Should You Take the Cost Approach Valuation?

ATLANTA—First time property owners may be surprised to learn that commercial real estate appraisals are typically significantly different and more complex than single-family residential appraisals. This nugget of wisdom comes from Paulk Turner, director of J.H. Berry & Gilbert's appraisal and valuation services division.

“Commercial appraisals require a greater level of research and analysis than residential appraisals, but the primary difference is based on the income-producing potential of commercial properties,” Turner tells GlobeSt.com. “The three accepted approaches to value in a commercial appraisal include the Cost Approach, Sales Comparison Approach, and Income Approach, which are described in greater detail in the following paragraphs.”

(Do appraisals have the final word? Get one opinion.)

In this first installment of this exclusive series, Turner helps us tackle the cost approach. The cost approach is based on the principle of substitution, that an informed and rational investor would pay no more for a property than the cost to construct a similar and competitive property.  This approach is defined in The Appraisal of Real Estate – 14^th Edition, published by the Appraisal Institute as, “a set of procedures through which a value indication is derived for the fee simple estate by estimating the current cost to construct a reproduction of (of replacement for) the existing structure, including an entrepreneurial incentive or profit; deducting depreciation from total cost; and adding the estimated land value.”

“The Cost Approach tends to set the upper limit of value before depreciation is considered, and is most applicable for proposed or recently-constructed properties, where minimal depreciation has accrued,” Turner says. “Therefore, this approach is often not used for older properties where depreciation would be difficult to estimate.”

However, he says, the Cost Approach is the preferred method for estimating the insurable value of a property, which is increasingly required by lending institutions in addition to any other market values. Basically, he explains, the insurable value is the replacement cost of the property less all uninsurable items associated with the property, such as land, foundations, underground piping, etc. This value represents the maximum reimbursement for direct physical damage or loss of property.

In part two of this interview, Turner will educate us on the sales comparison approach.

ATLANTA—First time property owners may be surprised to learn that commercial real estate appraisals are typically significantly different and more complex than single-family residential appraisals. This nugget of wisdom comes from Paulk Turner, director of J.H. Berry & Gilbert's appraisal and valuation services division.

“Commercial appraisals require a greater level of research and analysis than residential appraisals, but the primary difference is based on the income-producing potential of commercial properties,” Turner tells GlobeSt.com. “The three accepted approaches to value in a commercial appraisal include the Cost Approach, Sales Comparison Approach, and Income Approach, which are described in greater detail in the following paragraphs.”

(Do appraisals have the final word? Get one opinion.)

In this first installment of this exclusive series, Turner helps us tackle the cost approach. The cost approach is based on the principle of substitution, that an informed and rational investor would pay no more for a property than the cost to construct a similar and competitive property.  This approach is defined in The Appraisal of Real Estate – 14^th Edition, published by the Appraisal Institute as, “a set of procedures through which a value indication is derived for the fee simple estate by estimating the current cost to construct a reproduction of (of replacement for) the existing structure, including an entrepreneurial incentive or profit; deducting depreciation from total cost; and adding the estimated land value.”

“The Cost Approach tends to set the upper limit of value before depreciation is considered, and is most applicable for proposed or recently-constructed properties, where minimal depreciation has accrued,” Turner says. “Therefore, this approach is often not used for older properties where depreciation would be difficult to estimate.”

However, he says, the Cost Approach is the preferred method for estimating the insurable value of a property, which is increasingly required by lending institutions in addition to any other market values. Basically, he explains, the insurable value is the replacement cost of the property less all uninsurable items associated with the property, such as land, foundations, underground piping, etc. This value represents the maximum reimbursement for direct physical damage or loss of property.

In part two of this interview, Turner will educate us on the sales comparison approach.