Can the cost approach be used over the sales comparison approach since it’s higher?

sales comparison approach vs cost approachThis was a question I got asked today from a frustrated seller. She had called me to get my opinion of an appraisal that was done on her home that had appraised lower than the contract amount. I would like to share with you my answer to her as well as my thoughts on the cost approach to value and its relevance in an appraisal.

A little background is in order before we get into my response to her question. As I stated, she had just received a copy of the appraisal on her home which was under contract, and it had come up short of the contract price. She noted that the cost approach had come in very close to the contract amount but the sales comparison approach was much lower. She asked me why the cost approach couldn’t be given more emphasis in the appraisal since it was closer to the contract price.

The cost approach is one of the three approaches to value, along with the sales comparison and income approach, that an appraiser uses to estimate the value of a property. Unless a property is being rented, or is in a market with numerous rentals, the income approach does not provide a very reliable estimate of value. This leaves the cost approach and sales comparison approach as being the most commonly used approaches to value. The cost approach considers current construction costs while taking into consideration depreciation and then adds in the value of the land. This approach is typically more accurate on newer homes because it can be difficult to accurately estimate depreciation. The last approach to value considered is the well known sales comparison approach, where recent sales are compared to the home being appraised. After adjustments are made for value differences between the subject and sales a range of value is provided that the appraisers uses to reconcile a value estimate from the sales comparison approach.

After these two approaches to value are developed the appraiser must then determine which approach is the most appropriate for the subject. In the past several years an interesting scenario has developed where building costs have continued to rise and property values of existing homes have dropped due to the collapse of the real estate market. Large inventories of homes and an increase in foreclosures and short sales have driven prices down, widening the gap between the cost approach and the sales comparison approach. Sales statistics are showing that the market is in the process of recovering, however there can still be a significant difference between the cost and sales comparison approach to value.

The appraiser’s job is to determine which approach best reflects the market value of the home. Because a reasonable and well informed buyer will typically pick the least expensive alternative, the sales comparison approach is usually given the most emphasis in the final value reconciliation. This is why the cost approach cannot be given the most emphasis just because it is closer to the contract price. The approach that best reflects the actions and motivations of buyers in the market is the one that is given the most emphasis. So as you can see while the cost approach may be similar to the contract price the majority of home buyers will usually look at what other homes have sold for as well as what is available for sale and make an offer based on what they find. This would reflect the most accurate market value and the sales comparison approach would be given the most emphasis.

I hope my explanation has helped you understand how the appraiser would emphasize the sales comparison approach over the cost approach in their final opinion of value. If you have any further questions about how appraisers arrive at the appraisal value leave me a message below.

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  1. The Real Tom Horn says

    This statement does not follow logically “Because a reasonable and well informed buyer will typically pick the least expensive alternative, the sales comparison approach is usually given the most emphasis in the final value reconciliation.” This implies that the least expensive alternative is equivalent. A “well informed” buyer would also consider deterioration of existing home, variance from current code and other factors that depreciate the value relative to new construction.

    • You are correct. They would consider depreciation so the sales comparison is usually the most accurate since these factors are “built-in” to the sales price and depreciation in the cost approach is a little more difficult to estimate.

  2. Morgan McCord says

    Hi Tom, I am wondering if you could explain to me what it might mean if the valuation by Cost Approach is significantly lower than the value by Sales Comparison (Market) approach.     Conversely, what might it mean if the valuation by Cost Approach is significantly higher than the value by Sales Comparison (Market) approach.   

    • There could be various reasons for the cost approach to vary from the sales comparison approach. One could be that the cost data or land value is not accurate. Another reason could be that the estimate of depreciation was not calculated accurately. The cost approach is most accurate with newer homes because of the minimal accrued depreciation. If the cost approach was accurately completed and it is lower than the sales approach this may indicate that the buyers are placing more value on existing construction and the benefit of being able to get into a home immediately rather than wait several months. I hope this was helpful.

  3. Tom,

    This is a very interesting topic. I got my appraisal last september 2017 (for the Birmingham/Hoover market), let’s say the the Cost approach came to $297k and the Sales Comparison approach came for $260k. That is a huge difference! Where I live there are houses that go from $150k to $500k if I step out of my neighborhood (which if you know the area is close to Sandpiper rd, close to the not so great Wine Ridge and the amazing Heatherwood/South Lake). How can you guys make an “informed” decision to select what comps are the ones they should pick to do the appraisal and why the almost $40k difference? It seems illogical that is a matter of perception rather than science. Am I wrong?

    • Thanks for your question, Juan. When we pick comps it is important to choose from an are that call a “competitive market area”. This means that they are areas that a buyer for the neighborhood we are appraising would also look. This means that they have similar schools, similar in style, quality, price range, etc. I know the area you are talking about. The Wine Ridge neighborhood is older homes and most of the homes if not all are located in the county with county schools, which is a big determinant of value. The Heatherwood and South Lake area has some very high-quality homes so if comps were chosen from this neighborhood it would be important to use those that are similar in size, bedroom bath count, etc. When valuing property 90% of the task is choosing the best comps and in order to do that you have to know the area you are working in and then match up the comps with the most similar physical characteristics.

      • First of all, thank you for taking time to reply Tom. I went back and review the comps. As you know Hoover has a very particular school system. They have special zones. It just so happen that I live in Hoover and zoned for Hoover schools and some of the comps were picked for Shelby county (oak mountain, etc). Also can you comment how normal it is to have an almost $40k difference on cost to comp approach? that seems to be a huge gap

        • It is preferable to use sales from Hoover schools if they are available. If they were not that may be the reason the appraiser used Oak Mountain sales. Sometimes there can be variances between the cost approach and sales approach due to the difficulty with estimating depreciation or in estimating land value. The cost approach is not very relevant except in cases where the property is new construction. The sales comparison approach provides the best indication of market value for existing homes.

  4. john carroll says

    Is it applicable or even reasonable to make a depreciation adjustment on the Age Line of the sales comparison approach especially when there is a clear evidence that older homes in this particular neighborhood have a higher resale value than newer homes with less improved conditions. Not sure that I would support an age adjustment on the sales grid for an older home when the subject property is newer while the comps with an older YOC have more upgraded conditions which is also supported by the market participants reactions to paying a higher final sales price for these older homes. please comment.

    • It sounds like you are saying that older homes sell for more because they are older. If this is what you mean then are you suggesting that the older home is superior to the newer home and should have a negative adjustment made to the age line? If so, that does not line up with conventional wisdom because older homes typically have a positive adjustment made to the age line since they would be considered inferior in age to the subject. If the older homes are selling for more than newer ones maybe it is something else, like design and appeal? Not sure what the age difference is but sometimes buyers do like the design and appeal of older homes. Your thoughts?

  5. I received an appraisal on a subsidized apartment community. The only approach used by the appraiser was the income approach. The community is fairly new, built in 2014 why wasn’t the cost approach included

    • I am not a commercial appraiser so I am not totally familiar with the reasoning behind their decision not to include the cost approach. It might be because the community is subsidized. Since it is not getting full rent the cost approach would probably overstate the value.

  6. I have a question. If the cost approach takes in all types of depreciation, including external depreciation (over supply in market), shouldn’t the Sales Comparison Approach always equal the Cost Approach, if all depreciation is truly accounted for?

    • Bryan, you are correct. If your market data indicates any type of depreciation then this should be reflected and accounted for in the cost approach and the sales comparison and cost approach should correlate.

      • I guess what I am saying is if we utilize the Sales Comparison Approach and have decent comparables wouldn’t it be correct to just make a deduction under external depreciation to make the Cost Approach equal the Sales Comparison Approach, stating that the external depreciated is derived and supported by the Sales Comparison Approach. Like if the Cost Approach without external depreciation is $46,000.00 higher, just making a – $46,000.00 deduction under external depreciation and the Cost Approach is now finished? I know it seems redundant but wouldn’t that actually be correct and supported by the research you just finished?

        • If you have analyzed sales and came to the conclusion that there is $46,000 worth of external depreciation (let’s say the home is located next to a chemical plant that has a bad smell, and homes next to the plant sell on average for $46,000 less than others not located next to the plant) then you would take the $46,000 and insert it into the cost approach under external depreciation to arrive at a cost approach estimate that takes into consideration physical and external depreciation.

  7. As a buyer, when the cost approach comes out lower than the sales comp, it is reasonable to go by the cost approach? Thanks.

    • If accurate cost data has been used then what this tells me is that prices are such that it makes more sense to build than to buy existing construction. This could be caused by low inventory and increased demand. You also need to consider the time involved in new construction. Bottom line is that if the cost is lower then it is the most economically feasible thing to do and should be considered as a reasonable alternative.

  8. Hi Tom, just a personal observation, the appraisal rules seem to work fairly well for normal track home properties, but when you get to custom homes of a log type the rules for both sales and construction cost are deplorably low. So low that the cost to build can be off more than $250,000 low!

    That is true in my case, three different appraisers ranged from $190,000 to $250,000 low on the cost to build. The sales comps were ridiculous, there just are not any even kinda comparables over the last several years.

    So we have sunk good money in our custom log home only to find ourselves robbed by appraisers to the tune of a quarter million. Needless to say that has caused a severe hardship financing by making our equity position appear non existent.

    I would like to be able to say something good about appraisers, but right now I’m more likely to put a load of rock salt in the next one I see posterior….

    • Sorry to hear of your predicament Mike. I’ll have to defend my appraiser brothers though by saying that it’s not there fault that there are no sales. I have found the same situation in my market because log homes just don’t sell much. People usually build them and never sell them. When I have had this type of assignment I explain this to the lender and tell them that I will have to search for comparable sales that occurred further back in time or are further away. While this is not ideal it is necessary if the bank wants all or some of the sales to be of log construction. Log homes are the perfect example of custom construction. Most of the time the cost to build is so much more than is reflected in what you can sell the home for on the open market, which is the value that the bank wants.

  9. Great post, Tom. Your reasoning makes sense. New construction really stopped in the Sacramento area for several years as values plummeted. As values surged last year though, new construction re-emerged because it became profitable again for new homes to be built (mostly for builders who already owned the land though). There are many different layers of the market to know and interpret. It sounds like you were able to give the owner a very informed answer.

    • Thanks Ryan. Our market has not came back as fast as yours, however there is some new construction in pocket areas. It sounds like the cost approach and sales comparison approach are probably more in line in your market.


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