The Cost Approach is founded on the principle of substitution, which implies that no prudent investor would pay more for a property than the amount required to acquire a site and construct a building of equal utility and desirability without undue delay.

The cost approach relies on sound logic and can provide good results when valuing a property as new.  It is important, however, that consideration be given to market conditions at the date of appraisal/assessment. Often the market value may be less than its replacement cost.      

The Cost Approach involves a series of steps as follows:

1. Determine the value of the land (usually completed in the Direct Comparison Approach) as if vacant and available for use in accordance with highest and best use.
   
   
2. Estimate the cost to reproduce or replace the improvements new as of the effective date of appraisal (assessment). The cost includes all direct (hard) costs, indirect (soft) costs, and entrepreneurial profit.
   
   
3. Estimate and deduct from the cost new an estimate for all forms of accrued depreciation:  physical deterioration, functional and external depreciation.
   
   
4. Add the value of the land to the depreciated cost of the improvements to provide for an estimate of value for the property.

It is important to note that when determining the replacement or reproduction cost, entrepreneurial profit and contractor’s overhead and profit are two separate items. Contractor’s overhead and profit is an amount usually included in costing estimates published by costing manuals such as Marshall Valuation Service. Entrepreneurial profit which is generally not included in costing manuals is a market derived figure representing the compensation a developer receives for the time, effort and risk associated with the project. It can be measured by the difference between the total cost and the market value of the project upon completion. The Cost Approach is not considered the primary approach to value with respect to hotels/motels due to the difficulty in accurately determining depreciation from all causes as a building ages. However, it is a good starting point for cost/value analysis in forming investment decisions, e.g., purchase v. build. It also serves as a check on the values determined by the other approaches to value.