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.
Related: How Important Is the Market Value of Land in Real Estate Investing?
Construction Costs
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.
Related: Here’s How to Calculate Depreciation on Rental Property
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.
Related: Investing in Commercial Property vs Residential Property for New Investors
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.
