Friday, June 2, 2023 | The Latest Buzz for the Appraisal Industry

Cost Approach in Fifteen Minutes or Less

This article was first published in the Fall 2021 Edition of Appraisal Buzz Magazine. To receive this subscription directly, click here.

Appraisers use three different property valuation methods:
(1) Sales Comparison relates the estimated value of our subject property to similar settled, active, and pending market sales.
(2)  The Income Approach considers the present value of expected future cash flows.
(3) Cost Approach has a basic formula: Property Value = Land Value plus Cost New minus Depreciation. It relies on the principle of substitution. Simply stated, the price someone is willing to pay for a property is influenced by the cost of acquiring a substitute or comparable.

Our residential appraisal forms make short work of all three methods of valuation, so it is pretty easy to apply at least two approaches to value for an appraisal report. The narrative format has similar utility with more detail.

As a real estate developer, prior to entering the field, I always costed out my projects for profitability. In 2010, I was still puzzled by the reticence of many appraisers to embrace the Cost Approach as it increases our level of credibility. To get a stronger grasp of the fundamentals, I took the Appraisal Institute’s site valuation courses, enjoyed Wayne Pugh’s excellent depreciation calculation course, increased the usefulness of the 1004 MC form filler product by interviewing David Braun, a superb software developer, and spoke with several industry luminaries such as Edward Pinto, former Chief Credit Officer of Fannie Mae.

Mr. Pinto was the clearest and explained, “When the Federal Housing Administration (FHA) and the Veteran’s Administration (VA) led the development of modern appraisal practice in the 1930s and 1940s, they determined that a property’s value required the reconciliation of four valuation principles: replacement, substitution, income capitalization, and suitability. Over time, the principles of replacement and income capitalization came to be relied upon to a lesser degree until they were made optional and ultimately ignored, leaving market sales as the sole value determinant.”

My experience told me that, just as we do not use only one sale on a sales grid, two disparate value methods would offer much stronger value support.

Now, we all fondly (?!) recall that there are six site valuation methods with the most popular and easiest to use being the sales comparison method. I have also used the other five (allocation, abstraction, subdivision, ground rent, and the land residual method) in my residential and commercial appraisals.

I use several easy-to-follow steps in my 10-15 minute cost approach development task and are detailed below in the five Cost Approach steps to follow.

The five simple steps to use the Cost Approach:

(1) Analyze national, regional, state, county, and city or town information (US Census) Hone in on your subject property zip code or market area. Expand and then narrow your scope and consider applicable report data. Know what average home values are in your area.

(2) Fill in the Cost Approach form

(2A) Place GLA above and below grade square footages in form and use public records/assessors. Always verify information acquired using only MLS Listings.

(2B) Use assessor data to determine $/sf of improvement and ratio of site to overall value for site value ratio. Be aware that assessors use updates which may be years old (such as in Maryland, where there is a three-year triennial review or update) or trend the data and only update on set longer periods of time. This means that the data was possibly accurate at one time and may not be now.

(2C) Call and ask your local assessors how their individual process works. They will be happy to tell you.

(2D) I then pull up my M&S Residential or Commercial Cost Handbook, choose a category of pricing for above and below grade (Page 117), plug it in, and then update later. I also use the depreciation chart found in Section 97 for a more balanced consideration.

(2E) Fill in the rest of the form, add in “as is” site value ($20,000-$50,000 includes costs of water, sewer, gas, electric), and add in other amenities such as the porch, deck, in-ground pool, barn, etc.).

(3) Determine the site value by sales comparison et al methods.
I use the MLS listing service and review all land sales over past two+ years in about a three-mile radius. I can use median or average, but I have to remember to cull the data for common sense bracketing and consider overall site sales related to the subject property use and size. The assessor information offers some guidance.

(4) Streamline (update)
Update the $/sf by adding profit and incentive percentages checked against your appraiser sales comparison method data. I then revisit the assessor’s data and the cost handbook.

(5) Reconcile
Reconcile the Cost Approach data already entered after determining a sales approach value. They are typically in sync, and if not, it can indicate a market anomaly such as a housing crisis (2008) or pandemic market effects. If so, start digging for the cause factor.

In conclusion, my average M&S Cost Handbook detached home value ranges from $60/sf-$200/sf, before the possible 15%-30% entrepreneurial profit and incentive. Recently, the Wall Street Journal published an increased building cost of 10%-20%, although this may be short-lived due to the pandemic and to-be-resolved supply chain issues.

The Cost section of the appraisal report is a simple mathematical formula in which you pop in the information and reconcile your data. Using this method well reconciles my development and appraisal side. However, The HR side has always enjoyed a lot of gray, like many of our client requests. ??????

Enjoy using the Cost Approach effectively. It takes me about 10 minutes per residential report and ensures a higher level of accuracy and credibility.