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

What is the Cost Approach to Real Estate Appraisal?

The cost approach to real estate appraisal considers the cost to replace the subject property from the ground up, including land and construction costs less depreciation. It is one of three methods appraisers use to determine the market value of a property.  

Appraisers also use the income approach and sales comparison approach. The income approach is used for investment properties, where the value of the property is based on how much money or income the property generates.  

The sales comparison approach is the most common property valuation method. This approach looks at recently sold comparable properties in the same market area to determine value. The cost approach is also used when comparable properties cannot be found because of the location or uniqueness of the subject property. However, for GSE loans, the sales comparison approach is always required. The cost approach adds support, but for Fannie Mae, Freddie Mac, FHA, and VA, the sales comparison approach must be done, even if the appraiser must go further away to find comparables. 

Valuation Based on the Cost Approach 

The cost approach is most applicable when determining the value for properties where comparables are hard to find. This typically means new construction, unique properties, isolated properties, schools, churches, and government buildings. This approach essentially determines how much the property would cost to rebuild, including today’s cost of the land.  

There are two primary methods to the cost approach appraisal: reproduction and replacement.  

1. Reproduction Method  

This method estimates the cost to build the exact property using original materials. Essentially, you’re building a replica and determining the costs to do so. The reproduction method is typically used when valuing historic homes or properties with unique finishes. 

2. Replacement Method 

The replacement method determines the value based on how much it costs to replace the subject property using current construction methods and materials. This method assumes the structure will provide the same function or utility.  

How to Determine Value Using the Cost Approach 

The formula for the cost approach is:  

Estimated Replacement Costs – Depreciation + Land Value = Property Value 

Estimated Replacement Costs  

These costs include materials, labor, and overhead. When estimating replacement costs, you will choose either the reproduction or replacement method based on the property type, client requirements, and type of assignment.  

Depreciation 

Calculate the value lost to physical deterioration (age), functional obsolescence (outdated features specific to the property), and external obsolescence (factors outside of the property).  

Land Value 

Determine the current market value of the land as if it was vacant and subject to the highest and best use. Often comparable sold lots in the area are used to estimate vacant land cost. 

When to Use the Cost Approach 

There are circumstances when it’s necessary to use the cost approach, for example, unique properties and new construction. The cost approach can also be used to support the sales comparison approach.  

Fannie Mae only accepts the sales comparison approach as its primary valuation tool. However, that does not preclude an appraiser from also using the cost approach to substantiate their findings. And there are other lenders who may accept the cost approach over other real estate appraisal methods for certain properties or situations.  

Here are just a few examples:  

Special Use Properties 

Properties like schools, government buildings, and churches are exclusive-use properties. Finding comparables is challenging enough; finding comparable properties in the same location is virtually impossible. These properties typically do not generate income comparable with highest and best use.  

New Construction or Unique Properties 

Often construction lenders require the cost approach, especially during construction. Unique properties can require too many adjustments to comparable properties using the sales comparison approach, so lenders may prefer the reproduction method of a cost approach appraisal. 

Insurance 

Many insurance providers require the cost approach when issuing homeowners’ policies. Most insurance policies only consider the structure, which is accounted for independently of the land value when using the cost approach.  

Some Disadvantages of Using the Cost Approach 

There are inherent benefits of using the cost approach, especially when you’re tasked with challenging properties that have little or no comps. But there are also some downsides. 

One of the primary disadvantages is the assumption that land is available for purchase to build an identical property. Land is a scarce resource. When comparable land sales are not available, the value must be estimated.  

The bigger issue here is undervaluing the land costs based on scarcity. In real estate, location is everything. A small ocean-front cottage has its value because of the land it sits on, not necessarily its four walls. 

Other disadvantages include how to depreciate an older property or find costs for similar building materials. This can be particularly tricky when using the reproduction method of the cost approach or appraising a historic home. 

Appraisers should consider whether the cost approach is the best tool to use. In many situations, it’s best used in tandem with the sales comparison approach. 

Tips for Using the Cost Approach 

As part of our monthly survey series, we asked our community of real estate appraisers, “What’s your best tip for using the cost approach to appraise?” They shared many helpful comments, including common pitfalls to avoid as well as general advice and recommendations. Here’s what they said: 

“Use and research valuable comps and educate yourself on the surrounding market.” 

“Call local developers for better support on cost estimates. Make friends with builders.” 

“Stay consistent.” 

“I use Dwellingcost.com.” 

“Use the most credible cost service AND support your land value with real data.” 

“No matter how much you believe in your cost source(s) and your method of determining total depreciation, there is still a significant potential margin of error. Keep this in mind as you reconcile with other methods.” 

“The cost approach is a great tool and check for the sales comparison approach. If you have a good indication of land value, once you determine depreciation, the cost approach should be somewhere in line with the sales comparison approach. If they are way off, it gives me pause to go back and see where I might be missing something.” 

“Using it as a method to obtain adjustments by the depreciated cost method.” 

“Make sure you understand that a land sale doesn’t mean that is the site value.” 

“Make sure that you research in fill land/lot sales and/or research new home subdivisions to establish what the builders are paying for lots to the developers. I see many appraisals that have the opinion of site value incorrectly stated.” 

“Most build-to-suit properties use a yield on cost of construction to determine a lease rate. In markets with little new development (and thus fewer lease comps for new properties), comparable cost yields can be used to support a market rent estimate for the property.” 

“I have found that the cost approach is most effective when the builder provides an accurate sworn statement of true estimated costs.” 

“Include disclosure about inaccurate information based on methodology costs which will differ from true actual costs.” 

“Always remember to keep detailed records of all your assumptions, sources of cost data, and depreciation estimates. This not only helps in justifying the appraisal, but also in defending it if challenged.” 

Conclusion 

To determine the appraised value of a property, appraisers use one of three methods: the sales comparison approach, the cost approach, or the income approach. The sales comparison approach is the most versatile and widely used method for valuating residential properties.  

That’s why it’s important to know how and when to use the cost approach appraisal method.   

Mandatory and continuing education courses, like McKissock’s The Cost Approach, prepare appraisers to effectively determine property values using the cost approach method through real-life case studies.  

Learn everything you need to know about the cost approach to appraisals in our course, and find a wealth of other appraisal continuing education courses offered by McKissock!