Cost approach

Key Takeaways

• The cost approach estimates value as the current cost to build the improvements, minus accrued depreciation, plus the value of the land.
• Only the improvements are depreciated in the cost approach. Land value is added back at full value after depreciation is subtracted.
• The cost approach carries the most weight when a property rarely sells and few similar properties have sold nearby, because there is little sales data to work from.
• The three approaches to value, cost, sales comparison, and income, are calculated independently of one another and then weighed against each other.

What It Means

The cost approach answers one question: what would it take to build this property again today, and how much value has the existing building lost since it was new? An appraiser prices the improvements at current construction costs, subtracts accrued depreciation for age, wear, and outdated design, then adds the value of the land as if it were vacant. The result is an indication of value built from construction economics rather than from recent sales.

That makes the cost approach the natural choice when sales data is thin. New construction fits well, because a building finished last year has almost no depreciation to subtract. So do buildings that seldom trade hands, where a search for Comparables turns up almost nothing usable.

Appraisers normally develop more than one approach and then weigh the results in Reconciliation. The three approaches are worked out independently of one another, so a weak set of comparable sales does not quietly bend the cost figure. Read the cost approach as one opinion among several, not as the answer by itself.

How It Works in Washington

Washington writes the cost approach into its property tax statute. RCW 84.40.030 requires all property to be valued at one hundred percent of its true and fair value in money. Subsection (3)(b) allows consideration of cost, cost less depreciation, reconstruction cost less depreciation, or capitalization of income. The same subsection goes further: for property of a complex nature, or property with no record of sale within five years and no significant number of sales of similar property in the general area, those factors must be the dominant factors in valuation. RCW 84.40.030(3)(c) also requires the assessor to determine the true and fair value of the land, exclusive of structures, and the value of the structures separately, which is the cost approach in miniature.

Who may be paid for the number matters just as much. Under RCW 18.140.020(1), no person other than a state-certified or state-licensed real estate appraiser may receive compensation of any form for a real estate appraisal. RCW 18.140.020(2) then allows compensation for a broker price opinion prepared by a licensee under chapter 18.85 RCW. RCW 18.140.020(6) adds the catch: if a written broker price opinion goes to someone who is not a prospective seller, buyer, lessor, or lessee, it must carry a statement that it is not an appraisal, and it may not be used as an appraisal in a federally related transaction. Broker license requirements are published by the Washington State Department of Licensing. When a lender's number lands under the contract price, the tactics are covered in our guide to what happens when a home appraises low, and the income side is broken down in beyond cap rate.

Example

Maria lists a two year old custom home outside Wenatchee. Only one similar custom build has sold in that neighborhood in five years, so the appraiser leans on the cost approach. She prices the 2,400 square foot house at a local replacement cost of $185 per square foot, which comes to $444,000. The detached shop adds $46,000, bringing the improvements to $490,000. The roof, paint, and carpet show two years of normal wear, so she subtracts $14,700 of accrued Depreciation, about three percent. Depreciated improvements come to $475,300. Comparable vacant lots in the same area sell for $140,000, and land is never depreciated, so the full $140,000 goes back in. Her cost approach indication is $615,300, which she reports rounded to $615,000. She still develops the sales comparison approach as a check, and the single comparable sale supports the range.

Common Mistakes and Exam Traps

• Replacement cost is the cost to build a structure of equal utility using current materials and methods. Reproduction cost is the cost to build an exact replica, including outdated features. Exam questions swap the two.
• Depreciation in the cost approach means loss in value from physical wear, functional problems, and outside influences. It is not the straight line depreciation an accountant claims on a tax return.
• Land is added at full value after depreciation is subtracted. An answer choice that depreciates the land is wrong.
• A broker price opinion is not an appraisal. In Washington a written broker price opinion issued to someone outside the transaction must say so, and it cannot be used as an appraisal in a federally related transaction.