What is the Cost Approach and when is it used?

The cost approach is another method an appraiser may use to develop an opinion of value.

In a nutshell, it’s a breakdown of what it would cost to rebuild the property today if it were destroyed. But it’s not that cut and dry-you also have to take into consideration the value of the land and deduct for any depreciation.

There is a common misconception with the cost approach. The cost approach is a valuable approach to use when appraising newer homes that might have little or no depreciation; however for homes older than a few years, it is not very reliable. Some underwriters still want these completed regardless of the age of the home and that’s when start running into confusion from borrowers. There is a big difference between the cost of building a home today versus 30 or 40 years ago.

Why is it completed then?

Some lenders still require this, even though Fannie Mae, Freddie Mac and FHA do NOT. If it is a lender/client requirement, the Cost Approach will be completed, regardless of the property’s age.

So, to clear this up for your borrowers, the easiest way to explain it is to simply break it down.

First, we have the site value. This is the value of the land minus any improvements. This is typically determined by vacant land sales in the market area.

Next, there is the cost to construct the dwelling-this is a big one for borrower’s because they often think that this cost per SF should be what their home’s value is per SF, which is not the case. This is showing what it would cost per SF to build this home today as new construction, using today’s materials. The age of the home has not yet been taken into account, but we’ll get to that in just a minute.

After this the appraiser will add any additional improvements and what their cost new would be. This property has a porch, patio, screened pool, FP and boat dock, which the appraiser is estimating would total $85,000 new.

Right beneath this is the cost for garage or carport-this is again showing the cost per SF to build new. These items combined give you the estimated cost if the property were NEW.

Now comes the fun part. We have the depreciation-which takes into account the age and condition of the Subject as well as any functional or external obsolescence (RR tracks, commercial influence, only access to the bath through a BR…). In this case the property had functional obsolescence due to being a 2 BR property which is not common for the market). That, combined with the physical depreciation due to age/condition is estimated at $40,518, which is deducted from the cost to construct new.

There is one last thing to do in order to get to an estimated value of the property. The “as is” value of site improvements, which would be driveways, private wells, sewer systems, etc. Some appraisers include these items in the site value or additional improvements above, so it may be blank. As long as they’re including this and are consistent, this is okay. All of these items you see provide an estimated value of the property.

For residential appraisals, the Sales Comparison Approach is almost always the driving force behind determining current market value, with the Cost Approach lending additional support.