Cost Approach (Real Estate)
A valuation method used to determine the fair value of a real estate asset using the sum of the cost of the land and the total construction costs invested on the building
What Is The Cost Approach (Real Estate)?
A real estate valuation method used to determine the fair value of an asset is the cost approach/contractors valuation method, which uses the sum of the value of the land on which the property was built as well as the total construction costs invested into the building to arrive at the value of a given property.
Therefore, 'costs' incurred to create real estate are fundamental in this real estate valuation method.
The worth of a property using the cost technique is equal to the cost of land plus all construction expenditures, less depreciation. When a property is new, it provides the most accurate market value than other approaches.
There are two slightly different perspectives when analyzing the value of a property using the contractor's valuation approach. These are used in valuation appraisals:
- Replacement cost analysis: Estimate the costs associated with replacing the property today, assuming it serves the same functions. Therefore, the costs used in the formula are based on current construction costs, hence, accounting for new technologies and design requirements.
- Reproduction cost analysis: Estimate the costs associated with replacing the property, giving emphasis to the use of old materials and designs to create a replica that serves the same functions.
The rationale behind this approach is that a buyer should not pay more for a property than what it costs to build it from scratch. Of course, you may already recognize the limitations associated with this thinking.
It is one of the three valuation methods used for real estate. The other methods include:
- Income Approach: Using income generated from a property as a proxy to determine the value
- Comparables Approach: Comparing properties with similar characteristics to gauge the value
What is the Cost Approach formula?
According to this approach, the value of a given property is equal to:
Property Value = Total construction costs + Value of land - Depreciation
Total construction costs include investments made for the creation of a structure on a piece of land. This includes:
- Labor costs
- Equipment
- Materials
Usually, there is a construction contract that is agreed upon before the start of this activity. Therefore such data should be readily available for the newly built property.
However, for estimating construction costs for replacing property built a while ago, there are several methodologies:
- Comparative Unit Method: Use overall estimates of costs per square foot based on materials; for example, how much does it cost per foot to construct a concrete frame? Such questions are asked to determine the cost per foot or cubic feet for each material to find the lump sum cost for all components together.
- Segregated cost method: Calculate average costs for different components and then apply them to estimate the total cost of construction. For example, sum up costs of different segments such as roof, floor, heating system, etc., together.
- Unit-In place method: A detailed approach where individual units of major components are estimated. For example, estimating the cost of floor coverings by summing up the costs of each and every tile put in place to cover the floor.
- Quantity survey method: The most reliable but time-consuming approach where each and every small component's cost is summed together in a detailed manner.
The value of land is simply the market price of land. This is the fair value based on current market conditions and characteristics related to the property, such as accessibility, location, area, and utility.
In this context, depreciation would refer to the fall in the fair value of the asset if it is used every year and thus experiences wear and tear. Therefore, for a newly built estate, depreciation would not be applicable.
When to Use the Cost Approach
The contractor's valuation approach has several applications where such an analysis fits well. As we have established, judgments on real estate valuation are complex, and thus knowing which methodology is appropriate is critical.
We will consider many situations where the using costs will provide an individual with a reasonable valuation.
1. New Construction
Costs incurred on newly built real estate are very relevant to the fair value of a given property as they reflect the 'value' a property has based on the investment that was made in the near term.
Therefore, a common strategy that Real Estate Investment Trusts (REITs) or individual investors use when analyzing newly built construction is the costs associated with creating the estate, arguably the most bias/error-free indicator if the construction is brand new.
Further, as renovations on a property are made, the property can be reappraised at every stage of construction. Hence, construction lenders can understand valuation at different stages.
2. Insurance
Usually, insurance firms cover damages on only the structure and not the land that the property was built on. Thus, insurance firms can make judgments on the value of a structure using only the relevant costs associated with creating it.
3. Commercial Property
Any renovations or changes made to commercial property to adjust the functional utility of a commercial property can be used to reassess the post valuation of the property.
4. An Indicator of Market Sentiment
A market that is overpriced/oversold for any reason is a market where comparable real estate is not reliable in arriving at valuations, as identical real estate is not trading at fair value.
Moreover, given that the market is expecting a correction, it is difficult to predict potential cash flows far into the future for any property.
In such situations, the income and comparables approach becomes impractical. Therefore, the cost approach can provide an analysis that is bias-free as it is not impacted by market sentiment or hindered by speculative forecasting.
5. Special Considerations
Buildings with specialized uses can be valued accurately using this approach. This may be appropriate for the following types of property:
- Museums
- Religious buildings
- Government facilities such as healthcare facilities, police stations, firefighter stations, etc.
In such cases, the use of the real estate is specific; thus, there may be limited/no comparables available to make evaluations. Further, it may also be the case that there is no income being generated from the property as it is freely accessed by the public.
Therefore, in such specific considerations, the approach can provide a great analysis.
Cost Approach Appraisal Example
The Cost Approach can benefit unique or specialized properties where comparable sales data may not be readily available.
Example #1: Estimating value for a newly built home
Let's consider an example where a newly built residential home with the following characteristics is being appraised:
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The land area is 1 acre, and you find that land with similar characteristics sells for $40,000
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You find that the cost of a similar home with the same materials and quality standards is $40 per square foot for a $25,000 square feet building through any one of the analytical approaches outlined above. Thus putting the value of the home at $1,000,000 (40*25,000)
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You also assume that this new home would last about 50 years; given that this is new construction, you find that the value of the home has not depreciated. Therefore, there are no depreciation costs associated with the property.
Therefore the final property value is the price of the land and the price of the home. Thus arriving at
= $1,000,000 + $50,000
= $1,050,000
Example #2: Estimating value for a home built some time ago
Let's consider the same home from example one; however, it has now been ten years since you bought this home, and you would like to know the value of the home now using the cost approach.
Here is the information you have collected:
-
Remember that the land area is 1 acre, but you find that land with similar characteristics sells for $50,000 now.
-
Further, you find that the new cost of a similar home with the same materials and quality standards is $50 per square foot for a $25,000 square feet building through any one of the analytical approaches outlined above. Thus putting the value of the home at $1,250,000 (50*25,000) now.
-
You remember that when you built this home ten years ago, you were told that it would last about 50 years before a need for reconstruction; thus, given that it has already been ten years since you've been living in this home, you find that the value of the home has depreciated ⅕ of $1,250,000 ($250,000).
Therefore the final property value is the price of the land, and the price of the home deducting depreciation gives us:
= $1,250,000- (1/5 * $1,250,000) + $50,000
= $1,050,000
Therefore, we can apply the cost approach to a home that isn't newly built in such a manner.
Advantages and Disadvantages of the Cost Approach
Valuing real estate can be tough as many factors come into play when determining the value of a property; further, individuals observe 'value' differently, as people have different preferences and tastes.
This applies to both residential and commercial real estate. For residential real estate, people have different requirements that they are looking for; some are extremely specific.
Firms also have specific needs for a property that they are opting to purchase or rent based on business requirements. Therefore, it is understandable that valuation is complex and requires experience.
The three valuation methods discussed so far can provide exceptionally great fair value estimates. However, there are obvious pros and cons to the techniques. Thus, a well-informed investor should know where each technique works best.
Here is a table below:
| Valuation Method | Advantages | Disadvantages |
|---|---|---|
| Cost Approach/Contractors valuation method | 1. Straightforward analysis 2. Works well with newly built real estate and other special considerations | 1. Does not give a reliable inference for real estate that's not built in the last 3-5 years 2. Requires know-how in construction cost estimates |
| Comparables/Market/Sales Comparison Approach | 1. Leads to a sound valuation given the availability of identical comparables 2. Particularly useful for residential real estate | 1. May not be applicable in areas with limited ‘identical’ real estate 2. Requires extensive information gathering 3. Leads to an incorrect long term valuation in a heavily overpriced/underpriced market because comparables make prices seem “fair” |
| Income Approach | 1. Use of discounted cash flow (DCF) allows for in-depth analysis 2. Applies well to commercial real estate Analysis also serves as an ‘investment thesis’ due to forecasts | 1. Requires experience in forecasting cash flows 2. Requires accurate judgment of future economic environment for relevant real estate subgroup |
Given the disadvantages of relying only on the cost approach, the most reliable judgment on the value of a property is likely a combination of all three approaches, as when put together, the analysis covers key characteristics that determine the value of any given property, such as:
- Location (community/society)
- Building construction cost
- Land acquisition cost
- Cash-flow potential
- What Identical real estate sells for
These factors are all captured well when the three approaches are used together in an analysis. Therefore allowing for a well-defined model.
Cost Approach (Real Estate) FAQs
No, Fannie Mae does not accept valuations that have been determined via the cost approach. Instead, only valuations from the comparables approach are acceptable.
Therefore, the firm will not purchase the mortgage for a property that has been evaluated using the contractor's valuation method.
The reason for this restriction is likely because amounting depreciation is subject to the appraisal; therefore, estimated valuations can be manipulated.
The first step is to estimate the costs of the structure (home, building, etc.). There are different methods to determine the costs associated with the construction of the property, such as the replacement and reproduction costs.
Then, these costs can be plugged into the formula to determine the valuation.
The input costs incurred to create a property become less relevant to the market value of the property as it becomes older. This is due to several factors such as
- Factoring in changing Market conditions
- Trouble estimating depreciation
- Factoring in changing construction costs due to innovation over the years
Hence, preference for the other approaches is given in the case of older real estate.
Property Value = Building Construction Cost - Depreciation of Existing Property + Cost of Land
Building construction costs can be determined through several analysis methodologies. Further, the depreciation amount is subject to the judgment of the appraiser.
Sometimes the approach is referred to as the contractor's valuation method.
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