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The cost approach is a metric loosely used in real estate appraisal, which is based in old rules stating no one wants to pay to use or buy a building if it would cost less to build a similar one. This metric is mostly used when determining the market value of a home or commercial building and is figured by the average building cost, plus land and minus depreciation. The cost approach can be highly inaccurate in some areas, however, due to constant fluctuations in land and building costs.
Cost approach takes the current average cost to build the same or a similar building into consideration, but this base number can change due raw material prices, land availability and area popularity or demand. The average price of the land which a building sits on is also factored. Depreciation, or a margin that represents it, is deducted from the cost approach. Since so many variables can change the end number so quickly, it is common to see the approach in terms of a price range rather than a definite number.
Sellers and real estate agents use cost approach in an effort to offer competitive prices on commercial and residential properties. This method is especially useful when valuing properties which are unique or rural areas where no immediate market data is available. In areas with many similar buildings, comparable prices and market data may be used instead to determine real estate value.
Buyers who are aware of how a building was appraised will have a better understanding of their ability to negotiate prices. Although the prices are not as straightforward as they once were, cost approach is still a solid place to begin estimating the value of a property from the buyer's view. Builders will especially use cost approach to decide how to construct a home or business site. If builders ignore this metric, it may be easy to build a property at a higher price than it could be sold for.
Many real estate experts even believe that only those who have a moderate understanding of construction and material costs should use cost approach to appraise a property. Other factors such as demand and market data are more commonly used in developed areas because these valuation techniques tend to be more stable. These valuation techniques are more complex, but are also likely to present a more accurate estimate of property value.