What is the Cost Approach to Valuation?
Cost approach refers to the method of valuing a property (real estate) in which the accrued depreciation is deducted from the replacement cost of the property at current prices. It is one of the basic valuation methods, holding the premise that a potential real estate user should not pay more for a property than an equivalent would cost. The cost approach is also based on the fact that real estate components could be added together and summed to get an estimate of value when valued separately. This means that the cost of construction plus the land, less depreciation is the limit of the market value. When a property is new, it yields a more accurate market value.
How Does the Cost Approach to Real Estate Valuation Work?
The cost approach methodology involves certain assumptions including land availability. If there is no comparable vacant land, then the value of the property must be estimated, which would make appraisal less accurate. The appraisal estimation would also be less accurate in the case that similar building materials are not available. The cost approach is very useful in valuing unique properties with comparable sales for new construction. If a church was to be appraised, for instance, one must use the cost approach because it is challenging to find many church sales.
Types of Cost Approach Appraisals
There are two main types of cost approach appraisals: the reproduction and the replacement method. The former assumes that a replica of a property is built and provides attention to duplication of the original materials. The latter appraisal assumes that the new structure has a similar function to newer materials, using an updated design and a current construction method.
Residential Real Estate
Residential appraisal rarely utilizes a cost approach, except in situations where the property in question is under-improved or over-improved for its neighborhood. In such a case, the improvement value with accurate estimation adds to the value determination precision, which is not possible when a comparable approach is the only appraisal used.
Special Use Properties
In the valuation of exclusive-use properties like churches, schools, and libraries, contractors always use the cost approach. Such property still generates less income and are not often marketed thereby invalidating comparable approaches and income.
Insurance
The cost approach is also applied in the valuation of insurance appraisals since the only improvement value is insurable and land value is separated from the total property value. The determining factor for this form of valuation is always a choice between the depreciation value and the reproduction value (full replacement).
Commercial Property
To appraise a commercial real estate, all the three valuation techniques are used, with the income approach being the key. In this case, the cost approach is usually included in the case that construction, design, functionality utility, require individual adjustment.
Verifying Market Conditions
When the market pricing is higher than the cost approach appraisal, it can be a sign of an overheated market. On the other hand, regular evaluations above the pricing of the market can signal a buying opportunity.