The Cost Approach Formula
The cost approach starts from a different premise than the income or sales comparison approaches: it asks what it would cost, today, to replace the improvements, then adjusts for the fact that the existing building isn't new. The formula is Value = Land Value + (Replacement Cost New − Accrued Depreciation). Land value is typically estimated separately using comparable land sales, while replacement cost new is built up from current construction costs — materials, labor, contractor profit, and soft costs — for a functionally equivalent building.
Estimating Accrued Depreciation
Accrued depreciation captures the total loss in value the existing improvements have suffered relative to a brand-new equivalent, and it's typically broken into three categories: physical deterioration (ordinary wear and aging), functional obsolescence (outdated layout, systems, or design relative to current standards), and external (economic) obsolescence (value loss from factors outside the property itself, such as a declining surrounding market). Estimating depreciation is inherently judgment-heavy, which is one of the approach's core weaknesses.
When the Cost Approach Is Most Relevant
The cost approach carries the most weight for new or recently constructed properties, where replacement cost is easy to document and depreciation is minimal, and for special-purpose properties — such as a church, school, self-storage facility, or manufacturing plant with unique improvements — where too few comparable sales exist to rely on the sales comparison approach and there's no stabilized market rent to support the income approach.
When the Cost Approach Is Least Relevant
For older, income-producing stabilized assets — a seasoned multifamily property or a well-leased office building, for example — the cost approach tends to carry little weight. Depreciation estimates for an older building are difficult to support with precision, and the market ultimately prices these assets based on their income-generating ability and how similar assets have traded, not on construction cost. In these cases, the income and sales comparison approaches are typically far more persuasive.
Components of Accrued Depreciation
- Physical deterioration — ordinary wear and aging of the structure
- Functional obsolescence — outdated design, layout, or building systems
- External (economic) obsolescence — value loss from factors outside the property
When the Cost Approach Carries the Most Weight
- New or recently constructed improvements
- Special-purpose properties with few or no comparable sales
- Insurable value or replacement-cost estimates for lending or insurance purposes
- Land residual analysis for proposed development
Cost Approach
Value = Land Value + (Replacement Cost New − Accrued Depreciation)
- Land Value
- — Estimated value of the land as if vacant, typically from comparable land sales ($)
- Replacement Cost New
- — Cost to construct a functionally equivalent new building using current materials and methods ($)
- Accrued Depreciation
- — Total loss in value from physical deterioration, functional obsolescence, and external (economic) obsolescence ($)
Estimate what the land is worth on its own, add what it would cost to build the improvements brand new today, then subtract the value already lost to wear, outdated design, or outside market factors.
Worked example: Land value is estimated at $800,000. Replacement cost new for the building is $4,200,000, and accrued depreciation is estimated at $600,000. Value = $800,000 + ($4,200,000 − $600,000) = $4,400,000.
Least Reliable for Stabilized Income Properties
For an older, stabilized, income-producing asset, precisely estimating accrued depreciation is difficult, and the market prices these properties on income and comparable sales, not construction cost. Appraisers typically give the cost approach little or no weight in the final reconciliation for these assets.
Module Check
Under the cost approach, value is estimated as: