A Layman’s Guide to the Cost Approach
Heck,” said the real estate agent, “you couldn’t buy land and build it for this price.” This commonly heard bit of wisdom is often shared by agents to provide the buyer with a little perspective and help them to recognize the real estate opportunity in front of them. By framing the buyer’s decision as being between two basic options: 1) Buy what you want or 2) Buy land and build what you want, the agent is essentially making an appeal to the intuitive logic of the Cost Approach, which is one of three approaches that a real estate appraiser uses to estimate value.
While the Sales Comparison Approach asks what similar properties are selling for and the Income Approach focuses on the property’s income potential, the Cost Approach is concerned with how much it would cost to reproduce a property or to replace it with a similar structure.
How the Cost Approach Works
The Cost Approach is founded on the principle of substitution, which states that a knowledgeable buyer would pay no more for a property than the cost to acquire a similar site and construct improvements of equivalent desirability and utility without undue delay. The basic elements of the Cost Approach are simple: Land + Cost New – Depreciation = Value
• Land: Estimate the value of the subject site. The Sales Comparison Approach is most frequently used to estimate land value and involves gathering comparable sales and listings.
• Cost New: Estimate hard costs (think materials and labor), soft costs (think architectural and other professional fees), and entrepreneurial incentive (think developer’s profit) to determine the replacement cost new. Often, the best source of cost data is an actual construction contract or recent construction costs for the subject or similar properties. Another option is to utilize a cost-estimating service, such as the Marshall & Swift Valuation Service, that publishes cost data for a wide variety of property types.
• Depreciation: Estimate depreciation, which comes in three forms: physical deterioration (think wear and tear with the passage of time), functional obsolescence (think poor design or an awkward floor plan), and external obsolescence (think issues outside of the property that affect value, such as a new garbage dump next door).
When is the Cost Approach Most Useful?
• The Cost Approach is most reliable when dealing with a relatively new or proposed structure.
• When appraising property types that are infrequently sold or leased, such as school buildings, churches, libraries, government buildings, and special-purpose properties, the Cost Approach often becomes front and center in the appraisal report.
• The Cost Approach is increasingly useful if a typical buyer of the subject property would at least consider buying land and constructing a building rather than purchasing an existing structure.
The Limitations of the Cost Approach
• For older, mature properties where numerous items of depreciation are evident, the Cost Approach is less reliable and likely given less weight in the analysis. The older the structure, the harder it becomes to estimate depreciation and to accurately apply the cost approach.
• Good cost data can be hard to find. The appraiser does not always have a current construction quote in hand or recent cost comparables of similar properties to guide them. Further, when using the cost estimation programs, the appraiser must make somewhat subjective judgments about building type, class, and construction quality, which can lead to large swings in the cost estimates.
• It is far easier to say that the property has an outdated interior finish and an awkward floor plan than it is to estimate a dollar amount to deduct for functional depreciation.
• With so many moving parts and inputs to be estimated along the way, including land, a variety of hard and soft costs, and depreciation, the Cost Approach provides the appraiser several opportunities to get off track and ultimately overstate or understate value. What Does Cost Approach Thinking Look Like in the Real World?
• An office user runs the numbers and realizes that buying land and building even a modest office would overshoot their budget, so they refocus their search on existing properties that won’t break the bank. They end up buying a 15-year-old office building formerly occupied by an insurance agent that, with a little cosmetic work, meets their needs just as well as a new building would have.
• A dentist wants to buy a place of their own, but the only options on the market are a couple of 1960s/1970s dentist offices with aging mechanical systems and in serious need of updating. After looking at the hefty price tag of a total renovation, the dentist thinks, “Why don’t I just build exactly what I want?” In their search for land, they find that the prime pad sites at high-traffic corners are too expensive and the cheapest sites are too far out-of-town or on the side of a hill. They eventually find a nice 2.0-acre site on a secondary roadway with the business zoning that they need and build that modern dentist office they’ve always wanted.
• A church outgrows their current building and decides to pursue a larger facility to serve their community. While the church would love to buy or renovate an existing property, the search for available church properties and feasible conversion opportunities comes up empty. Because what they need does not exist in their market, the church purchases land and builds a new facility to meet the needs of their growing congregation.
Appraising is at its best when it truly reflects the actions and thinking of actual market participants. If real buyers are trying to decide between buying an existing structure or buying land and building what they want, the Cost Approach should mirror the market well and provide a helpful perspective to all parties involved.