Is The Cost Approach Flawed?

[Have Laser-Will Travel]

As soon as the word "value" is used, to me it all goes back to the market because people decide on value. The cost approach doesn't exist in a vacuum, not if it's going to be relevant. From there, I suppose the underlying assumption of the cost approach is one of substitution, that the market won't pay more than the cost to construct. But anything beyond that I find troubling. Once I calculate depreciation, who's to say it has any accuracy in reflecting market reaction? Is the cost approach only relevant for new construction? Am I missing something?

 

[Eli]

I like the cost approach. Depreciation is hard. It takes time. New construction is a good starting point.

 

[residentialguy]

It's all about correctly adjusting for the factors that affect it. As you mentioned, depreciation, including adjusting for various obsolescence...the end result will go hand in hand with the sales comparison approach. If not, then one (or maybe both) approaches were adjusted incorrectly.

 

[Eli]

Yeah. The cost approach forces an appraiser to get a land value opinion as if vacant to its highest and best use. Big key.

It also forces looking at obsolescence from all sources.

 

[Howard Klahr]

Once I calculate depreciation, who's to say it has any accuracy in reflecting market reaction?

Why is it any less accurate than adjusting for condition in the sales comparison approach?

Is the cost approach only relevant for new construction?

No

Am I missing something?

Yes

 

[Meandering]

As soon as the word "value" is used, to me it all goes back to the market because people decide on value. The cost approach doesn't exist in a vacuum, not if it's going to be relevant. From there, I suppose the underlying assumption of the cost approach is one of substitution, that the market won't pay more than the cost to construct. But anything beyond that I find troubling. Once I calculate depreciation, who's to say it has any accuracy in reflecting market reaction? Is the cost approach only relevant for new construction? Am I missing something?

When the financing for construction loans differs from the financing for what exists, the market will pay more. We saw multiple examples of that 2006-2007.

If you believe the neighborhood impacts "value" and that construction costs are fixed, with the variable being value of the land, how could anyone be made to believe that the one new house in an existing older neighborhood is not differently impacted than the existing houses in the neighborhood, or a new house in a new development? If the market does not have the ability to substitute their purchase of what exists, with building a new house, because of a lack of land available to purchase, or because of depressed economic conditions (think Detroit), then, that imaginary replacement house appraisers develop in a cost approach is no indication of market substitution, no matter how many imaginary numbers appraisers throw at their imaginary creation and call it depreciation, and a representation of "market" value.

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[BRCJR]

When the financing for construction loans differs from the financing for what exists, the market will pay more. We saw multiple examples of that 2006-2007.

If you believe the neighborhood impacts "value" and that construction costs are fixed, with the variable being value of the land, how could anyone be made to believe that the one new house in an existing older neighborhood is not differently impacted than the existing houses in the neighborhood, or a new house in a new development? If the market does not have the ability to substitute their purchase of what exists, with building a new house, because of a lack of land available to purchase, or because of depressed economic conditions (think Detroit), then, that imaginary replacement house appraisers develop in a cost approach is no indication of market substitution, no matter how many imaginary numbers appraisers throw at their imaginary creation and call it depreciation, and a representation of "market" value.

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If the Cost Approach is developed and reported correctly it is a good method.
It may take a good bit of time and discovery in some cases to do but , that is different than it is a 'fairy tale" method.

 

[sail143]

Depreciation, in its various forms, is not the only issue. Entrepreneurial profit is also a challenge. Some time ago I called Marshall and Swift (then) to discuss my difficulty in reconciling the cost approach in an area of many high end properties - I was advised that I was underestimating builder's profit! The AI book "In Defense of the Cost Approach" is an good reference.

 

[DWiley]

Once I calculate depreciation, who's to say it has any accuracy in reflecting market reaction?

It would be the appraiser who derived the depreciation saying that

Depreciation is supposed to be market based, not taken blindly from some manual. Unfortunately, there are some who simply flip through pages in manuals or click through online entries without any actual market testing of the resulting data.

As for the title of the OP, it is not the cost approach itself that is flawed, but the application of the cost approach is, in my experience, sometimes flawed.

 

[Meandering]

If the Cost Approach is developed and reported correctly it is a good method.
It may take a good bit of time and discovery in some cases to do but , that is different than it is a 'fairy tale" method.

When there is support in the market that new homes are a substitute for what exists, yes, it can be reliable and a great data point. However, we see so many fairy tales, we've developed methodology for developing them. Allocation of site value, cause no one's built a home in that neighborhood in 100 years, but we can pretend some one will. Extraction, well only house/land packages are sold in the neighborhood, but we know the land is worth some percentage of the overall price, so lets apply that in an existing neighborhood.

After all, if credibility is in the eyes of the intended users, and they find it credible to have imaginary cost approach home comps, why should they limit the imaginary neighborhood by leaving out imaginary sales comps? Same premise.

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