Basic steps in the cost approach are:
Estimate the value of the land as if vacant
Estimate the replacement cost new of the improvements
Estimate the loss in value from all forms of depreciation
Deduct the total amount of depreciation from the replacement cost new
Estimate the same amount for any other improvements
Add the land value estimate to the depreciated cost value to arrive at the total property value
Step 1, land valuation, may involve any of the methods already mentioned (allocation, abstraction, etc.). Step 2, estimating the replacement cost new of the improvements, requires that a distinction be made between replacement cost and reproduction cost.
Replacement cost is defined as, "the cost and overhead that would be incurred in constructing an improvement having the same utility as the original, without necessarily reproducing exactly the same characteristics of the property, but using today's materials, labor, and building techniques." In other words, replacement cost represents the cost to create an equally desirable substitute property.
Reproduction cost is defined as, "the cost, including material, labor, and overhead, that would be incurred in constructing an improvement having exactly the same characteristics as the original improvement."
Reproduction cost is sometimes difficult to measure because the same building materials or methods are not available. Reproduction cost for an older building with 12 foot ceilings, working fireplaces in every room (as opposed to modern central heating systems), and elaborate trim would be computed on the basis of creating an identical structure today. The reproduction costs of these types of physical characteristics in older structures often tend to create an element of depreciation (value loss) identified as functional obsolescence.
This is illustrated using the principle of substitution, which states that in a competitive market, a buyer will typically not pay more for a particular property than the amount to acquire a similar property with comparable utility (a satisfactory substitution). Thus, reproduction cost may often require adjustments for construction techniques, building materials and various forms of depreciation to be indicative of current market value.
Replacement Cost New
The Replacement cost rather than Reproduction cost is used as the basis for the cost approach in most appraisal situations where cost is considered an appropriate measurement of value. Replacement Cost New is generally applicable to most classes of property and leads to a greater degree of uniformity and equity in assessed values.
Cost Value Methods
There are several methods used to arrive at a cost value: the quantity survey method, the unit-in-place method, and the square foot method.
Quantity Survey Method
The quantity survey method requires that the appraiser create a detailed inventory of every item of material, equipment, labor, overhead, and fees involved in the construction of a property. This method is not routinely used by appraisers because it is extremely time consuming.
The unit-in-place method is less detailed than the quantity survey method, but still reasonably accurate and complete. This method combines direct and indirect costs into a single cost for a building component (the unit-in-place) which is then multiplied by the area of the portion of the building being valued to arrive at a total cost for that component.
This is the method used in the Construction Cost Manual prescribed by the Arizona Department of Revenue, for many building components. These allow the appraiser to make adjustments for individual components for various types of structures.
Square Foot Method
The square foot method combines all the costs for a particular type and quality of structure into one value as a cost per square foot (or cubic foot). This method produces a value based on the floor area of the structure.
The cubic foot method is used when the wall height varies within a building class, such as warehouses or factories. Generally the square foot or cubic foot methods are not considered sufficiently accurate compared to the first 2 methods for estimating cost.