Cost Approach

What is the cost approach valuation? Property valuation method that assumes that the buyer should pay the price of constructing an equivalent building.

What is the cost approach valuation?

The cost approach valuation method is used to estimate the value of a property. This method estimates the cost of a property that the buyer should pay given that he will pay the same amount if he were to build the property from scratch. The cost of building a new property includes the value of the land, cost incurred to construct the building and cost incurred to make improvements, minus the depreciation cost of the improvements. 

This provides the buyer with an accurate value of a new property. It helps a new buyer or investor to understand what it would cost him if he purchases a new property and what it would cost him if he constructs a new building if the existing building was destroyed. A buyer would not want to pay more for a new building if he can pay the equivalent or less amount in building a new property. 

The special or unique properties in which cost approach valuation is used include schools, museums, religious buildings, hospitals and theaters. 

Why is cost approach important?‍

It is important for new buyers to know the exact amount that they can pay for unique properties by conducting research based on the value of similar properties. This method provides a reliable value estimation and is also a more useful method in comparison to other approaches to valuation.

For example, if you are a buyer and you want to purchase a new building that costs $1,00,000. Now, after researching a bit, you find out that if you were to construct an equivalent building in its place, it would only cost you $80,000. Would you still purchase the property by paying an additional $20,000? You wouldn’t. 

This is the basic idea behind the cost approach valuation.

What is the formula for cost approach?‍

The formula for cost approach is pretty straightforward as it is based on the amount that will be incurred to build a new property today, less any depreciation. Hence, the formula is:‍

Property value = Land value + Cost of the property when purchased new - Depreciation‍

OR

Property value = Land value + Cost New - Depreciation‍

What is an example of a cost approach?‍

To understand how to use the formula, here we have an example.

Suppose you want to purchase a newly built building that is only 5 years old and the land values at $50,000. Now, you find out that if you built a new building on the same land it would cost you $20 dollars per square foot for 1200 square feet of property. You also found out that the depreciation value is 20%. Here, we can use the formula as:

Property value = $50,000 + {$20 x 1200} - {20% ($20 x 1200)}‍

OR

Property value = $50,000 + $24000 - $4800

OR

Property value = $69,200

Hence, your property value is $69,200.

What is the advantage of the cost approach?‍

There are some great advantages of using the cost approach valuation method over other methods for new and unique properties. Some of the most attractive ones are as follows:

• It is the most accurate method to estimate the value of new and unique properties. 
• This method tells buyers if a property is overvalued or undervalued. 
• Cost approach valuation method includes the land value and simultaneously deducts the depreciation. This is not possible when you invest in other types of property.

What are the 3 valuation approaches?‍

There are professionals who do the real estate valuation such as appraisers, surveyors and property valuers. They use either of the three methods to determine the value of a property in real estate. These are:

1. Cost approach: This method is used by appraisers to value the property based on the cost of constructing it from scratch on the same land. It takes into account the value of the land, cost that will be incurred to construct a new building and estimated amount of depreciation of the current building. It is most helpful for determining the value of unique and new properties. 
2. Sales comparison approach: In this method, property valuers take into account the amount at which other similar properties were sold in the area in a particular time period. The time frame is usually 6 months. This is a go-to method of valuation for residential real estate. 
3. Income capitalization approach: This method is used by property valuers to find the valuation of income-producing properties such as office buildings, multi-family properties or shopping complexes. In this, the cost incurred by the investor to repair or maintain the property is taken into account.‍

What is the difference between replacement and reproduction methods in cost approach?‍

The cost approach valuation method includes two steps where the buyer can determine the estimated cost to build a new building from scratch. These two methods are replacement method and reproduction method.

Replacement cost method means determining the cost of replacing the current building with a new building using the existing construction materials, standards, layouts and designs. 

On the other hand, reproduction cost means estimating the cost of reproducing the exact same building using similar materials and construction methods. It is majorly used for historic properties. 

However, if you are only interested in estimating the cost of constructing  a new building, the amount for replacement and reproduction cost will be almost the same. 

Conclusion‍

Using the cost approach valuation method can be very helpful for people who are interested in investing in newly built properties, unique and special use properties. Additionally, it is also used by insurance companies to underwrite homeowners’ policies or while considering claims as then only the value of improvements made is insurable and the land value is separated from the total value of the property. 

This approach provides buyers with an accurate analysis and can save them big bucks if the property is overvalued.