In part two of our discussion of the three approaches to value we are going to look at the cost approach. This is a methodology for determining the appraisal value of a property. The main crux of this approach is to determine the depreciated reproduction value or replacement cost(new) of improvements, plus the market value of the site.
While it may be complicated to calculate the cost approach on your own, it can be done when doing a quick and dirty calculation to determine band of value to compare against the other two approached to value, market(sales), and income. It is recommended that you hire a qualified real estate appraiser to make these determinations if you are going to use the income approach appraisal in your lending documents and/or application with the bank.
So here is a simplified definition when determining depreciated reproduction value:
Depreciation is the loss in value from any cause such as physical deterioration, functional obsolescence and external obsolescence. Deterioration is the loss in value resulting from average wear and tear over time (such as exposure to the sun, peeling paint, . Functional obsolescence is the loss in value caused by deficiencies within the property such as lousy room layout or design and inadequate mechanical equipment (such as a home with only an evaporative cooler instead of an air-conditioner). External obsolescence is a loss in value caused by negative conditions outside of the property such as a change in zoning or excessive noise and traffic.
When using this approach to value, the idea behind this approach is that a knowledgeable buyer will not pay more for a house than the cost of reconstructing a substitute house on a similar lot in a similar condition. It is calculated as follows:
Cost of reconstruction – Depreciation + Value for land = Property Value
The subject house is similar in size, design and quality of construction to a new house that cost $250,000 to build. The subject house has depreciated by ten percent due to normal wear and tear and is on a lot valued at $100,000. Using the cost approach, the estimated value of the home is:
$250,000 – (10% x $250,000) + $100,000 = Property Value
$250,000 – $25,000 + $100,000 = $325,000
The final value to compare against the other approaches is $325,000.