How To Value A Property Using The “Cost Method”

GoodPlace Homes

There’s really no two ways about it – the biggest factor which determines if an investment is going to pay out or not in the future is the buying price. Figuratively speaking, you can buy a dud and still turn a profit as long as you have got the patience (and the holding power) to ride the fluctuations of the market cycles. However, even if you’ve gotten yourself a prime piece of freehold real estate in the middle of Kuala Lumpur, you’re not gonna be ballin’ hard anytime soon if you’re paying through your nose at face-palmingly high valuations (cough, TRX, cough).

In short, forget the usual “location, location, location” crapola piece of a Guru granola, folks. Whether you’re gonna make money tomorrow depends on how much you’re paying today, period.

Here at GoodPlace we like the topic of property valuation so much that we have written numerous guides and blog posts on it – of course, if you’ve not read our legendary “Goldie and Patrick” fable then by all means go get it (email optin required so that I get to spam you later). 12,000+ people have downloaded the guide so far, though I’m not sure how many actually read it given the amount of property valuation questions that I still get from GoodPlace readers every week…

Hey…. sexy lady

Now, despite what your friendly money grubbing neighbourhood property Guru tells you in his seminars, there’s really no one right way to value a property. We like the “Comparison Method” method a lot, and if you’re one of the perhaps 20 people out of the 12,000 who actually read the Goldie and Patrick story, it’s the method that we use the most here at GoodPlace. However, there’s also an alternative method which is called the “Cost Method” which we are going to talk about today.

Sidenote: my lawyer Matthew has been getting his panties in a bunch lately with some of our more incendiary posts (like the recent one on Gekko Strategies), and I have been forced somewhat to plaster the site with disclaimers in order to protect our collective behinds. So that Matthew can sleep better tonight, here’s today’s post’s disclaimer: I am not a property valuer, and anything you’re gonna do with the information I provide below is at your own risk. Thank you for your kind understanding.

The Cost Method

To value a property using the Cost Method, use the following formula:-

cost-method

Simply put, the value of a property (VP) is the sum of the value of the land (VL) and the structure on that land (VS). Now let’s examine each of these variables and see how we can calculate them.

VL is the value of the land ALONE, and as far as Malaysia properties are concerned, this never depreciates. On the other hand, this is not true for the other variable VS – the value of the structure residing on that land. Let’s look at this next.

The value of the structure is a function of the “Replacement Cost” (RC) and its associated Depreciation (D), and can be represented in the following mathematical formula –

depreciation-real

The Replacement Cost is simply the cost to build the same structure on the land. It is often quoted on a price per square feet (PSF) basis.

Depreciation, on the other hand, is the loss in value of that same structure over time. Now the topic of depreciation in itself deserves a whole thesis on its own, but to make things simple, usually we will consider what we call a “straight line depreciation” (which often is a good enough approximation for most cases). On an annualized basis, depreciation is simply:-

annual-depreciation

T here represents the useful life of the property, and is measured in years. For example: a Kiaraville unit in Mont Kiara has a replacement cost of $250,000 (OK, I’m just making this up) with a 25 year life expectancy. The annual depreciation of Kiaraville is therefore $250,000 / 25 = $10,000 a year.

OK, so all this mathematical mumbo jumbo may make some of you keel over and frothing in the mouth by now…

head-screw

So let’s go through an example next to see how it works. It’s really simple so don’t worry. 🙂

Example: Using The Cost Method To Appraise Land Value

An advantage of the Cost Method is that you can use it to appraise the value of a land (something which can be tricky to do with the Comparison Method) – this is especially useful if you’re searching for an empty plot of land to build your retirement home. 😉 In this example, we will use the Cost Method to appraise the value of a piece of land. Boo ya!

Let’s say a 15-year old bungalow in Petaling Jaya has an appraisal value of $2,850,000. This bungalow occupies a 4,000 sq ft piece of land, and is expected to have a useful life of 35 years. The replacement cost is $200/sq ft. You want to buy the land, nuke the bungalow and build your own. What is the fair value of the land?

First, let’s calculate the replacement cost. Simply, it’s $200 / sq ft x 4,000 sq ft = $800,000. In other words, it costs $800,000 to rebuild a similar structure today on the same piece of land.

Next, let’s look at depreciation. Now take the replacement cost above and depreciate it over the building lifespan. The annual depreciation is therefore $800,000 / 35, or $22,857 per year. And since it’s already 15 years old, its total depreciation is therefore $22,857 / year x 15 years, or $342,857.

Now plugging in everything we have now into the main formula,

Land value = $2,850,000 – $800,000 + $342,857 = $2,392,857, or nearly $600 per sq ft. QED!

We have an in-house Excel template that we use to calculate property value using the Cost Method. If you want it, email me or leave me a message below.

Cost vs Comparison – Which To Use?

Both Cost and Comparison Methods are widely used in the professional property valuation industry, and there’s good and bad associated with both. Here at GoodPlace this is what we typically do:-

  1. Value the property using the Comparison Method – usually up to six comparable properties (“Comps”) with transacted prices back dated to six months.
  2. Do a “five percent” sanity check with the Cost Method.

Now here’s how the Cost Method becomes useful – if you arrive at a figure (from the Cost Method) which varies greatly from the Comparison Method (typically 5% or more) then alarm bells should start ringing in your head. You should then revisit your adjustments and assumptions, or even double check the validity of the transactions data (especially if you have acquired them elsewhere apart from JPPH).

On the other hand, if both methods yield figures in the same +/-5% ballpark then congratulations; you should be good to go. 🙂

Really, no matter what method you used though, you’ll still be ahead of most Malaysians who rely on their “gut” to value property like they would when they buy kangkong from the pasar. I know, I know, I’m beating this ailing horse to death already, but when buying or selling property, use your head, not your heart.

About Khai Yin

When I am not writing for GoodPlace.my and helping my readers find properties though the DealMatcher service, I spend time doting on my three kids: Wenyi, Qinyi and Eian. My personal stuff, some published essays and contact details can be found at khaiyin.com

Comments

  1. Kenny Tong says:

    Hi Khai Yin, Appreciate if you can provide a copy to calculate property value via Cost Method. Thanks in advance

  2. isn’t the replacement cost based on PSF BUILT UP? Not based on the area of the plot of land?

  3. I would use a comparison method for obtaining the Land cost. the rest of the formula is the same, so i’d end up with my own “appraised” value. That’s why i’d go for low density old condos, the land appreciates always as time goes by, and i’m paying less for the structure on the land.

    • @Trik – yes, that’s correct. There’s really more similarities between the two methods than there are differences, and that’s why you can use them to do sanity checks against one another.

  4. Hi Khai Yin, may i have the said “Excel Template” please. Thank you and best regards.

  5. khai yin, it would be glad if you can send me also the spreadsheet and the video…need it so much to understand it more.. many thanks!!

  6. hi Khai Yin,
    I would love to have the Excel Template too once you are done with the video guide.
    Thank you and have a great day!

  7. Frederick says:

    Just a small clarification on cost method. You use land size x Cost of construction i.e 4000 x $200 =$800,000. It should read as : built up areas desired or permitted x $200. This is applicable to mostly landed structures.

  8. Hi Khai Yin, may I have the Excel Template, once you are done with the video guide? Thank you very much, appreciate it. =)

  9. Mungsar says:

    Hi, Khai Yin,

    Please include me to your list too for the valuation spreadsheet. Thanks heaps!

  10. Hi Khai Yin,

    First of all, great job on the website..

    Would really appreciate it if you could send me a copy of the template as well..Thank you..!!

  11. Hi Khai Yin

    Please add me to the dist list of the spreadsheet as well ! Thanks ! 🙂

    • Hi Khai Yin

      Great insight — I learn more from your website than what so called Property Gurus taught
      Thanks for generously sharing your knowledge!
      Would love to have your EXCEL template, too

  12. Hi Khai Yin, I just come across this piece of valuable article.

    I appreciate if you could send me a copy of the excel template and video guide as well.

    Thank you!

  13. Nicholas Chee says:

    Hi Khai Yin

    I would appreciate it very much if you could send me the Excel template. Thanks for sharing.

  14. abdulazeem says:

    Hi Khai Yin, could you send me the excel template please. Thanks.

  15. Hi, Khai Yin, be most grateful if you can send me the valuation template and video. Thanks in advance.

  16. Dear Khai Yin, can you please share a copy of the Excel template please?.

  17. Hi Khai Yin,

    I would love to have the Excel Template

    Thank you

  18. Arif Sazali says:

    Hi Khai Yin,
    What a useful input .
    Appreciate if you could sent me as well the template for the costing. also is the video done ?
    would love to watch the video as well !

  19. Vinson Tan says:

    Hi Kahi Yin,
    Would appreciate if you can share the xls when it is ready. Thanks.

  20. LEONG KOK WEI says:

    Khai Yin,

    Can you send me a copy of the Excel calculation template for “Cost Method” as alternative valuation of Properties. Thank you – from Leong

  21. Hi Khai Yin,

    I learn a lot from GoodPlace.
    I would love to have your Excel Template.

    Thank you, bro.

  22. Lian Foo says:

    Hi Khai Yin

    Would be much obliged if you could provide the excel template when it is ready.
    Keep well.
    Thank you and regards
    Lian Foo

  23. I’d like your template too Khai Yin! So did i fairly valued my house for sale i wonder? Tq in advance, sir.

  24. i’d like to be on the list for the excel sheet too please! Thank you

  25. Me too, please include me in your list for the excel sheet too thanks 🙂

  26. hi Khai Yin
    good article for learning. can you share me the excel template and Our Free Property Valuation Guide as well. thank

  27. hi khai yin, i would appreciate if you can send me a copy of the cost method excel template.

  28. Hi Khai Yin,

    I would love to have the Excel Template

    Thank you

  29. koh soo keong says:

    Pls send me Excel template t to calculate property value using the Cost Method.

    Thanks

  30. Neena Priyanka says:

    Please share guideline/methodology to calculate replacement cost based on structural attributes of buildings such as built-up year, roof material, exterior wall, duct system etc.

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