Cost approach
The cost approach values a property as the cost to replace the improvements, less depreciation, plus the value of the land.
Land value + replacement cost − depreciation = value.
The three depreciation categories#
This is where the approach does its real work, and the categories are the same three that explain value loss generally.
Physical deterioration. Wear, damage, deferred maintenance. Curable with money.
Functional obsolescence. The building's own design — one bathroom in a four-bedroom house, a bedroom reachable only through another, a kitchen sealed off from everything. Sometimes curable, sometimes not.
Economic obsolescence. External factors the owner cannot fix — a highway built alongside, a plant closure, concentrated vacancy on the block. Never curable by the owner.
Estimating all three on an older building is largely judgement, and small differences in that judgement produce large differences in the answer.
Where it is most reliable#
New construction. Little depreciation to estimate, and the cost is known rather than reconstructed.
Unusual and special-purpose properties. A church, a school, a grain elevator — buildings with no comparable sales, where the sales comparison approach has no raw material.
Insurance. Replacement cost is what a building is insured for, and the calculation is the same one.
Where it is weakest#
Older buildings, for the reason above.
Markets where cost exceeds value. Building a house can cost more than the finished house is worth, particularly in areas with falling or stagnant values. Where that is true, replacement cost overstates market value substantially and the approach should carry little weight.
That situation is common in exactly the Minnesota communities where distressed property concentrates, which is worth knowing before relying on a cost-based figure there.
The insurance connection#
The most practical use of the approach for an ordinary owner.
Replacement cost value insures the building for what it would cost to rebuild. Actual cash value insures it for replacement cost less depreciation, which on an older roof is a substantially smaller number.
The difference between those two policies is the depreciation estimate this approach produces — and it is the difference between a new roof and a partial payment toward one.
Against the other approaches#
An appraiser considers all three and weights whichever the evidence supports.
On an ordinary house with plenty of nearby sales, the sales comparison approach dominates and the cost approach is a check.
On a new build, a unique property, or an insurance question, the cost approach is the one doing the work.