Cost Approach: Why Sidestepping It Can Be Costly

Cost Approach
Why Sidestepping it Can be Costly
By Gretchen Gary and Richard Vishanoff

"I don't like using the cost approach. It's too time consuming. Market-based appraisals are always more reliable. Besides, I'm not required to include the cost approach in my appraisals. It's not relevant anymore." Sound familiar?

If you're skipping the cost approach, you could be doing a great disservice to your clients and your appraisal practice. Here's why.

The cost approach is the most reliable valuation method for a variety of assignments. It is primarily useful when projecting costs for new or proposed construction or where a lack of market activity limits the effectiveness of the sales comparison or market approach. It is an essential method when land value is well supported, when improvements represent the highest and best use of land, and for special-purpose properties not frequently exchanged on the market.

It is an excellent way to verify the validity of market value and to adjust estimates to account for unique features of the subject.  It is also extremely useful in determining depreciation values for physical deterioration or functional or external obsolescence, as applied to the market approach.

Dollars and Sense
The market approach supposes that the value of a property is best measured by what similar properties in similar environments have sold for, all differences accounted for. Obviously, prices can not exceed what buyers are willing to spend, but in times of housing shortages and increasing demand, it becomes difficult to gauge what a reasonable price is.  

Based on the reasoning that a buyer will not pay more than the cost to reproduce or replace the subject property, the cost approach is used to determine a replacement or reproduction cost minus depreciation. That figure is then added to the estimated land value to complete the appraisal. Many argue that the cost approach can be unreliable and incomplete. And depending on the extent of the training and expertise of the appraiser, this can be the case. But in these instances, incorrect usage and wrongly applied methodology are more to blame than the method itself.

Market Approach: Appraiser Beware
Today's real estate market presents unique challenges for appraisers who only use the market approach. In many markets throughout the country, a housing shortage coupled with increased demand has driven prices up considerably. In markets such as these it is quite common to see a surge in prices that misrepresents the real value of the subject property. While sales of previously owned homes keep the economy churning, not nearly enough new units are being built to satisfy short-term demand. If market values substantially exceed replacement cost, including land, there is a significant risk that values will slide over the next few years when the expected supply surge catches up with demand.