The Cost Approach Appraisal Method

Verifying market and income based valuations:

Most appraisers know that using the Cost Approach is an essential method for appraising one-of-a-kind and special-use properties. But what may come as a surprise is the wide range of opportunities where the cost approach can help validate your market and income-based valuations.

What is the cost approach?

The cost approach method, quite simply, is an estimate of the replacement value of a property that’s determined by the cost of its components – land and improvements. Based on the principle of substitution, the cost approach method in essence says, you shouldn’t pay more for a property than the cost of a comparable site and building. Rather than valuing property as a whole, the cost approach adds up the separate values of the land and improvements. Here’s how it works:

Estimate the value of the land as if vacant.

Estimate the replacement cost of the building.

Estimate the building’s loss in value from depreciation.

Subtract the building’s depreciation from the estimated replacement cost.

Calculate the value of the property by adding the estimated land value to the depreciated value of the building.

When to Use the Cost Approach:

You’ll find that the cost approach method is particularly useful in situations when market data is scarce, the property value significantly exceeds its replacement cost, prices surge due to housing shortages and increased demand, and of course those properties that have unique or one-of-a-kind features.

And in markets where demand for new housing outstrips the available supply, appraisers are faced with the challenge of accurately estimating properties that run the risk of significantly losing value after supply catches up. Estimating property valuations in type of environment using a market-based approach alone may mislead clients into believing that the market is sustainable.

The cost approach gives appraisers a pure cost-based perspective on the market and their clients a more complete picture of the property valuation.

The cost approach can be used in a number of appraisal applications – and not just because it’s required. You can use this method to add validation to your appraisal.

Here are some applications:

Use an independent valuation method - Appraise manufactured homes.
Value unique property features - Monitor local real estate markets.

FHA appraisals

Fannie Mae’s cost approach requirement for manufactured housing:

Manufactured housing represents one of the fastest-growing housing markets in the US . Fannie Mae’s investment in manufactured housing is part of its larger mission to expand affordable housing to Americans of modest means. However, in recent years, there are fewer financing options available today for manufactured homes. Industry analysts estimate that the number of repossessed and foreclosed manufactured homes is at record high levels.

Manufactured homes are built on a permanent chassis at a factory and then transported to a permanent site and attached to a foundation.

In an effort to help ensure that consumers purchasing a manufactured home do not pay more for the house than it is worth, Fannie Mae in June 2003 announced that all market-based property valuations must be supplemented with Cost Approach appraisals.

Appraisers must now qualify their opinions on the quality and condition of the manufactured home when filling out the Manufactured Home Appraisal Report Addendum (Form 1004C).

These new appraisal requirements are part of Fannie Mae’s ongoing effort to improve lending practices in the manufactured housing market, and ensure that people have opportunities for successful, long-term homeownership under financing terms that are appropriate for this housing type.

Getting the whole story:

In an increasingly complex and dynamic real estate market, appraisers are challenged to provide estimates that are accurate, reliable and complete to their clients. Appraisers are finding that using the market-based approach alone is no longer enough. As a result, appraisers are relying more on the Cost Approach method to verify the validity of a property’s market value and for the confidence their clients are getting the whole story.