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The Cost Approach to Valuation
The Cost Approach is based on the principle of substitution which asserts that no prudent buyer or investor will pay more for a property than that amount for which the site could be acquired and which improvements that have equal desirability and utility can be constructed without undue delay.  It is a method of appraising property based on the depreciated reproduction or replacement cost (new) of improvements, plus the market value of the site.

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This approach has the most validity/reliability when improvements are new or near-new. For older/aged structures, the cost approach may not be relevant due to the greater subjectivity involved in estimating accrued depreciation

The cost approach begins with the determination of site value. Sales of vacant land with similar zoning, utility, and acquired for the same or similar use as the subject property being appraised, are analyzed.  In markets where site sales are limited, other site sales of varying property type may be considered as long as they have core similarities in legally acceptable use.

Once site value has been determined, reproduction or replacement costs of the improvements are estimated as if the improvements were new.  The estimate is then further adjusted for all elements of accrued depreciation including physical depreciation, functional and/or external obsolescence. 

The following breakdown method shows how the cost approach is used to value a commercial building. 

 
 

Cost Approach Analysis

Improvements

Building Improvement

6937

Sq Ft @

$ 86

Sq Ft

$ 594,778

Other Improvements

$ 32,000

Canopy

567

Sq Ft @

$ 25

Sq Ft

$ 14,175

Estimated Reproduction Cost New

$ 640,953

Estimate Of Physical Depreciation

A. Physical, Curable (Deferred)

$ 2,500

Physically Curable

$ 2,500

B. Physical, Uncured (Anticipated Future)

Items

Cost New

x Deprec

$Deprec

Roof

$ 25,000

33%

$ 8,250

Mechanical

$ 20,000

33%

$ 6,600

Floor Cover

$ 8,000

50%

$ 4,000

HVAC

$ 48,000

30%

$ 14,400

Subtotal

$ 101,000

Physically Uncured (Short Lived)

$ 33,250

C. Physical, Incurable (Based On Observed Condition-Estimated)

1. Chronological Age (Actual)

20

Yrs

2. Effective Age

15

Yrs

3. Remaining Economic Life

30

Yrs

4. Estimated Life Expectancy,

             Similar New Building

45

Yrs

5. Reproduction Cost New

$ 640,953

6. Proportionate Cost - Basic Structure

$ 640,953

Less

$ 103,500

$ 537,453

7. Estimated Physical Depreciation - Long Lived

15

(/)

45

33.33%

Uncured (Long Lived)

$ 537,453

(x)

33.33%

$ 179,133

Total Physical Depreciation

$ 214,883

Estimate Of Functional And External Obsolescence

A. Functional Obsolescence

$ 0

B. External Obsolescence

$ 0

Total Estimate Of Accrued Depreciation

$ (214,883)

Subtotal

$ 426,070

Site Improvements

$   30,000

FF & E

$   10,000

Site Value Brought Forward

$ 814,000

Subtotal

$ 1,280,070

Estimated Depreciated Value

Cost Approach

R

$ 1,280,000

 

Accrued Depreciation

Any diminishment, loss of utility, or loss in value of a building calculated from the time the structure was built to the present. Accrued depreciation is calculated as the difference between what it would cost to replace the building new and the current appraised value of the building.

A method of estimating accrued depreciation by applying to the reproduction cost new of the property the ratio of the property's effective age to its economic useful life.

 
Economic Life
 
The period of time that improvements contribute to value.  Can be shortened by a  change in zoning such as from residential to commercial e.g., commercial land values exceed the combined value of the land and home as a residential dwelling.
Effective Age
 
The age indicated by the observed/perceived condition and utility of a structure (as opposed to chronological/actual age).

External Obsolescence 

A defect (usually incurable) outside the property that negatively affects value. (An element of accrued depreciation).  Examples include heavy traffic on a residential street, commercial businesses encroaching into a residential neighborhood, etc. 

Functional Obsolescence

Incurable Functional Obsolescence
A defect caused by a deficiency or a superadequacy in materials, structure, or design.  Example: an in-ground swimming pool in a neighborhood where this item is not essential to value. 
Curable Functional Obsolescence
A curable defect in the structure, materials, or design.  Example: a four bedroom home with only one bath.
 
Incurable Physical Deterioration
 
A defect caused by physical deterioration that is impractical or not economically feasible to repair.  Example: a roof that is worn but does not require immediate repair and still has 5 to 6 years remaining physical life. 

Physical Depreciation

Wear and tear on the improvements - includes deferred maintenance (items needing immediate repair), short-lived components (furnaces, hot water heaters, roof, carpet, etc.), and long-lived components.

Replacement Cost

The cost of erecting a building to replace or serve the functions of a previous structure.

The cost of exact duplication of a property as of a certain date. Reproduction differs from replacement in that replacement requires the same functional utility for a property, whereas reproduction is an exact duplication.

 
 
         

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