The cost approach was historically prepared as a part of most commercial real estate appraisals. However, the compunction to include the cost approach (when it was not relevant) has dissipated over the last 20 years.
The principle of substitution is the technical basis for employing the cost approach. According to the principal of substitution, a prudent buyer would not pay more than the cost to build a like property. In other words one would not spend $2,000,000 to purchase a new apartment complex if they could build it for 1,500,000.
The cost approach value is the sum of the market value of the land, depreciated replacement cost and entrepreneurial effort. Land is typically Valued using the sales comparison approach. The replacement cost is the cost to build a building of the same quality and functional utility as the subject property. (Reproduction cost is the cost to build an exact duplicate. This approach is used occasionally for old buildings built using materials and or types of craftsmanship not currently used.)
External obsolescence occurs when circumstances outside the subject property's boundaries negatively impact its value. For example, an office building in New York would suffer from external obsolescence if Manhattan office occupancy fell from 93% to 75%. A mansion built next to a slaughter-house is another example of external obsolescence.
Entrepreneurial profit is the amount of compensation necessary to induce someone to organize the site, investors, debt, architecture, construction and leasing necessary to plan and build a property. The appropriate amount of entrepreneurial profit depends on factors such as competition, the difficulty of the project, market conditions and the wisdom of the developers plan. In some cases external or functional obsolescence prohibit entrepreneurial profit.
Following is a summary of the cost approach:
Market Value of Land
+ Replacement cost new of improvements
- All forms of depreciation
+ Entrepreneurial Profit
= Market Value via the Cost Approach
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The income approach is often given primary emphasis when appraising a commercial real estate used to generate income. Estimates of value via the income approach are highly sensitive to changes in revenue, expense and capitalization rates.
Correctly performing a cost approach analysis appears to be and is technically difficult. It appears easy to correctly prepare an income approach analysis for commercial real estate. However, correctly preparing the analysis requires three criteria: 1. an understanding on the type of value, 2. accurate data, 3. accurate application of the income approach.
Commercial income properties can be valued based on the leased fee estate. The fee simple estate is appropriate for properties with leases consistent with market rent and terms. Valuation of the leased fee estate is more appropriate for properties with above market or below market rents. Valuing properties with below market rental rates based strictly upon its actual rental rates would understate its value. Valuing it using market rental rates would overstate its market value.
Accurate data is the basis of a reliable income approach conclusion. This includes information on rental rates, occupancy rates, new construction, absorption, operating expenses and capitalization rates. Rental rates are usually obtained from rental comparables, subject property leases and aggregate market data. The same is true for occupancy rates. New construction can be obtained from personal observation while doing fieldwork, research and aggregate market data.
The appraisal division of O’Connor & Associates is a national provider of commercial real estate appraisal services including
insurance valuation,
commercial real estate appraisal, cost segregation studies, due diligence, feasibility studies, financial modeling, gift tax valuations, highest and best use analyses, casualty loss valuations and HUD map market studies.
