The Cost Approach

The Cost Approach is one of the classical methods of appraisal. Like an old, push lawn mower, it sits in a corner of the garage, little used except in those times when the power mower breaks down. The Depreciated Replacement Cost Approach (its full, technical name) asks the appraiser to measure land value by sales comparison, to add construction cost new, to deduct depreciation in a variety of categories, and to add profit. The result is an indication of value. The Cost Approach was once the pride of the profession, applied by skilled practitioners who lived and breathed its intricacies. It has been relegated to a corner because it is generally viewed as an approach divorced from the market where rent and price rule. Appraisers today seldom apply cost analysis. An article in The Appraisal Journal (Richard Marchitelli, "Rethinking the Cost Approach") called into question whether it still had any place in practice at all.

Yet, when a builder constructs a building at known cost, who can say that cost does not inform us in some way about value? And when other methods of analysis are lacking, doesn't cost become a primary factor in an estimation of value? Some would say yes. Others would say not necessarily. They would say that cost and value are different things, and cost in fact can be misleading in the appraisal of, say, a church that may have required $200 per foot to construct, when older and often more solidly-built churches may sell for only $40 per foot. In one sense, a 50-year-old church has a value at cost, less factors for depreciation. In another, the only relevant method of valuation is by sales comparison. We go back and forth in our thinking about analysis based on cost. Cost is good. Cost is bad. We are like the dog that has a ball in her mouth but that also wants the ball on the lawn. To get the ball on the lawn, she needs to let go of the one in her mouth. Much as she may want to, she can't hold them both. 

If the Cost Approach is discredited, it is largely because its textbook application asks the appraiser to make measures for obsolescence that the appraiser knows are at least partially arbitrary and that, to an extent, may be viewed as false. Little wonder that appraisers back off from application of cost analysis when they know that it may amount to little more than an academic exercise.

If that is our course, we have missed the boat. The Cost Approach can in fact be a highly useful method of valuation. For new buildings and buildings that serve a special use (churches, temples, schools, museums), it can be among the most important. Yet it provides only a part of the larger picture of value. And, so, it is best not applied alone.

In a market in which some buildings continue to be built at high cost and others are sold for much less, an appraiser's client needs the advice that the value in use to the owner who has just built the building (and to any others who may find equal utility in it as designed) may best be measured by cost but that a second and often lower level of value applies for others who may only find the building suitable for an alternate use. The spectrum of value for a building of this kind may thus be broad. To say that the end of the spectrum defined either by cost or by market activity is the only useful view of the value of that property is to see only half the picture. A client needs advice concerning both ends of the spectrum, as well as a discussion of the conditions that in a hypothetical marketing of the property are likely to produce a price at either end. For the sake of our clients, we as appraisers need to be able to get our teeth around both those things.

Eric T. Reenstierna, MAI

The Reenstierna Associates Report is published as a service to the clients of Eric Reenstierna Associates and other real estate professionals. The views expressed are those of the articles' authors and do not necessarily reflect those of other members of the organization. Copyright 2001. All rights reserved.

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