The Cost approach. What is it?
Another method an appraiser may use to develop an opinion of value is the cost approach.
In a nutshell, it’s a breakdown of what the cost would be to rebuild the property today if it were destroyed – but it’s not that cut and dry. The term reproduction cost is used if an exact replica of the original property is produced. If a property is rebuilt with comparable utility but uses current design and construction methods and materials, it is referred to as replacement cost.
The appraiser also takes in to account the land value and any deduction or additional value for depreciation or appreciation.
Depending upon the age of the home, the cost approach may not always be the most beneficial for your appraisal. The cost approach brings value when appraising newer homes that might have little or no depreciation. For homes older than a few years, it is not considered very reliable. There is a big difference between the cost of building a home today versus 30 or 40 years ago.
If there are limitations, why would an appraiser utilize this method?
This may seem confusing to the borrower, but it could be a requirement per the lender – even though Fannie Mae, Freddie Mac and FHA do not require it. If this is a concern, research all potential lenders you may be using if you don’t think it would be in your best interest.
Now let’s break down the process to clear things up.
First, we have the site value. This is the value of the land minus any improvements and is typically determined by vacant land sales in the market area.
There is also the cost to construct the dwelling – borrowers often assume that this cost per square foot should equal what their home’s value is per square foot, which is not the case. It shows what it would cost per square foot to build this home today as new construction, using today’s materials. The age of the home has not yet been considered.
Following the construction cost of the dwelling, the appraiser will add value for any additional improvements such as an in-ground pool, or a porch at what their cost new would be at today’s prices.
A borrower’s favorite term – depreciation, is now the not so fun part. The appraiser must consider depreciation-which considers the age and condition of the property, as well as any functional or external obsolescence (for example, railroad tracks, commercial influence, only having access to the bath through a bedroom). To arrive at an estimated value of the property, the appraiser must consider the “as is” value of site improvements, which could include driveways, private wells, sewer systems, etc.
Together, all these items described provide the appraiser with an estimated value of the cost to reconstruct the same property.