How can you avoid risks when using the cost approach for new construction?

1 Know your sources

The cost approach requires you to estimate two main components: the land value and the construction cost. To do this, you need reliable and updated sources of information. For the land value, you can use recent sales of comparable vacant lots in the same area, or consult with local appraisers or brokers. For the construction cost, you can use published cost manuals, such as the Marshall & Swift or the RSMeans, or get quotes from contractors or builders. Make sure you adjust the costs for location, quality, design, and market conditions.

2 Consider depreciation

Depreciation is the loss of value due to physical deterioration, functional obsolescence, or economic obsolescence. Even new construction can suffer from depreciation, especially if it is not completed or occupied yet. To account for depreciation, you need to apply a percentage or a dollar amount to the construction cost, depending on the type and extent of the depreciation. For example, if the new construction has a poor layout, outdated features, or low demand, you may need to deduct some value from the cost.

3 Verify your assumptions

The cost approach relies on a lot of assumptions and estimates, which can introduce errors and biases. To avoid this, you need to verify your assumptions and check your calculations. For example, you can compare your cost estimate with other sources, such as insurance values, replacement costs, or reproduction costs. You can also cross-check your cost approach value with the other valuation methods, such as the sales comparison approach or the income approach. If there are significant discrepancies, you may need to revise your assumptions or explain your reasoning.

4 Document your work

The cost approach is not always accepted or preferred by lenders, buyers, or sellers, as it may not reflect the true market value of the property. To avoid disputes or challenges, you need to document your work and provide evidence for your cost approach value. For example, you can include copies of the cost manuals, sales data, quotes, or adjustments that you used. You can also provide a detailed narrative that explains how you applied the cost approach, what factors you considered, and what limitations or uncertainties you faced.

5 Update your value

The cost approach is sensitive to changes in the market conditions and the construction industry. Therefore, you need to update your value regularly and make sure it reflects the current situation. For example, if there are changes in the supply and demand of land or materials, or if there are new regulations or trends that affect the construction cost or quality, you need to adjust your value accordingly. You can use indexes, multipliers, or trend factors to update your cost estimate, or consult with experts or professionals.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?