When it comes to estimating the market value of real estate, some choose to use the cost approach. The other two methods are the income approach and the sales comparison method. We’ll give you a brief description of each valuation method before diving deeper into the cost approach.
The income approach can be most accurately used when conducting commercial property valuation on income properties in active markets. This method considers the value of investment property as the present value of future expected cash flows generated by the property. In short, valuation is based on the property’s ability to generate monthly income.
The sales comparison method uses the market price of real estate comps (similar properties which recently sold in the same market) to estimate a property’s value. It’s best to use this method in cases of high similarity between properties selling under similar market conditions in the same time period. So both of these appraisal approaches rely on active markets.
Now, what is the cost approach method?
The Cost Approach in Real Estate
To put it simply, this method takes on the approach of valuing a property based on the cost of the building and the market value of the land. So there are two main market values to consider here: the building itself and the land it’s on. The cost approach values real estate properties based on how much the building would cost if it needed to be replaced; or the cost it would take to build an equivalent building. After factoring in the land value and deducting any loss in building value (real estate depreciation), the cost approach yields an accurate market value.
Property buyers who use this approach typically do so for newly constructed or renovated properties. The logic with this real estate valuation method is that there is no sense in paying more for a property if building its replica would cost less.
As mentioned, there are three main components when it comes to valuating investment property with the cost approach. The value of the land, the cost of building construction, and real estate depreciation. The cost approach formula is:
Market Value= Land Value + Building Construction Cost – Building Depreciation