The cost approach takes a different look at the value of a property. Essentially the value of the property is derived by first establishing the value of the land or section (the market approach may be used for this) then adding to this is the current value of the structure (adjusted for depreciation) and other improvements to give an overall value for the property. This approach has some limitations in terms of residential valuations, the key one being able to accurately calculate the depreciated value amount of the building and improvements. One situation where it would be used in the residential market would be to calculate the value of a property that is yet to be constructed.
An ‘on completion’ valuation would take into account the land value and the construction costs to determine the final value of the finished product. This is a highly subjective technique and can vary from valuer to valuer. There are times where external influences may interfere with this method, one of those being a market where supply is short and demand is high, in cases like this the value of an older property under the cost approach may not be in line with the value of the property using the market approach. The heterogeneous nature of property plays into the cost approaches technique when it comes to unique homes and properties. Where there may not be suitable comparable sales under the market approach, the value can be assessed by determining the land and building cost.
One needs to be careful when using this method that the amount spent on the property may in some cases not accurately reflect its value. A unique architecturally designed home that has had no expense spared in terms of its construction, may have been overcapitalised and the final value would be less than the actual construction costs. A couple building their dream home in which they plan to retire in may undertake such a development. In a situation like this, the valuer would need to apply common sense and perhaps undertake an additional valuation approach in order to conclude a fair value. The substitution principal is one of the paramount considerations to apply in the cost approach to valuation, taking into account that someone will not pay more for a property that they could acquire a similar site and construct a similar building for a cheaper price.
Click here to read the Investment or Income Approach to Property Valuation.