Cost Approach to Real Estate Valuation Definition

Cite this article as:"Cost Approach to Real Estate Valuation Definition," in The Business Professor, updated March 18, 2019, last accessed August 5, 2020, https://thebusinessprofessor.com/lesson/cost-approach-to-real-estate-valuation-definition/.

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Cost Approach Definition

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.

A Little More on What is the Cost Approach to Real Estate Valuation

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.

References for Cost Approach

https://www.investopedia.com/terms/c/cost-approach.asp

https://en.wikipedia.org/wiki/Cost_approach

http://www.businessdictionary.com/definition/cost-approach.html

Academic Research on Cost Approach

  • The economics of organization: The transaction cost approach, Williamson, O. E. (1981). American journal of sociology, 87(3), 548-577. This article describes the transaction cost approach and its financial effect on an organization. According to the author, the transaction cost approach refers to the study of economic organization which includes transaction as the basic unit of analysis. The transaction cost approach also holds that understanding of transaction cost economizing is the best way to study organizations. According to the author, the transaction cost approach application requires the dimensionalized transaction and that alternative governance structures are described. The approach involves both the efficient boundaries determination and the internal transactions organization including the design of employment relations. The author further compares and contrasts the transaction cost approach with selected part of theory literature of organizations.
  • A transaction cost approach to make-or-buy decisions, Walker, G., & Weber, D. (1984). Administrative science quarterly, 373-391. This study explores the concept of transaction cost approach. It focuses on make-or-buy decisions as paradigmatic problem used to analyze transaction costs. The author tests Williamson’s hypothesis on the efficient boundaries framework using multiple-indicator structural equation model. The authors also assess the influence of transaction costs on decisions to make or buy components; the assessment was conducted indirectly through the supplier market competition effects and 2 types of uncertainty, technological and volume. Apart from the transaction costs, the authors hypothesized the decisions which are to be predicted by the buyer production experience and the comparative production costs between the supplier and the buyer. They then tested the hypothesis using make-or-buy decision sample in a division of an automobile company in the US. The findings reveal that comparative production costs are strong predictor of make-or-buy decisions and that both volume uncertainty and supplier market competition has effects that are small although significant. The authors use complexity of the components and the communication patterns and influence among managers who make key decisions to explain the findings.
  • A transaction cost approach to families and households, Pollak, R. A. (1985). Journal of economic Literature, 23(2), 581-608.  This article illustrates how the transaction cost approach is relevant to households and families. The author asserts that social scientists have discovered, over the years, that households and families are fit subjects for serious analysis. There has been a gap in proper analysis as most of the family analyses have been conducted by demographers, anthropologists, sociologists, and historians who do not consider the economic and market role of the units. The author, therefore, begins to analyze the traditional economic theory of households as well as the weaknesses. Based on the observed gap, the author introduces the transaction cost approach.
  • A transactions cost approach to the theory of financial intermediation, Scholes, M., Benston, G. J., & Smith Jr, C. W. (1976). The Journal of finance, 31(2), 215-231. The authors of this study applies the transaction cost approach in accordance with the theory of financial intermediation. First, they explore the concept of financial intermediation and how this affects monetary policy through the theory of financial intermediaries. This approach, however, has been criticized by several authors who assert that since financial intermediaries are firms, they should be analyzed using microeconomic tools that are used in the case of industries. Furthermore, authors suggest that the intermediaries maximize something, sometimes growth or utility.
  • A transaction cost approach to outsourcing behavior: some empirical evidence, Aubert, B. A., Rivard, S., & Patry, M. (1996). Information & management, 30(2), 51-64. This article presents the findings of an outsourcing behavior study involving 10 large organizations. The author asserts that outsourcing of information services is a fast growing trend and continues to receive attention in the community. The study utilized the transaction cost framework to illustrate the concept outsourcing behavior in 2 different levels. In the first level, the authors investigate the role of asset specificity, measurement problem, and the frequency in explaining the choice of outsourced activities. The second analysis level focused on the influence of asset specificity and measurement problem on the contract terms and management between a firm and the outsourcer. The findings presented support the basic principles of transaction cost and theories of incomplete contract.
  • A transaction cost approach to supply chain management, Hobbs, J. E. (1996). Supply Chain Management: An International Journal, 1(2), 15-27. This article explores the concept of transaction cost approach to explain the process of supply chain management. It is observed that supply chain management is a rapidly growing concept with provide insights into how industries are organized as well as the efficiency gains made under different organizational structures. The author also explores supply chain management as an interdisciplinary concept which draws its assumptions from several aspects of economics, marketing, logistics, and organizational behavior. The article also presents a framework from economics literature which is found useful for those interested in understanding the concept of supply chain management. Further, the potential effects of transaction costs are discussed in line with vertical coordination within an industry. Finally, the authors suggest key methods for empiricizing transaction cost analysis which results in recommendations for closer co-operation between business managers and researchers.
  • Strategy, structure and performance of Korean business groups: A transactions cost approach, Chang, S. J., & Choi, U. (1988). The journal of industrial economics, 141-158. This article explains the concept of transaction cost approach through the structure and performance of Korean business groups. The authors utilize transaction coast approach to analyze the diversification strategy as well as the resulting structure chosen by business groups in Korea to overcome market imperfections common in developing nations. It is assumed that business groups that have multidivisional structure show superior economic performance since such structure reduce transaction costs which emerge from organizational failure. Additionally, key Korean business groups have “relational structure” which show both vertical integration and conglomerate characteristics.
  • Explaining inter-firm cooperation and innovation: limits of the transaction cost approach, Lundvall, B. Å. (1992). In Explaining Inter-firm Cooperation and Innovation. Rutledge. This article explains some of the limits of the transaction cost approach in regard to inter-firm cooperation and innovation. The author, Lundvall, reveals the key assumptions of the approach and how firms utilize the approach to carry out evaluation.
  • Making the information systems outsourcing decision: A transaction cost approach to analyzing outsourcing decision problems, Ngwenyama, O. K., & Bryson, N. (1999). European Journal of Operational Research, 115(2), 351-367. This paper uses a transaction cost approach to analyze outsourcing decision problems. In the past decade, outsourcing has emerged as a key issue in information systems management. As competitive forces pressurize business firms, management teams are structuring their organizations with the aim of attaining or maintaining competitive advantage. Several IS outsourcing strategies have emerged, and some outsourcers are already contracting with a single sole vendor while other contract with several. Up to date, no studies are available to determine the appropriate strategies under specific conditions. The study explores how managers choose from a set of options that are appropriate to the firm; this is crucial since a wrong decision can result in the loss of core capabilities and competencies, and exposure ot unexpected risks.
  • From transaction cost to transactional value analysis: Implications for the study of interorganizational strategies, Zajac, E. J., & Olsen, C. P. (1993). Journal of management studies, 30(1), 131-145. In this article, Zajac and Olsen (1993) examines interorganizational strategies in regard to the perspective of a transactional value rather than a transaction cost. The authors argue that transaction cost perspective has limitation when they are considered as analysis tools for interorganizational strategies. The limitations include: (1) a single-party, cost minimization emphasis which neglects the interdependence between joint venture exchange partners; and (2) over-emphasis on interorganization exchange’s structural features that neglect important process issues. Thus, the authors propose a transactional value framework that analyzes interorganizational strategies. They also discuss the implications of the current approach for the study of interorganizational strategies as well as for the transaction cost perspective.

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