Cost Approach is one of the three methods of estimating the market value of real estate. The other two methods are: Sales Comparison Approach and Investment Approach. Cost Approach is also referred to as the Contractor’s Method. In Cost Approach, you arrive at the value of real estate by summing up the market value of land and the cost of the building. You may need to add to this profit. There are four steps in Cost Approach.
Step 1: Ascertaining the market value of land.
Under the cost approach, land is considered at the market value. Why? If you bought land cheaply, that does not make land cheap. You only paid less for it. On the other hand, if you paid more, you paid premium for it. You obtain the value of land by comparing it with other land sold. My article Sales Comparison Approach: Method of Real Estate Valuation will lead you through this process.
Step 2: Ascertaining the cost of development
The most accurate way to ascertain the cost of the development is to sum up the current cost of all separate components and material used in building. However, this method is quite tedious and best left to quantity surveyors. Working with construction rate per square foot or per square meter is easier. You can obtain this rate from your friends who have recently built their houses. The rate is obtained by dividing the cost of the building by the building area. For example, if it cost 4,500,000 to put up a 1,500 sq.ft. building, the rate will be 4,500,000 ÷ 1,500 = 3,000. A phone call to a valuer, quantity surveyor, contractor or an architect may be useful to obtain this rate. You will multiply this rate by the building area of your house to obtain the cost of the building. If the building is worn out, you may need to minus a percentage for depreciation.
Step 3: Summing up the value of land and cost of building
The third step in cost approach is to sum up the market value of land and the cost of the building. But does this give you the market value? The answer may be yes or no. Market value is a function of the market. If you build in a less popular place, you will not get a buyer at that cost. Giving a discount may attract a buyer and that means you sell the property at a loss. However, if the property can attract many potential buyers, competition among them would lead to a price higher than the cost. In this case you make a profit. This then takes us to step 4
Step 4: Converting cost to value
Cost is not equal to value. To convert cost to value, you will need to add profit element to the cost if the property is popular. However, if the property cannot attract buyers, you will have to discount the cost. The percentage of profit or discount will vary with the strength of the market.
Registered Valuer, Registered Estate Agent & Registered EIA Expert
Real Estate Consultant at Tysons Limited, Nairobi-Kenya
Personal blog: www.StephenOmengo.com
Personal email: stephen@StephenOmengo.com