Cost Approach for Real Estate: Depreciated Replacement Cost
Land value plus what the building would cost today, less what age and obsolescence have taken off.
The cost approach values a property as the value of the land plus what it would cost today to provide the building, less an allowance for its age and any loss of usefulness. In Indian reports this is often called the land and building method, and the building element is the depreciated replacement cost, or DRC.
It rests on substitution: a buyer would not pay more for a building than the cost of putting up an equivalent one. That makes it the method of choice where sales and rents are thin: factories, schools, hospitals, owner-occupied bungalows and other specialised property. It is also the base for insurance sums, which deal in rebuilding cost.
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Reproduction Cost vs Replacement Cost
- Reproduction cost
- The cost of an exact replica: same materials, design and workmanship, including features no longer needed.
- Replacement cost
- The cost of a modern building of equal utility using current materials and design. Usually lower, and the usual base in valuation because it strips out functional obsolescence automatically.
- Depreciated replacement cost (DRC)
- Replacement cost less physical depreciation and obsolescence, added to the land value.
- Obsolescence
- Loss of value not caused by wear: functional (poor layout, low ceiling height), technological (outdated services) and economic or external (a bypass that takes away traffic, a change in zoning).
Worked Example: DRC of a Factory at Chakan
Illustration only. 4,000 sq m of industrial land with a 2,500 sq m RCC factory building, 15 years old. Assumed total life 60 years, salvage 10%, straight-line depreciation.
Land value (from the market approach)
Working
4,000 sq m × ₹6,000
₹
2,40,00,000
Replacement cost of building
Working
2,500 sq m × ₹22,000
₹
5,50,00,000
Physical depreciation
Working
(1 minus 0.10) × 15 ÷ 60 = 22.5% of 5.5 crore
₹
1,23,75,000
Functional obsolescence (low eaves height)
Working
5% of replacement cost
₹
27,50,000
Depreciated building value
Working
5.5 crore less 1.2375 crore less 0.275 crore
₹
3,98,75,000
Value by cost approach
Working
Land plus depreciated building
₹
6,38,75,000 (about ₹6.39 crore)
| Step | Working | ₹ |
|---|---|---|
| Land value (from the market approach) | 4,000 sq m × ₹6,000 | 2,40,00,000 |
| Replacement cost of building | 2,500 sq m × ₹22,000 | 5,50,00,000 |
| Physical depreciation | (1 minus 0.10) × 15 ÷ 60 = 22.5% of 5.5 crore | 1,23,75,000 |
| Functional obsolescence (low eaves height) | 5% of replacement cost | 27,50,000 |
| Depreciated building value | 5.5 crore less 1.2375 crore less 0.275 crore | 3,98,75,000 |
| Value by cost approach | Land plus depreciated building | 6,38,75,000 (about ₹6.39 crore) |
How to Build the Building Cost
- 1
Choose the estimating method
Plinth area rate for most reports, cubic content for tall single-storey sheds, and a detailed quantity estimate where precision matters, for example in a dispute.
- 2
Use current rates
Cost at the valuation date, from published schedules of rates or recent contracts, with services, site works and professional fees added.
- 3
Estimate the lives
Separate economic life (useful in the market), physical life (until it is unsafe) and legal life (lease expiry or a demolition order). The shortest one governs.
- 4
Deduct depreciation and obsolescence
Use effective age (based on condition) rather than calendar age if the building has been refurbished.
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Cost Is Not Value
The syllabus asks for DRC to be adopted as value subject to demand and supply. A new factory in a weak industrial belt may sell for well under its DRC. If the market says less, the report must say so, usually with an economic obsolescence deduction and a cross-check against sales.
How the Valuation Examination Tests This
Typical questions ask you to compute DRC from a cost, age, life and salvage figure, or to pick which kind of obsolescence a fact describes. The traps: depreciating the land (land does not depreciate), depreciating the full cost when the question gives a salvage value, and confusing a flyover that blocks a shop (external) with an outdated layout (functional).
FAQs
When is the cost approach used for property valuation?expand_more
Where there is little sales or rental evidence: specialised buildings, owner-occupied bungalows, factories, public buildings and new construction. It is also the base for insurance reinstatement values.
What is the difference between reproduction cost and replacement cost?expand_more
Reproduction cost rebuilds an exact copy; replacement cost provides the same utility with modern materials and design. Replacement cost is the usual starting point.
Is depreciation applied to land in the cost approach?expand_more
No. Land is valued separately, usually by comparison, and only the building is depreciated.
Does the cost approach give market value?expand_more
Only if the market would pay it. That is why the result is tested against demand and supply and against the other two approaches.
Next steps
- Depreciationarrow_forward
- Land Valuationarrow_forward
- Insurance Valuationarrow_forward
- Valuation Approachesarrow_forward
Timed and scored, with negative marking.