Why Sidestepping it Can be Costly
By Gretchen Gary and Richard Vishanoff
donít like using the cost approach. Itís too time consuming. Market-based
appraisals are always more reliable. Besides, Iím not required to include the
cost approach in my appraisals. Itís not relevant anymore.Ē Sound familiar?
youíre skipping the cost approach, you could be doing a great disservice to
your clients and your appraisal practice. Hereís why.
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.
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
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.
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.
Todayís 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.
addition, loan officers hammer away at appraisers to hit the target prices on
the sales contract. This further fuels an already hyper-inflated market. In hot
housing markets, the cost approach can produce an estimate that is more in line
with sustainable real estate values than the inflated valuations that are
commonly derived using the market approach.
CA = QC (Cost
Approach & Quality Control)
The cost approach has always served a crucial quality control function. Historically, it has been used to verify market-based estimates and to help identify a potential runaway or rapidly declining market. If the cost approach comes in well below market prices, it may be a signal that the market is rising beyond sustainable levels. If the cost approach comes in significantly above the market, it may signal that prices have dropped below reasonable levels. In other words, the cost approach provides a much needed reality check in both strong and weak markets, establishing a trustworthy benchmark of value.
across the globe have witnessed time and time again that markets without reality
checks are capable of generating obscene transaction values, resulting in
dangerous bubble scenarios. Amid fears of the current housing bubble bursting,
appraisers would do well to incorporate the cost approach into their daily
operations to ensure accountability and avoid over-inflated appraisals.