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Real Estate
Trainers, Inc.

Real Estate

Lesson 9
Section 4

The Cost
Approach -
Outline Text

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I. Introduction

A. The cost approach to appraisal is based on the following formula:

Construction costs - Depreciation + Land Value = Appraised Value

II. Applications and Limitations of the Cost Approach

A. The cost approach is most valuable when the other approaches to value will not work, such as churches, libraries or schools.

B. The reliability of the cost approach is limited by:

1. The accuracy of the estimate of building costs; and

2. The accuracy of the depreciation estimate.

C. The cost approach tends to be more accurate for new buildings than for old buildings, because there would presumably be less depreciation in a new building.

III. Replacement vs. Reproduction Cost

A. Reproduction costs are the costs to build an exact duplicate of the existing structure.

B. Replacement costs are the costs to construct a building that would serve the same purpose as the existing structure.

IV. Estimation of Building Costs

A. There are three methods of estimating building costs:

1. Comparative unit (square foot);

2. Unit-in-Place method; and

3. Quantity Survey method.

B. Comparative Unit

1. The comparative unit method is the most common method.

2. It is also referred to as the square footage method.

3. It involves referring to published tables which list the cost per square foot for different types and qualities of construction.

4. e.g., Referring to a table, one might find that the cost to build a 2,000 square foot residence of good quality construction might be $73.50 per square foot.

C. The Unit-in-Place Method looks at the installed cost of each component part of the structure.

1. One would look at the installed cost per linear foot of the walls, per square foot of the flooring, etc.

D. The Quantity Survey method is the method contractors use to make a bid on a construction project.

1. One would look at all of the materials required, the labor costs, permit fees, overhead and profit allowance, etc.

V. Estimate of Depreciation

A. In appraisal theory, depreciation is anything which causes a property to lose value.

B. Depreciation can be either curable or incurable.

1. Depreciation is considered curable if the cost of fixing the problem adds at least that much to the value of the property.

C. There are three main categories of depreciation:

1. physical deterioration;

2. functional obsolescence; and

3. economic obsolescence.

D. Physical Deterioration

1. This is the normal wear and tear experienced by all physical assets.

2. Physical deterioration is usually, but not always, curable.

E. Functional Obsolescence

1. Functional obsolescence is a loss in value caused by reduced utility or desirability.

a. e.g., a house without a master bedroom would suffer from functional obsolescence if the other homes in the neighborhood have master bedrooms.

2. Functional obsolescence can be either curable or incurable.

F. Economic Obsolescence

1. Economic obsolescence is a loss in value caused by factors outside of the property itself.

a. A loss in value caused by a recession would be one example of economic obsolescence.

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