Rapidly fluctuating markets – particularly where there’s tremendous upward pressure on pricing like we’re seeing in many areas today – can present real challenges for appraisals. Freddie Mac has recently seen a rising trend in appraised values coming in below contract price (from an annual average of 7-9% from 2013-2019 to 20% nationwide in April/May of 2021).

Among the several tools and techniques appraisers can employ during a market like this, is the cost approach. While this is garnering a lot of attention now, not understanding the cost approach may limit an appraiser’s ability to properly support adjustments in the sales comparison approach. Since many trends in market conditions are often driven by building costs, a solid understanding of what this approach is (and isn’t) is fundamental.

Scott Reuter, Single-Family chief appraiser and director of valuation sat down to talk about the cost approach, how appraisers can use it in a rapidly changing market and what the Freddie Mac Single-Family Seller/Servicer Guide (Guide) says about it.

Q: There’s a lot of talk right now about the cost approach because of the current market. So, what is the cost approach?

A: The cost approach is one of three recognized approaches to value that are available to appraisers:

  • Sales comparison approach
  • Cost approach
  • Income capitalization approach

All three approaches are considered in each appraisal assignment, however only one or two are typically developed and used in single family appraisals. Essentially, the cost approach is a method of data analysis based on the principle that market participants relate cost to value. Here’s how it works.

First, the appraiser develops a reproduction cost of a new home – like the subject property – less any depreciation based on the age and condition of the property. The appraiser then adds that figure to an estimated value of the site on which the subject property resides. The result is the value of the subject property under the cost approach.

Q: How can the cost approach help appraisers in rapidly changing markets?

A: The most common challenge appraisers run into in rapidly changing markets is that closed sales transactions will generally lag current market conditions. Appraisers will need to take additional time to fully analyze the current market conditions to help support and develop a credible appraisal. As an example, the upward pressure we are seeing currently on both demand and pricing will likely be evidenced in other market indicators, like limited or shrinking available inventory, days on market and home price trends.

The cost approach can be a great secondary approach to value for an appraiser when considering these factors. It can be particularly helpful in providing support for cost increases in new construction. That said, it is not an easy fix for all valuation challenges and appraisers need to keep in mind that the cost approach is a market-based approach and increases in costs need to be accounted for with market support.

Q: What does the Guide say about the use of the cost approach?

A: The Guide allows for, but does not require, the development of the cost approach in an appraisal (the one exception is with manufactured homes, where the cost approach is required). It allows for appraiser discretion on the applicability and reliability of this approach. The cost approach is often recognized to be generally more accurate on newer properties where less depreciation needs to be estimated. Per our policy, it cannot be the sole approach used in developing value. The Guide requires that a sales comparison approach also be used in order to demonstrate marketability.

Q: So, what’s your take on the use of the cost approach? 

A: I believe the cost approach is an effective tool in an appraiser’s arsenal and it’s clearly an area where all appraisers should look to refresh and hone their skills. It can play a very important role in the development of value. That said, it does not apply to every assignment type and is certainly not a “quick fix” to challenges with rapidly changing market conditions. There’s bound to be continued discussion in the industry about the cost approach and its role in our current market. I think it’s important that we as appraisers – and we at Freddie Mac – are prepared to have honest conversations on the topic and professionally address any questions or concerns as they arise.