407: Cost Approach to Value

The cost approach to value assumes that a potential purchaser will consider building a substitute residence that has the same use as the property that is being appraised.  This approach, then, measures value as a cost of production.  The reliability of the cost approach depends on valid reproduction cost estimates, proper depreciation estimates, and accurate site values.  We will not accept appraisals that rely solely on the cost approach as an indicator of market value.

We do not require the appraiser to consider the cost approach to value for any appraisal that is documented on the Desktop Underwriter Quantitative Analysis Appraisal Report (Form 2055), the Desktop Underwriter Qualitative Analysis Appraisal Report (Form 2065), or the Desktop Underwriter Individual Cooperative Interest Appraisal Report (Form 2095).  Furthermore, the appraiser does not need to consider the cost approach to value when appraising a unit in a condominium or cooperative project since this approach may be impractical for estimating the value of an individual unit because each unit is an integral part of the project development.

The cost approach to value may be a good indicator of value for newer or renovated properties that are one- to four-family residences, or detached, semidetached, or townhouse units in PUD projects.  However, as the effective age of a property increases, the reliability of the cost approach may decrease because the depreciation estimates may be subjective.  An appraiser should use his or her best judgment regarding the applicability of the cost approach to value when the property being appraised is an older property; however, if the appraiser does not use the cost approach, he or she must explain why it was not used and provide an opinion of value for the site.

The appraiser arrives at the indicated value of a property by estimating the reproduction cost of new improvements, subtracting the amount of depreciation from all causes, and adding his or her opinion of value for the site if it were vacant and available to be developed to its highest and best use.

•    The reproduction cost estimate should reflect the cost of construction based on the current prices of producing a replica of the property being appraised -- including all of its positive and negative characteristics.  Although the construction materials used for the estimate should be as similar as possible to those used for the subject property, they do not have to be exactly the same. 

•    Physical depreciation (which is traditionally referred to as physical deterioration) is a loss in value that is caused by deterioration in the physical condition of the improvements.  An appraiser generally classifies physical deterioration as "curable" or "incurable." Curable physical deterioration refers to items of deferred maintenance -- for example, painting or items currently in need of repair (such as broken stair rails).  Incurable physical deterioration refers to other items that currently are not practical or feasible to correct -- for example, furnaces or roof shingles that have not reached the end of their economic life. 

•    Functional depreciation (which is traditionally referred to as functional obsolescence) is a loss in value that is caused by defects in the design of the structure -- for example, inadequacies in such items as architecture, floor plan, or sizes and types of rooms.  It also can be caused by changes in market preferences that result in some aspect of the improvements being considered obsolete by current standards -- for example, the location of a bedroom on a level with no bathroom, or access to a bedroom only through another bedroom.

•    External depreciation (which is traditionally referred to as economic obsolescence) is a loss in value that is caused by negative influences that are outside of the site, such as economic factors or environmental changes -- for example, shopping centers, expressways, or factories that are adjacent to the subject property.  

In reviewing the appraisal report, the lender should make sure that the appraiser's analysis and comments for the cost approach to value are consistent with comments and adjustments mentioned elsewhere in the appraisal report.  For example, if the neighborhood or site description reveals that the property backs up to a shopping center, the lender should expect to see an adjustment for external depreciation in the cost approach.  Similarly, if the improvement analysis indicates that it is necessary to go through one bedroom to get to another bedroom, the lender should expect to see an adjustment for functional depreciation.