certain assumptions that could prove to be faulty. When cost approach is used, it assumes the availability of sufficient land on which to build an identical property. A similar parcel of land may not be available, which would make the process of valuation inaccurate. It could also be challenging to find the exact building materials for the reproduction method, as certain construction materials become obsolete over time.