One commercial real estate valuation method is the cost approach method (sometimes called the “cost approach if developed”). In essence, the cost approach valuation method derives how much it would cost to rebuild an investment property from the ground up.
With the cost approach, the property value equals the value of the land, material, and labor costs, minus depreciation.
When Is the Cost Approach Method Used?
When comparables are few or non-existent, CRE professionals may use the cost approach to determine property value.
For example, a hospital typically does not have many (or any) comparables in the area to help with price analysis. So for highly specialized structures with customized renovations, the cost approach may be the best option to determine property value.
New builds in a market may also lack a sufficient number of properties that could be considered similar. This is why construction lenders typically require cost approach appraisals – new development value depends on the project standards and completion. So projects are reappraised at various stages of construction to release funds for the next stage of building.
Some assets that may require the cost approach method include:
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Hospitals
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Religious buildings
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Convention centers
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Sports arenas / stadiums
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Museums
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Theaters
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Libraries
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Schools
How to Calculate Cost Approach
The simple cost approach formula is:
Cost – Depreciation + Land Worth = Property Value
Common ways to calculate the cost approach include:
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Comparative unit approach - This calculates the total estimate for the costs to construct a new building on a per square foot basis. It is based on actual construction materials.
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Segregated cost approach - This method estimates the cost of each individual building component, such as steel framing, roofing, HVAC systems, plumbing, etc.
Two alternative ways to interpret cost approach appraisals are:
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Property reproduction - This method determines what an exact replica of the property would cost to build. It’s assumed original material will be used.
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Property replacement - This means creating a new structure with the same function using new materials, current construction methods, and modern design.
What Is Depreciation?
Property depreciation can be categorized as physical, economic, and/or functional obsolescence.
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Physical depreciation takes into account the normal wear and tear of a structure over time.
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Functional depreciation occurs due to outdated design and features or changes in customer tastes.
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Economic depreciation is the loss in property income value due to factors such as recession, local economic forces, or local property value/demand fluctuations.
The Cost Approach Method & Optimal Usage
It’s important to understand that the cost approach method emphasizes optimal usage for property value estimates. For instance, land near a densely populated area might be best for a multi-unit apartment building or an office complex. Meanwhile, a location near a busy seaport might be ideal for warehousing and exportation facilities.
What Are the Limitations to the Cost Approach Method?
Major limits to the cost approach are that it does not consider potential property income, and it does not take into account comparable properties.
Other potential limits to the cost approach include:
Cost Approach Helps Measure CRE Market Health
The cost approach can also be used as a market health benchmark. When market prices are higher than a cost approach appraisal, it can be a sign of an overbought market. On the other hand, market prices below cost approach appraisals may signal a buying opportunity.
