Have you already had a chance to read about the
Income Approach to real estate appraisal? If you have, you’ll know it deals with looking at how much income the property is likely to generate. But this only gives us one side of the story, so it never hurts to use the cost approach too.
What is the Cost Approach?
The cost approach is based on the idea that a property’s value should be equal to the cost it takes to build it in today’s dollars. In other words, if you were to rebuild the house today – what would it cost to do?
The benefits of using the cost approach
Here are the top three benefits of using the cost approach:
Accuracy – The cost approach allows for more specificity and accuracy than the comparable method. Investopedia suggests that this is a favorable method to use for a home located in a neighborhood where it clearly stands out from its neighbors. Mainly, it makes it hard to use the comparable method since no homes are similar.
Unique Properties – Specifically for buildings referred to as special-use properties, these tend to be public buildings like schools and libraries, as well as churches. Since these types of properties are low or no income generating, it makes it tough to use the income approach.
Market Indicator – Some say the cost approach can even help you to gauge a local real estate market. Namely, if your cost valuations are lower than market prices then you know the market is hot. And if your cost valuations are higher, well, you should look to change that.
The first step to apply the cost approach
First, you must choose between one of two ways to measure cost. You can choose the replacement method or the reproduction method. Allow me to explain:
Replacement Method: this is based on rebuilding the property using up-to-date materials
Reproduction Method: this is based on rebuilding the property using original materials
How to apply the cost approach to determine market value
Then to determine the market value of the property you must:
Find the cost of the land - Unfortunately if similar vacant lots of not available then you’ll have to make an estimate, which can skew the accuracy.
Add the cost of building the house to the cost of the land - this can be tough if outdated supplies were used and are no longer available for price reference.
Less any depreciation – if you’re looking into future years, you’ll need to account for any depreciation.
A good rule of thumb for all of you commercial real estate investors reading this. Remember that it’s best to use all 3 real estate valuation techniques. Each one has its best suited use. It’s also said that the cost approach allows more flexibility and accuracy when it comes to accounting for the details of a property.
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