Cost Approach - Explained

What is the Cost Approach?

The Cost Approach requires the Appraiser to estimate the value of the subject’s site, typically using comparable land sales with similar zoning, physical characteristics, and locations. After determining the value of the subject’s site, the Appraiser estimates the depreciated replacement or reproduction cost of the improvements. A variety of methods can be used to estimate the cost of improvements, including online estimators (e.g., Marshall & Swift’s Swiftestimator tool), applying an inflation rate to the original construction costs (when applicable), or by finding comparable construction budgets in the subject’s market area. The estimated site value is subsequently added to the depreciated cost of improvements, allowing the Appraiser to form an opinion of value for the subject. This approach is most appropriate for new or recent constructions.

How is the site valued in the Cost Approach?

It is important to note that sites in the Cost Approach are valued as if vacant. The building is not a component of the site valuation in the Cost Approach. 

An Appraiser uses multiple data sources like MLS, CoStar, and Crexi to find comparable land sales. Oftentimes, land sales are not publicly listed and instead occur between two buyers in an off-market or private transaction; in these instances, the Appraiser may search public records like their local assessor office and Registry of Deeds to find land sales. 

An Appraiser selects land sales based on their overall comparability to the subject's site. Some relevant characteristics may include location, frontage, land area, topography, environmental characteristics (e.g., wetlands or conservation easements), and local zoning ordinances. The land sales must also have a use that is consistent with the Highest & Best Use (HBU) of the property being appraised. The Appraiser cannot, for example, value the site of an office building using residential land sales. 

Due to the rarity of commercial land sales, it is common for Appraisers to choose commercial land sales that have a variety of HBUs, and then make an adjustment if it is deemed necessary.  An Appraiser may be valuing a site that has an HBU of retail, for example, but use a land sale that has an HBU of office. The Appraiser may find that land sold for office development was worth -10% overall, and make the appropriate adjustment.

The Appraiser determines an appropriate unit of comparison (see: our write-up on the Sales Comparison Approach) such as $/SF of land area or $/acre. After making the appropriate adjustments for differences between the subject's site and the comparable sales, the Appraiser will reconcile the indicated prices per square foot and arrive at a value for the site. Please see the example below:

• Subject: 30,000 SF parcel, irregularly shaped, 100' of frontage, flat topography and no wetlands, located on a busy thoroughfare, with an HBU of retail

• Land Comparable 1: 25,000 SF parcel, irregularly shaped, 80' of frontage, flat topography and no wetlands, located on a busy thoroughfare, with an HBU of retail. Sold for $10/SF after adjustments.

• Land Comparable 2: 30,000 SF parcel, irregularly shaped, 100' of frontage, flat topography and wetlands in the rear, located on the subject's street, with an HBU of retail. Sold for $15/SF after adjustments.

• Land Comparable 3: 35,000 SF parcel, irregularly shaped, 100' of frontage, undulating topography and no wetlands, located on the subject's street, with an HBU of office. Sold for $12.50/SF after adjustments.

In this case, the Appraiser is most likely to put the most weight on Land Comparable 2, despite its wetlands, because of its similar physical characteristics, location, and HBU. Land Comparable 2 indicates that the subject would be most appropriately priced at $15/SF, which translates to $450,000.

How are building costs determined in the Cost Approach?

After the Appraiser finds the value of the site, they are subsequently responsible for determining the replacement or reproduction cost of the improvements. The replacement cost reflects the cost to replace the improvements with comparable or even superior materials; the reproduction cost reflects the cost to completely reproduce the improvements with the same materials (usually reserved for historical buildings). Appraisers use a variety of sources to determine building costs, including:

• Estimates from local contractors / builders

• Estimates using an online tool or estimator, like Marshall & Swift

• Estimates from a cost manual, such as the annual Craftsman manual

Appraisers usually derive a $/SF  from these sources to apply to the building area, resulting in an estimate of the cost. Alternative methods may be used to derive a replacement or reproduction cost. Some of these methods are as follows:

• Cost-Index Trending: Applying an annual inflation rate to the original construction costs of a building. Most suitable when the Appraiser knows the original construction cost, and the building was constructed within the last 5-10 years.

• Segregated Cost Method: Finding the price for each item -- HVAC, roof, flooring, siding, etc. -- and adding them up to find a total construction cost. This is typically not used because it is time consuming.

How is depreciation determined?

Depreciation is commonly derived using the age/life method, and is expressed as a percentage. This method uses the following formula:

Depreciation = Effective Age / Total Economic Life

Example: Effective Age = 40 Years

    Total Economic Life = 50 Years

      Depreciation = 40/50

      Depreciation = 80%

Depreciation is subsequently applied to an estimate of the improvement's replacement / reproduction cost. For example, an Appraiser determines that building costs are $200/SF. The subject's building is 4,000 SF. $200/SF* 4,000 = $800,000 reflects the cost of the building new, but the depreciated cost is $800,000 * 0.2 (the percentage of the building that is still considered "Good," or not depreciated), or $160,000. 

Actual age can be synonymous with effective age; a single-family home constructed in 2020, for example, likely has an effective age of 4 years and an actual age of 4 years. With older improvements, such as those constructed in the 1900s, effective age and actual age can widely vary.

How is value derived in the Cost Approach?

After determining the value of the site and the depreciated value of the improvements, the Appraiser adds the two numbers. Keeping with the prior examples, we can value an improved site:

Site Value = $450,000

Depreciated Cost of Improvements = $160,000

Total Value = $610,000

The Cost Approach, as previously stated, is most applicable in cases where a building is newly constructed, and recent land sales are abundant in a given market area. Appraisers need to be careful to not directly conflate cost and value, however; sometimes, properties in a market area can be worth more than the cost to construct them, or even less depending on the location. 

Home | Request a Quote | Real Estate Appraisal Services | Massachusetts Service Areas | Rhode Island Service Areas | Your Real Estate Appraisal | About Us