Why Cost Approach Appraisal Matters
Most appraisers avoid the Cost approach appraisal because they were never taught to appreciate how much analytical horsepower it carries. Skip it, and you skip the answers to questions a state appraisal board may one day expect you to answer: site value as if vacant, age and condition adjustments, entrepreneurial incentive, financial feasibility, and where a neighborhood sits in its life cycle. This post walks through ten pointed questions that reveal the deep power buried in the Cost approach’s protocols. Master those analytics, and you will not only produce more credible reports, you will also have a stronger case for charging what your work is truly worth.
Table of Contents
Why Cost Approach Appraisal Deserves Your Respect
Let me be candid with you, because that is what I always try to be. Most appraisers do not like the Cost approach. We are not especially familiar with it, we do not use it often, and because of that unfamiliarity, we never come to appreciate the deep analytical power it actually holds.
That is a shame, and here is why. The Cost approach is not merely a box on the 1004 that Fannie Mae says you do not have to complete. It is a window into site value, into age and condition, into entrepreneurial incentive, and into the very life cycle of the neighborhood you are appraising in. When you push it aside, you are not just skipping a form section. You are skipping the analytics that answer questions the rest of your report depends on.
So I am going to ask you ten questions about the Cost approach and the analytics that surround it. When you finish reading, you may still not enjoy tackling it. That is fine. But you just might walk away with a better understanding of, and a healthier appreciation for, its powerful analytical capacities. And that understanding may be exactly what keeps you out of trouble.
Ten Cost Approach Appraisal Questions Every Appraiser Should Answer
Remember this as you read. The answers to these ten questions come, in large part, from engaging with the analytics inherent in the Cost approach. So if you are not engaging in those analytics, ask yourself honestly: are you missing the answers to these questions? And is that something you would want to explain to a state appraisal board?
Here are ten questions on the Cost approach. And frankly, there could be more.
The Form Instructions You May Be Skipping
Let’s start where the trouble usually starts, which is with the instructions printed right on the form you sign.
- On the 1004 form, Fannie Mae states it does not require the Cost approach to value. Fair enough. But where, exactly, does the form instruct the appraiser not to complete the analytics of the Cost approach? There is a meaningful difference between not requiring a result and telling you to skip the thinking.
- The form instructs the appraiser to provide adequate information to the lender and client to replicate the cost figures and calculations. So where does the typical appraiser actually provide such replicable information? Could another competent appraiser open your report and reproduce your numbers?
- The report form also requires the appraiser to support the opinion of site value with a summary of comparable land sales or other methods for estimating site value. Where in the typical report does that summary actually appear?
Cost Approach Site Value: The Analysis Hiding in Plain Sight
Now consider this passage from the Fannie Mae Selling Guide on highest and best use. Read it slowly, because it matters. Ask yourself whether this is part of your highest and best use analytics:
The appraiser’s highest and best use analysis should consider the property as it is improved, recognizing that existing improvements should continue in use until it is financially feasible to remove or renovate them. Where comparable sales show the improvements are typical and compatible with market demand, and they contribute value beyond the vacant site value, the existing use should be reported as the highest and best use.
The paraphrase above captures Fannie Mae’s point, and the point is this: appraising a single family residence includes an analysis and valuation of the subject site separate from the valuation of the site as improved. In other words, as if the subject site were vacant and available to be put to its highest and best use.
- So here is question four folded into the discussion: do you have those site-as-vacant analytics in your report or your work file? Or did the value simply appear?
- Suppose you did not know the market value of the subject site as if vacant, and you also did not know the values of your comparable sales as if vacant. How, then, would it be possible to adjust for differences in the site-value components of those comparables?
Age, Condition, and Entrepreneurial Incentive
- How is it possible to make an age and condition adjustment if you do not know how much the age and the condition of the subject and the comps contribute to their respective market values? An adjustment you cannot support is an adjustment you cannot defend.
- Assume you have not determined whether there is, or is not, an entrepreneurial incentive or profit in the market. That determination is normally part of the protocols of the Cost approach, or it should be. Without it, how can you determine whether new construction is financially feasible? And how could you determine whether repairs, renovations, or razing the improvements is financially feasible?
- How is the level of market demand, as indicated by the presence or absence of an entrepreneurial incentive or profit, an integral function of the highest and best use process? These pieces do not sit in isolation. They connect.
How Cost Approach Appraisal Reveals a Neighborhood's Stage
- Finally, how does the presence or absence of an entrepreneurial incentive or profit help you determine the stage at which a neighborhood finds itself as of the effective date of your appraisal? Growth, stability, decline, revitalization. The Cost approach quietly tells you where you are.
Notice what happened as you read those ten questions. Site value, adjustments, feasibility, highest and best use, and neighborhood stage all traced back to the same source: the analytics of the Cost approach. Skip the approach, and you have not skipped one section. You have skipped the reasoning that supports several.
Are Your Fees High Enough?
Here is the question I promised, and it is the one too many of us avoid. Are your professional fees high enough?
Think about everything we just covered. If you are performing genuine site valuation, defensible age and condition analysis, entrepreneurial incentive analysis, and feasibility testing, then you are delivering analytical work far beyond filling in blanks. That is competent, credible, defensible appraising. Work of that caliber deserves to be paid accordingly. Low fees and deep analytics rarely coexist for long, and the appraiser who charges for the thinking is usually the appraiser who does the thinking.
Key Takeaways
- The Cost approach is an analytical engine, not a throwaway form section. Fannie Mae not requiring a result is not the same as telling you to skip the analysis.
- Appraising a single-family residence includes valuing the site as if vacant, separate from valuing it as improved. That analysis belongs in your report or your work file.
- Without site value as if vacant, you cannot properly support site-component adjustments, age and condition adjustments, or feasibility conclusions.
- Entrepreneurial incentive or profit tells you whether construction, renovation, or razing is financially feasible, and it signals the stage of the neighborhood’s life cycle.
- The instructions to make your cost figures replicable and to summarize site value support are printed on the form. A reviewer or state board can read them too.
- Analytical, defensible work justifies professional fees. Charge for the thinking you actually do.
Let's Work on This Together
Has this series of ten questions helped you see the deep power in the protocols and analytics of the Cost approach appraisal? I hope so. And if it raised more questions than it answered, that is a good sign. It means you are thinking like the analyst you already are.
I am available to consult with you on the Cost approach, or on any real estate appraisal topic. We can work together on a one-time basis, or on an ongoing coach and mentor basis, whatever fits where you are right now. Reach me directly at tim@theappraisersadvocate.com, or visit www.theappraisersadvocate.com. It will be my honor to work with you.
Be safe and well. And one more time, because it matters: make sure your fees are high enough.
Additional Resources for Cost Approach Appraisal
If this discussion sharpened your thinking, these related articles from The Appraiser’s Advocate will take you deeper into the analytics that surround the Cost approach, highest and best use, and financial feasibility:
- Oh, Please! Not Another Highest and Best Use Question?! — Why the financial feasibility of an existing home is not about construction cost, and why so many Cost approach reports wrongly omit entrepreneurial incentive.
- Your Highest and Best Use Analysis Helps You Cover Your Assets! — A component-by-component walk through SR1-3(a), tying land use, supply and demand, and market trends to a defensible value conclusion.
- It’s Time for Appraisers to Grow a Pair! — On systemic and critical thinking, and how tying your analyses together is exactly what separates a credible appraiser from an AVM.
Frequently Asked Questions
Does Fannie Mae require the Cost approach on the 1004?
Fannie Mae does not require a Cost approach result on the 1004. What the form does not do, however, is tell you to skip the underlying analytics, including site valuation and feasibility analysis, that support your highest and best use and value conclusions.
Why does site value as if vacant matter so much in a Cost approach appraisal?
Because you cannot credibly adjust for differences in the site-value components of your comparables, or reach a defensible highest and best use conclusion, if you do not know what the subject and the comps are worth as if the sites were vacant.
What is entrepreneurial incentive, and why should I care?
Entrepreneurial incentive or profit reflects the reward the market requires to justify development. Analyzing it tells you whether new construction, renovation, or razing is financially feasible, and it helps you identify the stage a neighborhood occupies as of your effective date.
How does the Cost approach connect to highest and best use?
Directly. Feasibility, site value, and market demand all feed the highest and best use decision. When you engage the Cost approach’s protocols, you are already doing much of the analysis highest and best use requires.
Could skipping this analysis cause problems with a state board?
It can. If your file lacks the analytics behind your conclusions, you may be unable to explain how you reached them. That is a difficult conversation to have with a reviewer or a state appraisal board. This is not legal advice; when facing board scrutiny, consult a qualified professional.
Tim,
It is overwhelmingly obvious that there is intense interest about the cost approach among your respondents so to heck with everybody else. It would be consuming to publish the answers by the bloggers above to your questions and encourage critical thought among them. So far when I have tried this it attracts the trolls among us and it turns out badly.
I suggest a couple of rules if you can bring yourself to try this experiment.
1. No trolling.
2. No trolling.
Could you re-write the questions so I can understand them?
Edd, thank you for your kind remarks. Avoid the trolls and talk with me instead! You have my number. As to you understanding of the questions, you already understand them, you just may not realize that yet. So, call me! We’re friends!
What I consider remiss of the 1004 form is the fact that the GSE’s do not require it. As a result, the vast majority of appraisers do not complete it. Over time, the last 15 years anyway, appraisers have lost the value of it. The connectivity of the HBU analysis with the CA has also been missed. When did it become OK to disregard USPAP Standards 1 and 2 in considering ALL 3 approaches to value in the development of the opinion of value? Appraising real property in promoting public trust should never be told an essential component of analysis is not required. The robotics of the process will take that directive as a pass. This has become the new normal and, sadly, going back to our roots is a difficult battle.
Terri, Thank you for your thoughts and comments. Thank you, too, for taking the time to read the post. Clearly, we both conclude the Cost approach is more important to the analytics behind an appraisal that many appraisers want to conclude. You are very kind to share your feelings. Thanks again! Be safe and well! My Best to you and all of yours!
For me, the highest and best use of the cost approach is to support other assignment results. Site value and HBU as you point out; but also effective age and remaining economic life. When you have supported remaining economic life, you know the market value of the improvements as a percentage of cost. Now you can apply that percentage to things like GLA, baths and garage stalls. Use those adjustments in the sales grid and you have a coherent report free from the problems of using messy MLS data to extract adjustments.
Well said, Scott, Thank you!
I personally consider it appraiser malpractice to not use land sales in an appraisal report, when available. I live in the foothills of California, a mostly rural landscape with plenty of land sales and listings. The last report I completed, I noted 75 active listings of vacant sites. I complete an absorption rate and list the available vacant land sales & listings. What do I get from land sales? I support subject’s estimated land value. I support the depreciation models. I support view adjustments, I support site size adjustments, I support adjustments for location (busy streets), I can get all of this from land sales. Example, I reviewed a small development of 12 parcels. 2 of the 12 parcels front a busy street. These 2 properties sold at lot premium of minus 8%. The 2 backs lots had valley views and sold at a 12%+ premium. No cost approach, no support… The AMC replies, I wanted the report yesterday!
This is great, thank you!