Commercial Real Estate Appraisal Cost Approach

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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

Patrick C. O'Connor has been president of O'Connor & Associates since 1983 and is a recipient of the prestigious MAI designation from the Appraisal Institute. He is also a registered senior property tax consultant in the state of Texas and has written numerous articles in state and national publications on reducing property taxes. He continues to set the standard in direction and quality of our appraisal products, adding services ranging from business valuations and business appraisals to cost segregation analysis for income tax reduction. For more information please www.poconnor.com today!

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