Having a firm grasp of real estate valuation is essential before making any property investments. This is an excellent tool for estimating the profitability of a real estate investment. Appraisers use a variety of methods to determine the fair market value of commercial properties, however, one of the most common is the cost approach. So, what is cost approach appraisal?
What Is Cost Approach Appraisal?
In real estate, cost approach appraisal is a way of determining how much a property is worth by comparing it to the cost of constructing an equivalent structure. This means that the value of the property is equivalent to the cost of constructing a new, like-kind structure on the same lot. This includes construction costs and the cost of the land minus depreciation.
This strategy is grounded in the assumption that potential buyers will not offer to pay more money than is necessary to cover the present cost of building a property of a similar nature. It is the only real estate valuation approach that does not establish the price of a property based on the current market.
How Does Cost Approach Work?
Land availability is one of the many presumptions underlying this methodology. In the absence of comparable vacant land, you would have to estimate the worth of the property and this would result in a less reliable evaluation. If comparable building materials were also unavailable, the appraisal of the property could also become less precise.
Unique properties with recent comparable sales can be valued quite accurately using the cost method. Using this form of appraising, the value of a property may be easily calculated by following this formula:
- Cost of construction – Depreciation + Land Worth = Value of the Property
This approach disregards other market factors such as other similar structures because it is based primarily on the costs that are incurred during construction. This reason is why it is not necessarily the preferred choice for all investors.
Assuming that the lot on which it was built was assessed at $150,000, the cost to build the property from scratch was estimated at $210,000, and the property had fallen in value over time by $25,000, you can calculate the value of the property this way:
Cost of construction – Depreciation + Land Worth = Value of the Property
210,000 – 25,000 + 150,000 = Value of the Property
Therefore, based on this appraisal method, the value of the property would be set at $335,000.
Cons of Cost Approach Appraisal
Even if there are situations where this method of appraisal would be useful and enlightening, there are a few things to keep in mind. In practice, the income and comparative techniques may be more accurate than this approach.
This method of valuation relies on a number of presumptions. Among these is the presumption that:
- The purchaser will be able to find sufficient land on which to construct an exact replica of the subject property
- It is also assumed that a similar plot of land is readily available and accessible
When a similar plot of land or identical building materials is unavailable, then the accuracy of the appraisal is greatly reduced. Estimating depreciation, especially for older assets, can be difficult because it is not simple to measure and cannot be measured in a single way.
Ideal Situations to Use the Approach Appraisal
There are situations where this approach is not only appropriate, it is also essential, despite its drawbacks. For instance:
- When dealing with new or unique properties, it is extremely useful to value the various components of the property independently
- When dealing with relatively new property, the approach works best. This makes it less of a guessing game when it comes to depreciation and allows for more accurate cost new estimates.
Unfortunately, as the age of the property increases, so does the amount of uncertainty and the difficulty in reaching a valuation using this method.
Notably, the approach is equally appropriate for properties that are either under-improved or over-improved. These kinds of properties are not excellent candidates for the sales comparison approach and would require an appraiser to consider their unique features. This also includes buildings like libraries and churches amongst others.
Alternatives to the Cost Approach Appraisal
The cost approach appraisal is one of many other methods for commercial real estate valuation. Here are some other valuation methods that can be used alternatively or in conjunction with the approach:
Sales Comparison Approach
This valuation method determines the value of a property based on recently sold comparable properties. Appraisers also consider factors like price per square foot, cap rates, building conditions, and tenant information.
Cap Rate Approach
Cap rate helps you evaluate commercial property value. Divide net operating income (NOI) by the cap rate to calculate property value. This formula is most useful when you expect cash flow to stay the same.
Discounted Cash Flow Approach
Although the discounted cash flow method is more difficult to calculate, it yields a more practical valuation because it takes into account the cash flow’s potential future growth. This method can be crucial when you want to examine cash flow on a yearly basis.
If you are looking to conduct a valuation on your commercial property, it is best to work with commercial real estate experts like Si Vales Valeo Real Estate. We have vast experience in advising and handling commercial real estate transaction steps including various valuation methods. We are your best shot if you want to invest in the Cincinnati MSA.
What Is the Difference Between Income Approach and Cost Approach?
Most of the time, the latter is used to determine the maximum possible price for a piece of property. The income approach, often called the income capitalization approach, is commonly used by appraisers and valuers to precisely calculate the worth of any income-generating property.
Which Cost Approach Is Mostly Used?
The version of this approach most commonly used is land value. When estimating land value, most people opt for a direct comparison.
This appraisal method may not be the most popular. However, it is particularly useful when a building is new or there are few comparable buildings on the market. This will help you comprehend the cost strategy. This knowledge should help you appraise and analyze commercial investment properties.