Cost Approach to Property Valuation: Definition & Process

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson, we will learn about the cost approach to valuation, a widely-used method for determining market value of real property. We will explore some of the benefits and limitations of this method. Test your knowledge afterward with a quiz.

Cost Approach Defined

Bill is shopping for a home in a new development. He's not sure if he would like to have a new house built for himself or if he should buy an existing one. What can he do to figure out how much the two options would cost? How can he determine how much he should spend on a new home to get a good deal?

The cost approach to property valuation compares the price of one piece of real estate with how much it would take to build a similar property. It is one of the three primary methods of property appraisal. Buyers work on the assumption that it doesn't make sense to pay more for a property when comparable newly built real estate costs less money. Cost approach can be calculated by the following formula:

Building Construction Cost - Depreciation of Existing Property + Cost of Land = Market Value

Cost Approach Limitations

The cost approach system has many limitations in practice. The method assumes that the buyer could find the land to build an identical property and that's not always the case. Higher cost of land on another lot might drive the price up even if building costs are reasonable. Construction costs are another vital factor. Would similar construction methods be used to build a new home in the area to those of existing homes there - or would the construction be functionally equivalent but with hidden expenses? One example of a building cost would be the material used to build walls in a new home. Do plaster walls have the same value as drywall in real world purchase prices?

Additionally, the local political or economic environment might not be friendly to new construction. The area could already be fully developed. Local planning authorities might be so restrictive that new construction is not worth the trouble. Unfortunately, these factors aren't considered in the cost approach.

Another consideration is that older property can have major depreciation. It might be difficult to accurately account for this. What if a certain construction material or method is no longer used? Sometimes making adjustments for depreciation is a challenging process. The appraiser has room for a lot of subjectivity.

Cost Approach Benefits

One benefit of the cost approach is that it can help identify market status. If the building cost of a new house would be greater than the value of an existing house in an area, it's a sign the older property could be undervalued. Likewise, if new home construction costs are cheaper than an existing property's value, the cost approach may reveal that the older property is overvalued.

The cost approach also works with other methods. If another method's accuracy is in doubt, the cost approach may give a stronger value estimate. A second or third valuation of a property offers other data points to estimate a fair market price.

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