Which of the following statements is true regarding the cost approach method of estimating value?

Your county Assessor and their appraisers use one or more of the three approaches to value to produce appraisals that are used by the Assessor to estimate fair market value for property tax purposes. The Cost Approach estimates value based on the typical cost of materials and labor necessary to build a structure of similar size and quality in that location while accounting for depreciation due to age and condition. The Sales Comparison Approach estimates value based upon the price, in the local market, necessary to acquire a property of similar location, quality, size, age, and condition. The Income Approach estimates value based upon typical market income of a similar property.

Cost Approach to Value

In the cost approach to value, the cost to acquire the land plus the cost of the improvements minus any accrued depreciation equals value.  Depreciation is a loss in value from any cause, and can take the form of physical deterioration, functional obsolescence, or economic obsolescence.  The underlying premise of the cost approach is that ‘a potential user of real estate won't, or shouldn't, pay more for a property than it would cost to build an equivalent.’ (PRINCIPLE OF SUBSTITUTION)

Sales Comparison Approach to Value

The sales comparison approach is directly rooted in the real estate market. The value of the subject property is equal to the sales prices of comparable properties plus or minus any adjustments.  The sales comparison approach compares a piece of property to other properties with similar characteristics that have been sold recently.  The sales comparison approach takes into account the affect that individual features have on the overall property value, meaning that the total value of the property is a sum of the values of all of its features.

Income Approach to Value

The income approach quantifies the present worth of future benefits associated with ownership of the real estate asset.  The income approach comes in two different forms:  net income approach and gross income approach.  Net income is what is left over after vacancy and collection loss and allowable expenses have been subtracted from the potential gross income.  The net income is divided by a capitalization rate (the investor’s desired rate of return) for an estimate of value.  In the gross income approach, the income is multiplied by a factor in order to arrive at the value.  The net income approach is typically seen on larger commercial occupancies like office buildings, retail, apartments and hotels / motels.  The gross income approach is typically seen on income producing residential properties.

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How It Works

The cost approach is based on the logic that informed buyers will not pay more for a property than it will cost them to build to a similar property from scratch and with the same level of utility. The cost approach is appropriate for unique properties, such as churches or schools with unique components. Also, for a new property, it is easy to estimate the cost of construction since the improvements were recently built.

The formula for calculating the cost approach is as follows:

Property Value = Replacement/Reproduction Cost – Depreciation + Land Value

Since the cost approach is not based on comparable properties or the property’s ability to generate revenues, the method considers the amount that will be incurred to build a property today, assuming that the existing structure is to be destroyed and rebuilt afresh. Hence, it takes into account the value of the land where the property is built, less any loss in value.

Steps in the Cost Approach Method

The following is the process of the cost approach method of real estate valuation:

1. Estimate the reproduction or replacement cost of the structure

The step involves estimating the current cost of building the structure from scratch and the site improvements. The cost can be estimated using the following two methods:

Replacement method

The replacement method estimates the cost of constructing a building with the same utility as the structure being evaluated, using the current construction materials, standards, designs, and layouts.

Reproduction method

The reproduction method estimates the cost of constructing a duplicate of the property, using similar materials and construction practices. It also uses the designs, standards, and layouts that were in place at the time the property was constructed.

The older and more historic a property is, the higher the difference between the replacement and reproduction costs. Building a duplicate property of a historical building is more expensive than duplicating a modern home because it will cost more to buy materials and undertake site improvements.

For a newly built property, there is no major difference between the replacement and reproduction costs. For example, assume that the reproduction/replacement cost is estimated to be $1 million.

2. Estimate the depreciation of the improvements

Depreciation is the loss in value of the building and or its improvements, and it causes the difference between the value of improvements and the current contributing value of the improvements. When estimating the depreciation of the property, you should consider the physical, functional, and economic depreciation.

Physical depreciation refers to the wear and tear that occurs as the building ages, while functional depreciation occurs with the changes in consumer tastes and preferences over a period of time.

Economic depreciation results from external negative trends, such as the collapse of major employers, recession, and new negative developments (such as the construction of a sewer treatment plant in the neighborhood). In this case, let us assume that the accrued depreciation is $150,000.

3. Estimate the market value of land

The next step is to estimate the value of the land on which the property is being built. The most appropriate method of estimating the land value is the direct comparison method, where the current price of land is obtained from the value of recently sold plots of land. It is the market value that you would pay for the land today if it was vacant. In this case, let us assume that the market value of the land is $750,000.

4. Deduct accrued depreciation from the reproduction/replacement cost

After obtaining the total value of depreciation of the improvements, deduct the figure from the estimated reproduction or replacement cost obtained in step one. In our case, it is calculated as follows:

Replacement/Reproduction Cost                                      $1,000 000

Less: Accrued Depreciation                                                  $150,000

Depreciated Cost of the Structure                                       $850,000

5. Add the depreciated cost of the structure to the estimated value of the land

The final step is to add the depreciated cost of the structure and improvements to the estimated value of the land. The figure is obtained as follows:

Replacement/Reproduction Cost                                      $1,000,000

Less: Accrued Depreciation                                                  $150,000

Depreciated Cost of the Structure                                       $850,000

Add: Estimated Value of the Land                                        $750,000

Total Value of the Real Estate Property                            $1,600,000

Limitations of the Cost Approach

One of the limitations of the cost approach is that it assumes that the buyer is in a position to find a vacant plot of land where to build an identical property, and that is not always the case. If there is no vacant land, the estimated value of the property will be inaccurate.

Also, an area can be fully developed, and local authorities can be restrictive on new developments, and so it will be impractical to estimate land values in that area.

Another limitation is that it will be difficult to estimate the depreciation of older properties because there are many factors to take into account. For example, construction materials used during the construction of older property may no longer be available or in use. Estimating the value of such a property allows a lot of room for subjectivity.

More Resources

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