Cost Approach in Appraising Real Estate

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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.

Age-Life Method

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.

Reproduction Cost

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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