A Closer Look at the Cost Approach Valuation Method
First of a Three-Part Series Exploring Real Estate Valuation Methods
The result of the valuation process is a customized real estate appraisal report featuring one number every client wants to know – the estimated value of the subject property. To arrive at this number, real estate appraisers use three valuation methods: cost, sales comparison and income capitalization. During the valuation process, we calculate the value using the valuation techniques that are applicable, and then we reconcile our findings into a single point estimate in the determination of value.
In this series, we will examine all three methods, starting with the cost approach. The cost approach is predicated on the economic principle of substitution which means buyers or renters will not pay more for a property than it would cost to build, buy or rent a similar property. An appraiser will apply this valuation method for newer and proposed construction as well as special purpose properties like a school, theater, church, or public utility that do not typically have other comparable structures.
“The cost approach is typically applied to determine the value of building a brand-new structure versus using an existing structure,” said Argianas & Associates Vice President Alexander Argianas. “We calculate the property’s value by subtracting depreciation and adding back land value.”
Real estate depreciation can occur in the following ways:
- Physical Obsolescence – Wear and tear on the property that has not been repaired or taken care of like chipped paint, roof damage or worn carpet.
- Functional Obsolescence – Outdated construction or technology like a ten-story building without an elevator.
- External Obsolescence – Factors outside of the property that will hurt the marketability such as an apartment building that is across the street from a noisy highway.
- “When appraising a property, we work to determine whether or not a depreciation is a curable or incurable obsolescence. If it’s curable an owner can fix the problem with a fresh coat of paint or a new roof,” explained Alexander. “If it’s incurable, that means it would simply cost too much money to fix the deficit.”
The cost approach is often used for a business owner to decide whether to use his/her money to build a new property or buy and update an existing one. “Say you own a mousetrap company. The mousetrap factory burns downs, and you want to build a new one,” explained Alexander. “It would cost $10 million to build a brand-new factory on your existing property. Or you could buy an existing factory at another location for half the cost. Cost Approach dynamics will help a decision maker determine the best course of action based on his/her business and financial goals.”
This information is essential as buyers weigh the cost of building a property versus acquiring existing property. The marginal difference in dollars can be used for the business owner’s operating capital, although some operators choose to build a new facility to specifically meet their business and branding needs.
From coal plants to churches to college campuses, there isn’t a special purpose property our team hasn’t appraised. If you have any questions about your property or real estate valuation report, do not hesitate to give us a call at (630) 390-0113. To read part two and three in our series outlining the sales comparison method and the income capitalization approach, be sure to join our mailing list to receive our e-newsletter.