How to Use the Cost Approach for Real Estate Valuation
Why Talk About Real Estate Valuation?
As I’m organizing this post, we’re still on something of a national “lockdown” from Covid-19. While there are plenty of predictions and lots of science out there, the only thing everyone agrees on at the moment is that none of us are entirely certain what things will look like in six months or a year. And yet, I’m about to share a popular real estate valuation method – the Cost Approach to Real Estate Valuation. I may even sound excited about it!
Seriously, Blaine – what’s the deal?
One way or the other, chances are good we eventually come out the other side of this. I’m not saying it will be easy or pleasant, but we all know that for better or worse, life goes on. People will need homes and start businesses. They’ll buy and sell stuff, including property to use as homes or for business. Some will invest in hopes of making a reasonable profit; others will use it themselves. And, just like now, some of them will understand how it works while others won’t.
The “Cost Approach” to Real Estate Valuation
I don’t want you to be part of the group that doesn’t know how it works. Plus, if you’re like me, you’ve got a bit too much time on your hands at the moment and we might as well learn a few things between binging on M*A*S*H reruns and finally organizing the workbench in the basement.
So wash your hands, don’t touch your face, and let’s get educated on a few real estate valuation basics, shall we?
The Four Factors of Real Estate Valuation
While there are different methods used to estimate the value of a residential or commercial property, they all consider these four factors in different ways:
How many people want this sort of residential or commercial real estate, right here, right now, at this price point? How badly do they want it? Can those who want it, afford it? Can those who can afford it, want it? The higher the demand, the more any property is worth.
This is equally true of pretty much everything from sports cars to comic books, by the way. Manufacturers can call something “collectible” as many times as they like, but if no one cares, it’s just more stuff.
What’s the supply of similar properties in the area look like? If you’re considering selling your home, how many similar places are already for sale in your neighborhood? If you’re looking to rent some office space, how many appropriate options are there in the same part of town? Scarcity is the flip side of demand.
If you’ve ever searched for an old album or toy you loved years ago, then found it online costing WAY more than you expected, the seller is relying on scarcity to get them the price they’re asking. Maybe demand isn’t so high – how many people are actually looking for Pavlov’s Lectures on the Work of the Principal Digestive Glands in the original Russian these days? Probably not TOO many – but then again, there aren’t many to be had, meaning it will cost you more than my car if you DO find one. That’s the power of scarcity.
How useful is it for its intended purpose? If the property in question is residential, this includes the condition of the building itself, the size of various rooms, the reliability of the actual “utilities” (electricity, plumbing, etc.), as well as location and other features.
If we’re talking commercial property, it matters whether or not customers need to find you easily or would feel comfortable in the area. Is there sufficient office space? A warehouse? Reliable heavy-duty electrical connections? And what’s that smell? These are utility considerations.
How easy or difficult would it be to do the paperwork to transfer ownership from one party to another? How easy or difficult is it to physically take possession? To move in or out? If there are legal, economic, of physical barriers to any of these, the property has less value.
What’s the Best Valuation Model for Determining the Value of Real Estate?
Which valuation model is the “best” is largely dependent on circumstances, and even then remains somewhat subjective. There are three common appraisal approaches you should be familiar with, however, before getting too far into buying or selling real estate.
The Sales Comparison Approach
This is the one with which most of us are familiar, and the one most utilized when buying or selling residential property. If you’ve ever been involved with buying or selling a house, you might not have thought of it in terms of “real estate valuation” because it was more personal than that – it was YOUR home you were looking to sell or YOUR house you wanted to buy.
But when your realtor showed up with those pictures and printouts from similar properties in your area which had recently been bought and sold, and he or she started talking about costs-per-square-foot and how long each one was on the market and what that says for your situation? Yeah, that’s real estate valuation using the sales comparison approach. Those other homes used to zero in on the potential value of yours or the one on which you were considering making an offer? Those are called “comparables” and they’re central to several of the most popular real estate valuation methods commonly used.
The Income Approach
This method is more common when considering the purchase of commercial real estate, like office spaces or rental homes. If you’re wanting to invest in a business park or thinking about becoming a landlord with a few of the homes that have been on the market for awhile in your area, this is the real estate valuation method you’ll find most useful.
The income approach starts with an estimation of the overall income potential of the property, minus the cost of maintaining it over time. The trick is to accurately predict that income and those costs, which is why it’s nice when there are comparables in the area to use as reference points. Even then, factors often change over time, so it can get tricky.
The Cost Approach
This is arguably the most complicated of the three. The sales comparison approach is mostly concerned with comparable values in the area – the “crowdsourcing” approach to value, if you will. The income approach is, of course, primarily focused on how much money you can make from leasing out the property or using it for your own commercial purposes – the “dollars and sense” approach, for lack of a better term. The cost approach, though, starts with the question of what it would cost to replace an entire structure if it burned down, was washed away, or mysteriously vanished on night and had to be completely rebuilt immediately.
That’s the one we’re going to spend the rest of this article talking about. It’s not the most popular method, and in many cases it’s not even the most accurate method. There are situations, though, in which it’s the only method that makes sense.
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Basics of the Cost Approach Real Estate Valuation Method
Just saying it all is a mouthful, isn’t it? That’s appropriate because while the concept of the cost approach isn’t so difficult, actually doing it well can get rather hairy. Let’s start with a general overview of this real estate valuation method, then zoom in on a few of the more essential specifics.
Here are the basic steps to real estate valuation using the cost approach:
Determine the cost of the land on which the property is located. This is usually rather straightforward since land doesn’t normally change in condition or value as quickly as other factors.
Determine the construction costs – labor, materials, permits, etc. – if you were to build the existing structures from scratch today. This is easier if the building is fairly new. For older structures, you’d need to decide whether to compute the value based on recreating what’s there more or less exactly – same materials, same design, same everything – or compute the value of replacing it with something of comparable size, quality, and usefulness using contemporary materials and design. (I told you it could get tricky).
Because we’re estimating the value of an existing property, not merely the cost of replacing it, you then have to factor in depreciation. Unless there’s some specific historical significance to the property – a landmark church that’s been there for centuries or the home in which someone important to the area grew up or whatever – older buildings simply lose value over time.
Be Pragmatic
This real estate valuation method often references comparables in much the same way as the sales comparison approach. With the cost approach, however, they’re not the primary factor so much as a guide for better computing replacement construction costs or estimating depreciation.
You’ve probably noticed as we talk through the basic steps that there’s an implied decision in play throughout – is it better to buy this existing property or build something like it down the street? Why would you build if it cost less to buy something just as valuable? On the other hand, why buy someone else’s property if you could build your own for the same cost? Whatever else it may be, the cost approach real estate valuation method is certainly pragmatic.
Some of us have auto insurance which works roughly the same way should there ever be damage serious enough that it makes more sense to replace the car or truck than to repair it. The vehicle is “totaled out” and you receive compensation based on replacement cost, only reduced based on how old the vehicle was. The cost approach valuation model for real estate is a bit more complex, but the basic ideas are the same.
Determining Construction Costs
I mentioned above that there’s an implied choice driving most of the cost approach method – should I buy this existing property, or build a new one? That’s not always literally what’s being decided. The method can be used to determine the value of a property for other reasons – insurance, taxes, etc. But it’s definitely founded on the idea that there are two basic choices whenever anyone wants to own property, whether residential or commercial – build or buy?
There are two frameworks for determining construction costs:
The reproduction method
This first method seeks to duplicate the existing structure as closely as possible – brick by brick, as it were, although it would be unusual for an actual project to be quite that specific. Sometimes this approach is taken solely “theoretically.” You need to compute the value of a property, so you assume replacement of these specific windows, this exact flooring, this many plumbing fixtures, this particular old furnace, etc. You no doubt see where this gets super-specific and potentially complicated. Once again, the newer the building, the easier this is to do.
In rare cases, such as assessing the value of a historical landmark or one-of-a-kind architectural accomplishment, this might be used to calculate actual duplication of the property in question. Most of the time, it’s an attempt at an accurate valuation model.
The replacement method
This one is a bit more pragmatic. If this building were to be replaced today, designed for the same purposes and duplicating its existing functionality, what would it cost? If you’re talking about small multi-family residential unit, for example, maybe it turns out there’ve been substantial improvements in roofing – more attractive shingles offering greater protection and durability than when the building was put up thirty years ago. Imitation wood floors which should hold up better than that generic 1980s carpet. More efficient doors and windows.
They don’t all have to be minor upgrades. If the original is mismatched stone (a housing thing popular in the 1970s) and people just don’t build that way anymore, it might actually cost a fortune to duplicate that style 50 years later. The modern equivalent might simply be siding – a completely different material, but the generic middle-class thing to use at the moment, the way stone was then.
Figuring Depreciation
Once you’ve got your reproduction or replacement costs, it’s time to figure depreciation. I can’t give you a do-it-yourself formula, but we can look at the general things professionals consider when doing it property. As you no doubt remember, the older the structure, the greater the depreciation (generally speaking). Also keep in mind that depreciation applies to the buildings on the land, not to the land itself. Land prices may rise and fall, but the land itself doesn’t “depreciate” – it doesn’t get “used up” for purposes of these sorts of calculations.
Physical Depreciation
The most obvious sort of depreciation when doing real estate valuation is physical depreciation, or what the rest of us call “normal wear and tear.” Over time, the weather takes its toll. Accidents happen. Stuff breaks, Paint fades. Stuff gets wet, scratched, dented, etc. This lowers the value, especially when the wear goes beyond the aesthetic.
Functional Depreciation
Functional depreciation is a bit more subtle. Remember when we talked about the role of demand and scarcity earlier? That part of the value is how many people want it and how few are available? Functional depreciation attempts to figure in reduced demand based on changing styles or preferences.
Some commercial property seems almost timeless – the art deco may be a century old, but each time it’s freshened up, it’s like new again and always in demand. Other properties quickly become the real estate equivalent of Betamax players or “New Coke.” Sure, they’re functional… but that doesn’t mean anyone wants them anymore.
Economic Depreciation
Economic depreciation depends on external trends. Housing that was near a hip new mall and plenty of local restaurants when it was built is now sitting next to abandoned commercial space at a thrift store. That warehouse that backed up to the railroad was prime commercial real estate when everything traveled by train – now most smaller products go Fed-Ex, UPS, or USPS, thus limiting the usefulness of your location.
Time to Land
There’s really only one main way to estimate land value, and that’s comparable land very close by. The land is worth what people are paying for land in the area, period. The old line about real estate costs and “location, location, location” is pretty much true here.
So here’s our final “formula”:
Cost Approach Value = (Replacement OR Reproduction Costs) – Depreciation + Land Value
It looks so simple when expressed that way, doesn’t it?
Conclusion
The concepts are simple, but the execution tricky. Still, my hope is that knowing a bit more about the cost approach to real estate valuation puts you in a better position to make educated decisions about your buying, selling, investing, or negotiation. Entrepreneurship many times comes down to a bold combination of information and instinct.
Keep learning, keep reaching, and keep reading. And if we can be of any assistance, let us know.