What Is the Cost Approach to Appraisal?
When a bank requires an appraisal before approving a mortgage, the appraiser generally uses three different valuation methods: the Income Approach, the Sales Comparison Approach, and the Cost Approach.
The Cost Approach operates on a simple economic premise: a rational buyer would never pay more for an existing building than it would cost them to buy an empty lot and construct the exact same building from scratch.
The formula is: (Replacement Cost of the Building) - (Depreciation) + (Value of the Land) = Property Value.
When Is the Cost Approach Used?
While the Sales Comparison Approach is best for standard residential neighborhoods (because there are plenty of similar houses to compare), the Cost Approach is heavily relied upon for unique, special-use properties where "comparable sales" simply do not exist:
- Churches and Schools — Because a church is rarely sold on the open market, an appraiser cannot compare it to recently sold churches. They must use the Cost Approach to determine its value.
- Brand New Construction — If a developer builds a massive, cutting-edge commercial warehouse, the best way to value it is to calculate the raw cost of the land plus the exact cost of the steel, concrete, and labor used to build it.
- Hospitals and Government Buildings — Highly specialized properties that do not generate standard rental income (making the Income Approach useless) and do not have market comparables.
Calculating Depreciation
The hardest part of the Cost Approach is accurately calculating depreciation for older buildings. If a church was built in 1950, the appraiser calculates what it would cost to build it brand new today, but then must subtract 70 years of physical wear and tear (physical obsolescence), outdated architectural design (functional obsolescence), and neighborhood decline (economic obsolescence) to arrive at the true current value.
Related Terms
- Appraisal — The overarching process of determining property value
- Fair Market Value — The ultimate goal of the appraisal calculation
- Mortgage — The bank loan that relies on the Cost Approach for collateral validation
Barnes Walker Real Estate Law
Barnes Walker's attorneys frequently challenge inaccurate property tax assessments and eminent domain valuations by scrutinizing the specific construction cost data and depreciation models used by government appraisers under the Cost Approach. Request a legal inquiry for assistance.
Reviewed by the attorneys at Barnes Walker, Goethe, Shea & Robinson, PLLC