Basic Principle
The basic principle underlying the cost approach is the principle of substitution. This principle is defined in The Dictionary of Real Estate Appraisal, Sixth Edition as:
The appraisal principle that states that when several similar or commensurate commod
Cost Approach Formula
Cost Approach Formula
Let's begin with the basic formula for the cost approach.
Reproduction or Replacement Cost New- Accrued Depreciation+ Site Value= Property Value
We start with an estimate of cost new. That will be the subject of the next chapter. The
The Dictionary of Real Estate Appraisal, Sixth Edition, defines the cost approach as:
A set of procedures through which a value indication is derived for the fee simple estate by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including an entrepreneurial incentive or profit, deductin
The IVS defines the cost approach as:
One of the approaches to value commonly applied in Market Value estimates and many other valuation situations. A comparative approach to the value of property or another asset that considers, as a substitute for the purchase of a given property, the possi
Fee simple estate is defined as:
Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.
So the basic application of the cost approach formula will indicate
Reproduction cost is defined as:
The estimated cost to construct, at current prices as of the effective date of the appraisal, an exact duplicate or replica of the building being appraised, using the same materials, construction standards, design, layout, and quality of workmanship and e
Replacement cost is defined as:
The estimated cost to construct, at current prices as of a specific date, a substitute for a building or other improvements, using modern materials and current standards, design, and layout.
The IVS weighs in and defines replacement cost (new) as:
A repla
Entrepreneurial incentive is defined as:
The amount an entrepreneur expects to receive for his or her contribution to a project. Entrepreneurial incentive may be distinguished from entrepreneurial profit (often called developer's profit) in that it is the expectation of future profit as opposed
Depreciation is defined as:
1. In appraisal, a loss in property value from any cause; the difference between the cost of an improvement on the effective date of the appraisal and the market value of the improvement on the same date. See also external obsolescence; functional obsoles
Approaches to Value
The cost approach has been around for quite a while. It is the oldest of the three traditional approaches that appraisers use. If you were an appraiser back in 1940, all you would have used was a cost approach.
As time went on the sales comparison approac
Cost Approach Applicability
It is important that you know when to apply the cost approach and when not to. If the approach is applicable, it is the appraiser's call (as part of the scope of work decision) whether to develop it. If the approach is necessary for credible assignment re
USPAP
USPAP establishes a number of standards rules. Certain work or analysis is required in all appraisal assignments and other types of work or analysis are only required if they are necessary to produce credible assignment results.
We are required to develop
The cost approach is most applicable when:
A lack of market activity precludes the use of the sales comparison approach
The property is not typically income producing and the income capitalization approach is not pertinent
The building improvements are new or relatively new
The land value is well
A lack of market activity precludes the use of the sales comparison approach.
This is a key factor. You can't develop the sales comparison approach without a reasonable amount of reliable sales data. There are times and there are certain areas where this is just not possible. It may also not be possible when you have unusual proper
The building improvements are new or relatively new.
The cost approach has good applicability when the improvements we are appraising are new or relatively new. The first step in the cost approach is to estimate the cost new of the building improvements. If it was recently built it most likely was construct
The land value is well supported.
Another step in the cost approach is estimating the value of the land or site. If it's a standard lot and there are adequate sales in the marketplace, it becomes a relatively easy and straightforward task to arrive at that value.
If the land is unusual in
The improvements represent the highest and best use of the land as though vacant.
The ideal situation for developing a cost approach is where the current building improvements truly do represent the highest and best use of the land as though vacant. Any time we stray away from that ideal, there is potential for errors.
Some properties
Estimating the use value of special purpose properties.
Special-purpose properties are sometimes called no-market properties. They represent things that are not normally bought and sold in the marketplace.
They include properties such as churches and schools, for example. That's not to say that churches and sc
Building additions or renovations are being considered.
Let's suppose you are asked to appraise a 30-year-old ranch house with a proposed addition that will include 800 square feet, three rooms, a full bath, and a fireplace. You may not be able to find sales of comparable properties that have an older house wi
The appraisal requires that land and improvements be valued separately; such as for insurance or accounting purposes.
This becomes an easy task for the cost approach. We cannot do a cost approach without valuing the two components of land and improvements separately.
When we perform a sales comparison approach of improved property, it is difficult to isolate these two el
Land value is a significant portion of the overall value; such as with agricultural properties.
You may be faced with appraising 400 or 500 acres of valuable farmland whose only improvements are a rickety old farmhouse and several sagging outbuildings. Again, finding improved comparable sales may be a problem. Even if you do find sales of similar im
Here are some situations in which the cost approach is least applicable:
The depreciation is a type that is more difficult to estimate
Data is scarce or lacking to estimate the amount of entrepreneurial profit
Data is scarce or lacking to estimate the land value
The interest valued is anything other than fee simple - adjustmen
The depreciation is a type that is more difficult to estimate.
I know we haven't gotten to depreciation yet, other than to define it as a loss in value from any cause. Depreciation is a difficult topic and it comes in many forms. We'll spend considerable time covering it later in the course.
Depreciation is one of th
Data is scarce or lacking to estimate the amount of entrepreneurial profit.
Entrepreneurial profit is another topic that we have not explored in depth yet; however, it is one of the vital ingredients of estimating the cost new of a structure. Investors must be motivated, or else they will not take on a project.
The same situation
Data is scarce or lacking to estimate the land value.
We can have the most elaborate and accurate cost estimates possible, but that is just one of the ingredients in the cost approach. As we discussed in earlier chapters estimating land value is sometimes a difficult issue.
If we are in one of those problem
The interest valued is anything other than fee simple.
We said at the beginning that the cost approach should result in an estimate of value of the fee simple interest. If we are appraising any unusual interests such as life estates, leasehold estate, partial estates, trusts, etc. the value may be better refl