The Declining Use of the Cost Approach for Commercial Real Estate Appraisals

In the past twenty years the use of the cost approach for appraising commercial real estate has taken a drastic downturn. The principle of substitution is the basis for using the cost approach. The cost approach valuation is derived by adding the cost of the land (using the comparable sales method), replacement cost and entrepreneurial efforts, then deducting depreciation. Put simply, with all other variations taken into account a buyer would not buy an existing structure that is priced at $1,000,000 when they can build the same structure for $750,000.

Much of the knock against the cost approach for commercial real estate appraisal is purely myth. This myth is enhanced by current appraisers spreading the idea that the market “doesn’t use” the cost approach anymore. This is likely a result of the perception that it’s too difficult to produce reliable valuations using the cost approach.

The cost approach has a few perceived stumbling blocks, such as “aging” and “lifespan” attached to commercial depreciation. These are numbers that can be calculated, just like any other number. Once those numbers are constructed (and the appraiser has confidence in them), commercial depreciation can be calculated with little effort, thus the cost approach method can eventually lose its “difficult” label. Commercial depreciation can be broken down into three parts with specific numbers attached. Physical deterioration, external obsolescence, and functional obsolescence are combined together to total the accrued depreciation.

Another hurdle to the cost approach is the need for in-depth knowledge of construction and materials costs. Appraisers with an engineering background will have an advantage. By either gaining knowledge of construction costs or sub-contracting a materials and cost evaluation, appraisers can easily overcome this hurdle.

The cost approach isn’t always going to be “used” in coming to a valuation by commercial real estate appraisers, but it’s important that appraisers are aware of what that number is. That number can be an indicator of other economic elements. These elements can then be injected into other methodologies to help come to a more accurate valuation.

The world of commercial real estate appraisal can be looked at like a three-legged stool. These three legs (income capitalization, sales comparable, and cost approach) all need to be present to get a clear view of commercial property value. Each one of those legs doesn’t have to be equal or even a rock solid valuation, but it definitely needs to be there for the stool to stand. The effectiveness of the cost approach as the primary methodology for coming to a valuation by commercial appraisers may have declined, but the importance of including the cost approach valuation in the overall report is as important as ever.