The Cost Approach: An Underutilized Approach to Value

Home valuation concept, real estate appraiser uses smart phone and calculator to estimate home value using the cost approach

In residential appraising, the cost approach and the income approach have in many cases become less utilized in favor of sole reliance on the sales comparison approach.

There are occasions when the income approach can be the primary indicator of value for residential properties, such as developments with a high percentage of homes owned by investors.

The fact that Fannie Mae won’t accept reports that rely solely on the cost approach, with a few rare exceptions, doesn’t mean that approach can’t be the primary indicator of value. It just means Fannie Mae won’t buy that loan.

When students defend their lack of including a cost approach by saying Fannie Mae doesn’t require it, my reply is always, “Try to imagine how little I care.” Fannie Mae not requiring the cost approach has nothing to do with whether it is applicable or necessary for credible assignment results.

I’m not saying the cost approach is applicable to every assignment. But if you don’t at least try the cost approach, how do you know whether it is or not?

Reasons for “resuscitating” this approach

Henry S. Harrison, in the Fall 2006 issue of his Real Estate Valuation Magazine Online, included an article titled “Let’s Resuscitate the Cost Approach.” Here are two quotes from that article that are still true today:

“How credible do you think a current estimate of market value will be if it is based solely on three sales made to low down-payment buyers at the height of the recent feeding frenzy?”

“The Cost Approach answers several key questions: What would it cost to build that house today? What should it be insured for? What would a reasonably well-informed buyer actually pay for that house—without the special market condition of a feeding frenzy?”

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More arguments for using the cost approach

The cost approach is a check-and-balance for the sales comparison approach. On multiple occasions, when there was a significant difference between my cost and sales comparison approaches, it turned out I had initially selected the wrong comparables.

Marshall & Swift is one of the most commonly used cost services for appraisers. In their 1996 marketing catalog were listed twenty-one Certified Marshall & Swift Instructors. They provided the group with excellent textbooks and visual aids that facilitated teaching many appraisers how the cost approach should be done utilizing their products. Although the program only existed for a year or so, and the certifications were discontinued, the materials remained in use. Here are a couple of student testimonials from my past cost approach courses using those materials:

“I just completed an M&S 1007 form today at $147,312. The contract price on the house was $144,000…You taught me well, I can’t say enough that if you know how to use this form correctly, you can value real estate.” 

“I completed an appraisal of an $11,000,000 home today…I spent 3 days of research on the appraisal, I spent 45 minutes on my Marshall & Swift 1007, which came in at $11,117,063…it’s uncanny how well this thing performs when you really know how to use the form correctly.”

Appraisers decide what is necessary for credible assignment results in their appraisals and resultant reports. USPAP requires us to explain the exclusion of any of the traditional approaches. In residential assignments, I can often attest that data to support a gross rent multiplier (GRM) was insufficient or non-existent to do an income approach. In contrast, I can seldom come up with a credible reason for not doing the cost approach, unless there was no onsite inspection of the property.

A while back a student brought to class a residential appraisal report from 1962 he’d discovered while sorting through a deceased relative’s papers. It was on a form identified as being from a national professional appraisal organization. It had space for the property description and details of the area, a sketch and a map, but the only approach to value on the form was the cost approach. There weren’t even any spaces for a sales comparison or income approach. Granted data for those two approaches was not as prevalent as it is today, but the cost approach has always been there, and it can be done on any improved property. The same can’t be said for the other two.

If you feel you need some guidance, there are books and courses that include training on the cost approach, and on estimating depreciation. There is even a good discussion on depreciation in the Marshall & Swift Handbook. McKissock has a great online course on the cost approach. Read some of the reviews on the website. Beginners and the experienced alike found the course helpful.

In feeding frenzy times when prices are climbing faster than cost service figure updates, appraisers should consider using known local costs to enhance accuracy. And remember if a nailed-in 2×4 still costs the same, maybe the value increases relate more to the site value.

It could also be argued that the cost approach, being based on replacement costs figures typically from independent sources, can be a good method to help avoid inadvertent undervaluations that could result in appraisal bias claims.

Job security is another reason for placing emphasis on the cost approach. Computer databases are filling up with details on residential properties, but it takes eyeballs and, in many cases, boots on the ground to estimate all three types of depreciation. Performing the cost approach and citing its importance in our reports helps keep appraisers in the valuation game.

Have I sold you yet, or do you want to hear more?

CE Course: Gain the skills you need to perform this useful approach to value. Enroll in McKissock Learning’s The Cost Approach.

Written by Steven W. Vehmeier. Steve resides in Florida where he is a state-certified general real estate appraiser and a licensed real estate broker. He has taught appraisal qualifying and continuing education courses for multiple colleges, professional appraisal organizations, his own school, and McKissock Learning since the mid-90s, often spending over 100 days a year traveling and teaching. He has authored dozens of appraisal courses and textbooks, including several for McKissock, and has been a member or affiliate of eight national appraisal organizations, and national director of two.

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