We follow a standard set of procedures in almost everything we do, whether it’s changing a tire to baking a cake. Appraising property follows a standard set of procedures as well. It is known as The Valuation Process.
A major component in the valuation process involves the approaches to value. These “approaches” include the sales comparison approach, the income capitalization approach, and the cost approach. The cost approach is described in this article.
In the cost approach, the value of a property is derived by adding the estimated value of the site to the current cost of constructing a reproduction or replacement for the improvements and then deducting the amount of depreciation in the structures from all causes. A factor for entrepreneurial profit or incentive is usually included in the value.
The current costs to construct the improvements may be obtained from cost manuals, estimators, builders, and other contractors. The various influences of depreciation are provided through market research. Depreciation can be applied due to physical wear and tear, functional deficiencies, and external or economic issues. Specific procedures are used in the calculation of these various forms of depreciation. Finally, the value of the land is derived through the application of the sales comparison approach where sales of land similar to the subject were recently transacted.
The conclusion of value in the cost approach usually provides an indication of value for the fee simple interest; however, if the subject property is encumbered by leases, an adjustment to the indicated value by the cost approach may be required.
The cost approach may be a good indicator of market value for properties that are relatively new since the factors of depreciation are typically minimal. However, the cost approach is seldom the only approach to value that is developed particularly if the property is leased.
In the next installment, the income capitalization approach will be explained. This approach to value is very important for the development of market value for leased properties.