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Approaches to Value: Cost Approach

Within any given real estate appraisal, there are three approaches the appraiser may utilize to develop an opinion of value; The Sales Comparison Approach, Income Approach, and Cost Approach. These “approaches” represent the analytical method for collecting, analyzing, interpreting and aggregating data, which result in the value opinion. This post is dedicated to a summary of the Cost Approach. The Cost Approach will first be explained in an easy to understand manner, specific details can be found below.

For additional questions, or to post your experiences with the Cost Approach, please use the comment section provided below.

Short Description

The Cost Approach arrives at an opinion of value by adding the land value to the depreciated value of the improvements, which is based on cost.

The Cost Approach Explained

The Cost Approach is one tool in the appraisers toolbox, which should be used under appropriate conditions. Just as a hammer would not be used to get a screw into the wall, the Cost Approach will not produce credible results in all situations.

Generally, the best and most reliable situation for utilizing the Cost Approach is on newly constructed properties  operating within “Normal” market conditions. This is because estimating the correct amount of depreciation can be difficult, if not impossible to objectively identify, whereas a new building is generally perceived as having little to no depreciation, if built correctly. Additionally, in markets that are in recession or expansion, the cost to build new may be higher or lower than what buyers are willing to pay. Though External Obsolescence attempts to account for this factor, it is extremely difficult to objectively attach a percentage adjustment to a market in this stage of the real estate cycle.

As a practical matter, the Cost Approach arrives at an opinion of value based on the site value, in addition to any improvements done to the property and their corresponding cost (improvements would constitute buildings and/or site additions such as landscaping or paving). If developed correctly, this approach can account for potential deficiencies of the property, in addition to market characteristics, development fees, soft costs, cost trends (location & time) and more.

Detailed Description

The Cost Approach is devoted to an analysis of the physical value of the property; that is, the value of land, assuming it to be vacant, to which is added the depreciated value of the improvements present on the site.  The latter is derived based upon an estimate of the cost of reproducing or replacing the improvements, from which must be deducted accrued depreciation in terms of physical deterioration, functional obsolescence and external obsolescence, if any.

  • Physical deterioration measures the physical wearing out of the property as observed during the field inspection.
  • Functional obsolescence reflects a lack of desirability by reason of layout, style or design; and
  • External obsolescence denotes a loss in value from causes outside the property itself, such as the macroeconomic conditions or neighborhood trends.

Within the Cost Approach, the appraiser may elect to utilize cost estimates for either the Reproduction Cost or Replacement Cost. Only one of these approaches is utilized, which should be a result of the situation of the property (age) and needs of the client.

Reproduction vs Replacement Cost

Reproduction Cost represents an exact duplication of the property, whereby Replacement Cost represents the cost to construct a similar property. More specifically, according to the HUD/FHA Handbook:

Reproduction Cost: Exact duplicate with all deficiencies and obsolescence
Replacement Cost: Cost at current prices with equivalent utility (utility meaning “function”)

Process for Developing The Cost Approach

Like all approaches to value, the Cost Approach can follow either a linear or dynamic process of development , though it is best explained on a step by step basis (linear). Provided below is a general outline of how one can undergo the Cost Approach, utilizing the Replacement Cost method.

Step #1: Land Value: The first step in developing this approach is to estimate the value of the site, as vacant. The “as vacant” assumption is integral to the land value opinion because it does not take into account any potential cost to destroy existing improvements or to dispose of the materials.  If Insurable Value is sought, these costs may be deducted. Although the land value will not be added  into the equation until the last step, it is generally the first thing done within the Cost Approach.

The most common way to value the land is to find comparable sites that have sold, adjust for any differences in the transaction ranging from physical site characteristics to transactional differences such as seller financing, and analyze these comparable sites on either a per square foot or per acre basis. This is known as the Sales Comparison Approach, which is typically the most reliable way of estimating market value for land, without getting into an extensive development/feasibility analysis which may contemplate the value of the land based on its development potential. The land value will be the crutch of the entire Cost Approach, therefore, it is important to take care when determining the price per square foot (a $0.50/SF difference on a several hundred acre site may have a devastating effect on the total site value).

Hypothetical Example: The concluded value for the property’s (a hypothetical property not in existence) site is $10.00 per square foot, and the total site is 25,000 square feet. The result is:

$10.00 x 25,000 = $250,000

Site Value = $250,000

Step #2: Building Improvements: After the value of the land is determined, the cost of the buildings improvements must be generated. This is most commonly done by multiplying the various space types by their respective sizes, in square feet. Selecting the appropriate space type is typically done based on the type of construction, as this is the most pertinent to cost. If there are multiple space types, each space type total would feed into the final cost of the building improvements.

Hypothetical Example: The property (a hypothetical property not in existence) has a convenience store measuring 2,000 square feet, and a carwash measuring 1,000 square feet. The cost to construct the convenience store portion is estimated at $160.00/SF, while the cost to build the carwash portion is $130.00/SF, not including the carwash equipment. The result is:

C-Store portion – 2,000 SF x $160 = $320,000

Carwash portion – 1,000 SF x $130 = $130,000

Total Building Improvement Cost Before Depreciation = $450,000

Step #3: Site Improvements: Next, any specific site improvements done on the property must be examined. This would include things like site work (grading, utilities), landscaping, paving, or other improvements to the site that are not part of the building.

Hypothetical Example: The property (a hypothetical property not in existence) is 25,000 SF in size and has the following site improvements:

Site Work – 25,000 SF x $2.00 = $50,000

Landscaping (10% of site) – 2,500 x $6.00 = $15,000

Paving (20% of site) – 5,000 SF x $3.00 = $15,000

Total Site Improvements = $80,000

Step #4: Total Improvements (Site & Building) Before Depreciation: Simply add the Site Improvements to the Building Improvements:

Total Site Improvements = $80,000

Total Building Improvement Cost Before Depreciation = $450,000

Total Replacement Cost Before Depreciation = $530,000

Step #5: Multipliers: Current and local cost multipliers take into account fluctuations of costs through time and location. The current multiplier as of July 2010 was 1.0, which takes into account market fluctuations in pricing (cost), relative to when the initial price per unit came out. Put another way, if costs are up or down, the current multiplier will adjust for this. The local multiplier for Denver was 0.99, which takes into account the location of Denver and the relativity of distribution costs. Indirect fees can also get lumped in at this time which takes into account various land carry costs, financing fees, appraisal, attorney, etc.

Hypothetical Example: Current Multiplier of 1.0, Local Multiplier of 0.99, Indirect Fees of 1.20 (20% of costs). The result is:

1.0 x 0.99 x 1.20 = 1.188

1.188 x $530,000 (Total Improvement Cost)

= $629,640

Step #6: Deduct Depreciation: This step involves deducting for any potential depreciation on the property. This takes into account Physical Deterioration, as well as Functional and External Obsolescence (also explained in this post), which would lower the value of the entire property. Estimating depreciation is very difficult and involves a high level of skill, though it is sometimes criticized  as being “subjective”, there is no other way to reconcile the fact that there may be outstanding circumstances, such as an old building, a dated floor plan that is no longer appealing, or a depressed market. Depreciation is typically estimated on a percentage basis.

Hypothetical Example: The property is relatively new, has a good floor plan, though neighborhood pricing is trending down:

Physical Depreciation = 5% – $31,482

Functional Obsolescence = 0% –  $0

External Obsolescence = 5% – $31,482

Total Depreciation = 62,964

Step #7: Total Depreciated Value of Improvements: Now that the amount of depreciation has been established, it is deducted from Total Improvement Cost to arrive at the Total Depreciated Value of Improvements.

Hypothetical Example: The property is relatively new, has a good floor plan, though neighborhood pricing is trending down:

Total Replacement Cost (New) = $629,640

(LESS) Depreciation = 62,964

= $566,766

Step #8: Developers Incentive: It this point, there is a relative understanding of the raw costs to bring the project to completion. However, without a profit of some sort, a developer would not be interested in taking on the risky venture of borrowing money and constructing a building. Estimating the amount of incentive a developer would need is typically a function of the project type, location, and market timing, though is generally in the 10% to 30% range.

Hypothetical Example: Developers incentive is estimated at 15%:

Developers Incentive (15%) x Depreciated Value of Improvements ($566,766) = $85,001

Depreciated Value of Improvements PLUS Developers Incentive = $651,767

Step #9: Add Back Land Value: The last step is to add the value of the raw land into the equation. This is done as the last step due to the fact that land is not depreciated under real estate appraisal principles. Once again, this is a hypothetical example used to illustrate the Replacement Cost method:

Land Value = $250,000

PLUS Depreciated Value of Improvements w/ Developer Incentive = $651,767

Hypothetical Cost Approach Value Opinion = $901,767

Rounded = $900,000