A Guide to the Cost Approach to Real Estate Valuation

When it comes to estimating the market value of real estate, some choose to use the cost approach. The other two methods are the income approach and the sales comparison method. We’ll give you a brief description of each valuation method before diving deeper into the cost approach.

The income approach can be most accurately used when conducting commercial property valuation on income properties in active markets. This method considers the value of investment property as the present value of future expected cash flows generated by the property. In short, valuation is based on the property’s ability to generate monthly income.

The sales comparison method uses the market price of real estate comps (similar properties which recently sold in the same market) to estimate a property’s value. It’s best to use this method in cases of high similarity between properties selling under similar market conditions in the same time period. So both of these appraisal approaches rely on active markets.

Now, what is the cost approach method?

The Cost Approach in Real Estate

Definition

To put it simply, this method takes on the approach of valuing a property based on the cost of the building and the market value of the land. So there are two main market values to consider here: the building itself and the land it’s on. The cost approach values real estate properties based on how much the building would cost if it needed to be replaced; or the cost it would take to build an equivalent building. After factoring in the land value and deducting any loss in building value (real estate depreciation), the cost approach yields an accurate market value.

Property buyers who use this approach typically do so for newly constructed or renovated properties. The logic with this real estate valuation method is that there is no sense in paying more for a property if building its replica would cost less.

Calculation

As mentioned, there are three main components when it comes to valuating investment property with the cost approach. The value of the land, the cost of building construction, and real estate depreciation. The cost approach formula is:

Market Value= Land Value + Building Construction Cost – Building Depreciation

The cost of the land is taken at its current market value, regardless of whether you can get it at a deal for a discounted or premium price. There are two approaches that real estate investors can take when finding the construction cost of the building:

Replacement Cost Approach: This assumes the cost of using current materials and construction methods to construct a building with the same function/utility.
Reproduction Cost Approach: Here more focus is given to the creation of a replica for this building using the same materials, construction method, and design at the original time it was built.

As you can assume, for newer properties, there really won’t be a difference between the two methods. However, when using the cost approach to value a historic building, there will be a significant cost difference.

Breaking the Formula Down

Let’s take each part of the cost approach calculation and give it a deeper look. How can each one be found?

Land Value

The easiest way to determine the value of the land is to simply compare it to the price of recently sold plots of land. While real estate investors can use other techniques, directly comparing the land is what’s most common.

Construction Costs

what is the cost approach?

There are a lot of costs to take into consideration when determining the cost of building. Let’s start off by differentiating between direct and indirect costs. Direct costs are any costs directly associated with the construction process (direct labor and material costs). Indirect costs are the other costs that come along with a construction project (insurance, taxes, administrative fees, etc.).

Whether you’re using the replacement or reproduction cost approach, there are four main methods to choose from when finding total building construction cost:

Comparative Unit Method: Start off with a lump-sum estimate per square foot. Then categorize costs according to construction materials. These categories can be narrowed down further based on quality.
Segregated Cost Method: From the name, you can tell that costs are not taken from a lump-sum view. Here component costs are directly related to separate construction material and quality, then added up. So take individual costs of things like the roof, plumbing, flooring, etc. and then combine them to get the final cost.
Unit-in-Place Method: This method is similar to the previous one but it breaks down each major cost material into its more detailed cost components. Include overhead costs in this method.
Quantity Survey Method: This method requires the most time, but it is the most accurate. Here, each individual cost involved in construction/renovation is estimated.

Depreciation

To get an accurate estimation of the investment property’s value, you must include any deductions for actual loss in that value. When it comes to calculating real estate depreciation in the cost approach, there are three forms to consider:

Physical: This is a result of the building aging and normal wear and tear.
Functional: Any changes in target needs and preferences which could lower the property’s utility need to be taken into account.
External: This refers to depreciation caused by adverse trends in the market or neighborhood the real estate property is in.

If you’re looking for the most accurate and comprehensive method for calculating depreciation, use the breakdown method. This includes each factor from all the mentioned forms. After adding them all together, you get total depreciation.

When to Use the Cost Approach

Rental property owners should know that residential appraisals don’t traditionally use the cost approach method. Usually, investors use the real estate prices of rental comps to valuate properties (sales comparison method). Real estate professionals sometimes use the cost approach method for new construction, commercial properties, or special use properties (like libraries or schools).

If you need to find real estate comps, Mashvisor’s investment analysis tools can help. Learn more about our product.

If you choose to do a valuation using the cost approach, here’s a tip. When the final valuation comes in below the property seller’s asking price, you could be facing an overheated market. If the property’s market value ends up being above market pricing, you could be looking at a buyer’s market.

While it’s important for real estate investors to understand how to value their properties, getting accurate appraisals can be difficult. You should consider turning to a professional in the later stages of a transaction.

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