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Appraisal Cost Approach

Appraisal Cost Approach uses the reproduction cost to estimate the market value of the subject property. The appraiser uses an estimate based on the cost to replace or reproduce the subject property being appraised. This approach takes into account the cost to build an identical house to the subject property. The cost of the identical house is determined at today's prices (if today is the "as of" date), minus the three forms of depreciation, (physical, functional and external). I will describe the three forms of depreciation a little later. The result of the cost analysis at today's prices minus the depreciation will give you the depreciated value of the building. The site value with the site improvements is then added to the depreciated value of the building to get the final estimated market value of the subject property. Please review the sample appraisals in this book to view examples of the Cost Approach for an actual written appraisal report.

You also need to review section HUD and FHA Guidelines and section Real Estate Appraiser Guidelines for more details and rules about appraisal standards and how to fill out the standard appraisal report forms.

Appraisal Cost Approach is based on the assumption that a typically informed buyer would not pay more for the subject property then it would cost him to build a similar property.

Appraisal Cost Approach is based on the assumption that a typically informed buyer would not pay more money for the subject property then it would cost him to build a similar property. The similar property being considered would have the same utility and depreciation as the subject property. Meaning, that if a house was selling for $215,000 and the typical buyer could have a similar house built for about $190,000, then the buyer would probably build a similar house. The buyer might want to build a similar house, rather than pay more money for the existing subject property. Now you have to remember that the cost of the similar house the buyer would be pricing to have built for himself must take into account all of the three forms of depreciation that the subject property currently has.

Appraisal Cost Approach uses the Replacement Cost and the Reproduction Cost. The Replacement Cost estimates the cost of replacing the utility of the subject property. This takes into account the three types of depreciation of the subject property: physical, functional and external. The Reproduction Cost is the cost to reproduce the subject property by building it with all new construction, from the ground up. The construction will be in the identical style, square footage, room layouts, construction materials, etc. as the subject property. The Reproduction Cost is the dollar amount of reproducing the building with its current materials, (plaster, stone, sheetrock, wood frame, etc.). In this reproduction cost, it also includes all of the building's current depreciation, (physical, functional and external).

Basically, the Cost Approach takes the Reproduction Cost New of the building, minus the depreciated items, plus the site value. The result is used as an estimate of current market value. Four methods used with the Cost Approach:

  1. Quantity Survey Method - A method of cost estimation that replicates the contractor's original procedure in detail. This is the most detailed way to estimate market value using the Cost Approach.

  2. Unit In Place Method - A method of cost estimation that includes materials and labor in the unit cost of component sections of thestructure "in place."

  3. Trade Breakdown or Segregated Cost Method - A method of cost estimation that breaks the major functional parts of the structure into an installed unit cost. It's the breakdown to cost out the structure as though you were building it new.

  4. Comparable Unit Method - A method of cost estimation that lumps together all components of the structure and converts the lump sum amount to a unit basis (e.g., per square ft., per cubic foot). This is the method that is most often used to fill out the form appraisal reports. Cost estimate books are used to assist the appraiser. Unfortunately, it's also the least accurate method to use for the Cost Approach to estimate market value.

 

The cost estimate that you arrive at in the Cost Approach does not have to equal the value of the property. This means that the estimate of value in the Direct Sales Comparison or Income Approaches, doesn't have to equal the value you estimate in the Cost Approach. Appraisal Cost Approach also DOES NOT have to be the highest estimate of value for all three approaches to value, (Direct Sales, Income and Cost Approaches). I'll elaborate on that again so you don't forget it. Don't use the assumption that the Cost Approach should always be the highest value for the subject property. This is an old myth that some appraisers are led to believe is always true. Because of this myth, all of their appraisal reports intentionally show the Cost Approach as the highest estimate of value. You have to keep an open mind about this. Many appraisers, and some third parties, will try to tell you that the Cost Approach has to be the highest estimated value in a report. Baloney!! Anyone who tells you that doesn't know what they're talking about. See section Appraisal Cost Approach on for an explanation of the logic and reason on this.

Appraisal Cost Approach also DOES NOT have to be the highest estimate of value for all three approaches to value. Many appraisers will try to tell you that the Cost Approach has to be the highest estimated value in a report. Baloney!!

Real Estate Expert Investing Advice FSBO Homeowners House Buyers Sellers Realtors Agents Brokers It's true that often the Cost Approach may be the highest estimate of value. However, let's say you're appraising a house and you do the cost analysis of the construction materials to duplicate the site and improvements. After you do this cost analysis, you find that it costs less money to build the subject property than it's estimated value using the Direct Sales Comparison Approach. The difference between the cost of the site and improvements and the value of the site and improvements, could be due to the builders profit! This has to be figured into the calculations of the cost to reproduce the property. Appraisal Cost Approach doesn't have to always be higher than the other approaches to value. The reason for this is: Why would someone go through all the work, problems and risks of building a house just to have a small profit, or no profit at all? The builder will certainly want to make a big profit on the deal for all of his/her time, effort and financial risk involved in building a house. If the cost of the site and improvements is greater than the value of the site and improvements, then the builder will lose money on the deal! How long could you stay in business if you lost money on every house you built? Not very long. If you want, you can include a figure in your cost analysis amounts to account for the builder's profit.

Appraisal Cost Approach is only really effective when used for relatively new buildings that are the Highest and Best Use of the site. This approach isn't very effective for older houses.

Appraisal Cost Approach is only really effective when used for relatively new buildings that are the Highest and Best Use of the site. This approach isn't very effective for older houses. It's not effective due to the margin for error with an older house in estimating the three types of depreciation. Also, with older houses there is a large margin for error in estimating the cost of using the same construction materials today. Appraisal Cost Approach is used more effectively when there are no good comparable properties available to assist the appraiser. A reason for a lack of sales could be due to unique or unusual improvements on the subject site.

For buildings in crowded urban areas, like a big city, there are probably very few (if any) vacant land sales to analyze and so the Cost Approach isn't very effective. If you have no vacant land sales, then you have to estimate the land value by using a residual technique. This simply means that you have to take sales and estimate the cost of only constructing the building. After that, you must take out for any depreciation that affected the sale. What you're left with is a residual value for the vacant land which is an estimate of the land value. There are three types of residuals used for appraisal purposes:

  1. Land

  2. Building

  3. Property

Land doesn't depreciate from wear and tear over the years. It can lose or gain value, but it doesn't depreciate from a tax deduction standpoint. You can use the residual values to help you in estimating the depreciation of a site or the improvements. For example, let's say you were doing the Cost Approach for a single family appraisal. We'll assume that you were trying to estimate the value of the lot for a sales comparable. However, you can't find any vacant land sales because the area is too built-up and/or there are no recent vacant lot sales to use as comparables. You could estimate the Reproduction Cost New of the building, and then subtract the depreciation amount. Then take this figure, plus the site improvements, and subtract it from the value of the property. You're left with an estimated value of the vacant lot.

You can also use the Assessed Value Ratio for the area to help you figure out the vacant land value. Do this if there are no vacant land sales in the subject neighborhood. See section Tax Assessments on for more information about the Assessed Value Ratio. There are various other techniques you can use. However, they're much more involved and you would be better off learning them while taking the State appraisal courses. They're too involved to teach properly outside a classroom atmosphere.

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