The Real Estate Cost Approach

Cost approach is an approach to real estate appraisal that requires appraisers to evaluate the property's worth by adding together the value of the land, the value of the property itself and the value of the improvements and then subtracting the value of accrued depreciation. While this approach works well with newer properties, it is less reliable with older properties. In fact, the older the building is, the less reliable this approach becomes. Furthermore, it tends to work best with public and municipal buildings.

Estimating the Value of the Land

The cost approach uses a number of variables. First and foremost, it estimates the value of the land the property stands on. This is done by looking at the sale prices for vacant lots of similar size and usage. For example, if the property is a mid-rise apartment building, the appraiser will look at the sales prices for similarly sized vacant lots that the real estate developers purchased to build mid-rise apartment buildings on. Ideally, the lots would be in close proximity to the original building, but if there are no buildings that fit the criteria, the appraiser will look at vacant lots in neighborhoods with similar demographics, geographic features and average incomes.

Estimating the Value of the Property

Next, the appraiser will calculate the value of the building itself. This can be done by calculating one of the following costs:

  • Reproduction cost--the cost of building the same structure from scratch on the same land area using materials and construction methods available at the time the building was built.
  • Replacement cost--the cost of building a similar structure using modern materials and construction methods.

Those costs, in turn, are calculated using one of the following methods:

  • Square foot method--This method takes the per-square-foot cost of building a similar property and multiplies it by the building square footage. The square footage is estimated using the structure's external dimensions.
  • Unit-in-place method--This method calculates the costs of building every individual part of the building. In other words, the costs of building the structure itself, installing utilities and adding doors, windows, elevators, and so on.
  • Quantity-survey method--This method adds together the costs of buying the construction material and hiring laborers and any other costs necessary to put the building together. Unlike the previous method, it considers the building as a whole rather than some of its parts.

Estimating the Value of Improvements

The value of improvements is calculated similarly to the value of the house, except each improvement is calculated separately. Oftentimes, they are split into two groups: improvements to the buildings itself and improvements to the property. Improvements can be decorative or functional, but they have to enhance the value of the property. For example, adding a new, more attractive facade is considered an improvement. Upgrading the heating system also is.

Estimating Depreciation

The term "depreciation" encompasses everything that causes the property to lose value. Depreciation can be either curable (fixable given enough money and resources) or incurable (something that either cannot be corrected or that can be corrected only for more money than the property is worth). Depreciation is further split into the following three classifications:

  • Physical deterioration--any depreciation that involves wear and tear of any part of the structure. This can include anything from peeled paint to cracked walls.
  • Functional obsolescence--any depreciation that results from some features of the property becoming either unfashionable or obsolete. This includes anything from dated interior design to an outdated heating system.
  • External obsolescence--any depreciation caused by external factors. This can include decline in neighborhood property values, damage from natural disasters, botched urban renewal projects and rising crime rates.
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