Cost approach and depreciation
The cost approach asks: what would it cost to build this property today, minus the value it has lost, plus the land? It rests on the principle of substitution: an informed buyer won't pay more for an existing building than the cost of building an equally useful one.
Value = land value + (cost new of improvements − accrued depreciation)
The steps
- Estimate the land value as if vacant, usually from sales of similar lots.
- Estimate the cost new of the improvements as of the appraisal date.
- Estimate accrued depreciation from all causes.
- Subtract depreciation from cost new.
- Add the land value back.
Land is valued separately because land does not depreciate. Only the improvements wear out or go out of style.
Reproduction vs. replacement cost
| Reproduction cost | Replacement cost | |
|---|---|---|
| What it builds | An exact replica: same materials, design, and layout | A building with the same utility using modern materials and methods |
Replacement cost is used more often. Reproduction cost copies the building's flaws along with its features.
Depreciation: three types
Depreciation in appraisal means loss in value from any cause. It is not the same as tax depreciation.
- Physical deterioration: wear and tear, deferred maintenance, pests, weather damage. Can be curable or incurable.
- Functional obsolescence: a problem with the design or features of the property itself, such as a poor floor plan, outdated systems, or too few bathrooms. Can be curable or incurable.
- External (economic) obsolescence: a problem outside the property lines: a nearby nuisance, a zoning change, or a weak local market. It is almost always incurable, because the owner can't fix something on someone else's land.
Curable means fixing the problem costs no more than the value the fix adds. Incurable means the cure costs more than it adds, or the problem can't be fixed at all.
Fannie Mae gives two clear examples: a floor plan where you must pass through one bedroom to reach another calls for functional depreciation, and a home backing onto a shopping center calls for external depreciation.
Straight-line (age-life) depreciation
The simplest method spreads depreciation evenly over the building's economic life.
Annual depreciation = cost new ÷ economic life
Accrued depreciation = annual depreciation × effective age
Effective age reflects condition, not the calendar. A well-kept 25-year-old house might have an effective age of 20.
Worked example
Land is worth $120,000. The building would cost $420,000 to replace new, has a 60-year economic life, and an effective age of 15 years.
- Annual depreciation: $420,000 ÷ 60 = $7,000
- Accrued depreciation: $7,000 × 15 = $105,000
- Depreciated building: $420,000 − $105,000 = $315,000
- Value: $315,000 + $120,000 = $435,000
When it is used
The cost approach is most useful for new construction, unique or special-purpose properties with few comparable sales, and properties with significant depreciation. Fannie Mae does not accept an appraisal that relies only on the cost approach; it usually supports the sales comparison approach.