The cost approach: reproduction and replacement cost and depreciation

Building the cost approach

The cost approach applies substitution: a buyer generally will not pay more for a property than the cost of acquiring a comparable site and constructing improvements with equivalent utility, allowing for time and other relevant conditions. It is especially useful for new improvements and special-purpose buildings with few comparable sales. Older buildings make depreciation harder to estimate.

Estimate land value as though vacant and available for its highest and best use. Estimate the current cost new of the improvements, subtract accrued depreciation, and add land value. Land is valued separately; do not apply the building's depreciation percentage to the land.

Two meanings of cost new

Reproduction cost estimates a duplicate using the same design and materials, including outdated features. Replacement cost estimates a building with equivalent utility using modern materials, standards, and design. Both are current costs, not the owner's historical expenditure. Construction estimates can include direct costs such as labor and materials, indirect costs such as design and permits, and an appropriate entrepreneurial incentive.

Three sources of depreciation

Appraisal depreciation is loss in value from any cause, not an income-tax deduction schedule. Physical deterioration is wear or damage, such as a leaking roof. Functional obsolescence arises within the property, such as an awkward layout or an expensive feature buyers do not value. External, or economic, obsolescence comes from outside the property, such as neighboring industrial noise or reduced local demand.

A defect is economically curable when correcting it adds at least as much value as the correction costs. Physical and functional problems may be curable or incurable; external obsolescence is generally treated as incurable by the individual owner. Cost to repair and loss in value are not necessarily identical. Avoid deducting the same deficiency twice, particularly when a replacement-cost estimate already excludes an obsolete feature.

Working the numbers

Suppose land is worth $90,000, improvement cost new is $300,000, and accrued depreciation is $60,000. Subtract $60,000 from $300,000 to obtain $240,000 for the improvements; add $90,000 for a $330,000 value indication.

Under a simplified age-life method, depreciation equals effective age divided by total economic life, multiplied by improvement cost new. Effective age reflects condition and utility, not just years since construction. Economic life is the period improvements contribute value. With effective age 10 years and total economic life 50 years, depreciation is 20 percent. Use this simplified estimate as directed; do not add losses already included in it.