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Understanding the Cost Approach A Division Advisory

In five minutes or less, you will learn when the cost approach should be performed and how to perform a supported cost approach.

Which one of the three approaches to value used in a real estate appraisal is a common source of complaints against an appraiser?

It is the Cost Approach

The Division of Real Estate ("the Division") routinely investigates complaints that result in the improper use of the cost approach when determining value in an appraisal. The Board of Real Estate Appraisers ("the Board") and the Division want to achieve better results by appraisers using this valuation approach so that credible assignment results can be accomplished for the public.

Definition of Cost Approach
  • The cost approach is a set of procedures through which value indication is derived for the fee simple estate by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including an entrepreneurial incentive or profit deducting depreciation from the total cost; and adding the estimated land value. Adjustments may then be made to the indicated value of the fee simple estate in the subject property to reflect the value of the property interest being appraised. (Source: The Dictionary of Real Estate Appraisal; 6th Edition, Appraisal Institute)

When the cost approach is necessary for credible assignment results, the appraiser must:

(i) develop an opinion of site value by an appropriate appraisal method or technique;

(ii) analyze such comparable cost data as are available to estimate the cost new of the improvements (if any); and

(iii) analyze such comparable data as are available to estimate the difference between the cost new and the present worth of the improvements (accrued depreciation) (See USPAP Standards Rule 1-4(b).

Determining value by the cost approach

Improvement Replacement Cost

Resources may include:

  • Builder estimates and costs
  • Marshall & Swift
  • All cost resources must be documented

Depreciation Types

  • Physical
  • Functional
  • External Obsolescence

Contributory Value of Improvements = Replacement Cost - Depreciation

Why use the cost approach?

The cost approach is a recognized technique to determine value.

When is it most appropriate to use the cost approach?

  • New and proposed construction
  • Special purpose properties (eg. churches, golf courses, etc.)
  • Situations where there is little or no market activity
Benefits of the Cost Approach
  • The cost approach is an integral component of the principle of "substitution", and serves as a “check” against the sales comparison approach.
  • A skewed result from the cost approach may point towards functional or external obsolescence.
  • Can help identify a potential runaway market or a rapidly declining market.
  • A knowledgeable buyer will pay no more for a home “than it would cost to buy a similar land and erect a similar structure without undue delay.”
  • May raise a red flag in cases of under-valuation in short-sale fraud, or overvaluation in mortgage fraud.

A supported cost approach can result in a better appraisal.

  • Document all sources of cost data and calculations.
  • Reconcile your value indications from various sources and retain your data and analysis in the workfile.

When is the cost approach not appropriate to use?

  • Significantly older improvements may make depreciation difficult to accurately estimate.
  • Effective age is a good indicator as to whether cost approach is appropriate.
  • When improvements do not represent the highest and best use of the land as though vacant.
  • When relevant comparable cost data is lacking or too diverse to indicate entrepreneurial profit.
  • In an appraisal for investment purposes, it is not appropriate since the time to develop and construct must be considered.

Common issues seen in the cost approach

  • Cost approach not developed properly (fabrication of cost data).
  • Unfamiliarity with cost manuals.
  • Inapplicable and/or unsupported “canned comments” such as: “Cost approach is irrelevant”; “Costs are not accurate”; “Not applicable as an indicator to value”; or “Not required”.
  • Just because the cost approach isn’t required, does not mean that it can’t be performed, or shouldn’t.
  • No support for: Replacement costs; Economic life and effective age; or Site value estimate.

Possible violations/outcomes

  • Failure to apply a supported cost approach may result in discipline from violation of the Scope of Work Rule, Competency Rule, Standards 1 and 2.
  • Failure to include the cost approach when it is applicable may result in violation of Standards Rule 1-4 and 2-2.

Conclusion

  • If the cost approach is applicable, ensure that it is performed correctly with credible support for conclusions relating to site value, effective age, cost data, and depreciation. Never use inapplicable “canned comments” that are not supported by market data.

Resources

Follow This Series of Common Appraisal Practice Issues

The Division conducts a significant amount of work product reviews every year through investigations and licensure applications. As part of the Division’s effort to better achieve compliance with frequently violated rules and for more meaningful communication, a series regarding the most common appraisal issues seen by the Division has been developed for licensed appraisers.

This has been an advisory of the Division of Real Estate.

If you have questions please contact the Division at dora_realestate_website@state.co.us.

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