Understanding The Appraisal Part 3: The Cost Approach

A Closer Look At The Cost Approach

There are three approaches to value that can be used in a residential appraisal. They are the sales comparison approach, the income approach, and the cost approach.

Today I will be explaining the cost approach to value. This approach is not given as much attention as the sales comparison approach, however, it can be a good indicator of value and it can provide some direction when choosing comps.

After the cost approach is properly developed it’s possible to use the value as a starting point to search for comps to use in the sales comparison approach.

The premise of the cost approach to value is that a consumer will not pay more for a home than it would cost to build an equivalent structure. So if market prices for existing homes are at $200,000 and it would cost $175,000 to build a similar home, the majority of buyers would choose to build a home because it’s cheaper and the cost approach is a relevant indicator of value.

New Construction

The cost approach is a better indicator of value when appraising new construction because you don’t need to calculate physical depreciation since the home is new. There are other forms of depreciation such as functional and external, however, physical depreciation is the most common.

When completing the cost approach to value there are several steps that need to be performed to arrive at an accurate valuation. These steps include estimating the value of the land, the cost of construction, and then deducting for depreciation.

When estimating the value of the land it must be assessed as though vacant and available for its highest and best use. This will ensure that the value assigned to it is the highest possible.

Land value can be estimated by using the sales comparison approach to compare the subject parcel to other similar properties. Closed sales, as well as active listings and pending sales, can be used to arrive at the most accurate value for the land.

Several factors that are considered when valuing land include the following: size, shape/functional use, topography, utilities, and location. Choosing comps that are most similar to what is being appraised is best because it will reduce the number of adjustments made and will lead to a more accurate value indication.

The next step in the cost approach is to estimate the cost of construction for all of the improvements. This is typically done using a reputable cost service.

There are various cost services available, however, one that is very reputable and used by a lot of appraisers is Marshall and Swift. In addition to construction costs, most of the good services will also include adjustment factors for the part of the country the property is located in and quarterly multipliers to adjust for changes in material costs.

During the appraisal observation (inspection), when the appraiser is at the property we are taking measurements of the gross living area (GLA) of the home as well as other areas such as porches, patios, garages, and other structures like storage buildings or workshops. These calculations are then used with the cost estimator to arrive at a cost of construction for all of the improvements.

It is important to keep in mind that only items considered to be real property are included in the cost approach and appraisal in general. If there is an improvement such as a storage building that does not have a permanent foundation or an above-ground pool that can be moved it WILL NOT be included.

After a cost estimate has been developed for all of the improvements on the property, an estimate of depreciation must be factored in so that the total cost estimate will reflect the current condition of the property.

Depreciation

A detailed discussion of how to calculate depreciation is beyond the scope of this article. What is important to know is that there are multiple forms of depreciation that must be considered.

There are physical, functional, and external forms of depreciation that can potentially affect the value of a property and that must be considered in each approach to value.

Physical depreciation of a property occurs due to age and the everyday wear and tear that occurs from living in it. This is also the most common type of depreciation, however, for new construction, there would not be any because no one has lived in the property and this is why the cost approach is most accurate for new construction.

Functional and external obsolescence are the two other types of depreciation that can affect a property. Functional depreciation addresses issues that the property may have with floor plan layout or other design issues while external depreciation is related to factors outside of the property boundaries such as it being located next to an airport or some other negative factor.

All forms of depreciation are considered and adjusted for in each approach to value. Within the cost approach, this depreciation is then deducted from the cost new of construction.

After depreciation is deducted, the remaining figure is then added to the cost of the land and site improvements for a total value from the cost approach. One question I get asked frequently is whether this cost approach can be used for insurance purposes, to help the agent arrive at an insurable value.

I wrote an entire blog post on this topic to emphasize the fact that the cost approach in an appraisal should not be used to determine an insurable value for your home. You can read my previous article to find out why but just so you’ll know if you use the figure arrived at from the cost approach you will most likely be under-insured.

When looking at the cost approach in the appraisal report it is important to keep in mind that the base price per square foot may seem low but that is because it is the base cost of construction and in order to get a number that most people can relate to you must take the total cost of construction and then divide it by the square footage.

As noted previously, the cost approach can be a reliable indicator of value for a property if it is new construction, however, if the home is older it may not be as reliable unless all forms of depreciation have been adjusted for.

In a market, like we are currently in, where material costs are high, the cost approach may indicate that it would be better to purchase an existing home if existing home prices are lower than new construction. Of course, the condition of the existing homes would need to be considered and accounted for when comparing it to new construction.

Question

This is just a basic discussion of the cost approach and only touches lightly on the depreciation aspect. Do you have any other questions about the cost approach? If so leave a comment below and as always thanks for reading.

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