FHA Home Loan Appraisals - Cost Approach

In the cost approach, the FHA appraiser estimates the current market value of the home by estimating the cost of reconstructing the home (to include any improvements) plus the value of the land minus the estimated depreciation of the home since the home was first built.  

Depreciation is the loss in value from any cause such as physical deterioration, functional obsolescence and external obsolescence.  Deterioration is the loss in value resulting from average wear and tear over time (such as exposure to the sun, peeling paint, .  Functional obsolescence is the loss in value caused by deficiencies within the property such as poor room layout or design and inadequate mechanical equipment (such as a home with only an evaporative cooler instead of an air-conditioner).  External obsolescence is a loss in value caused by negative conditions outside of the property such as a change in zoning or excessive noise and traffic.

The concept behind this approach is that a knowledgeable buyer will not pay more for a house than the cost of reconstructing a substitute house on a similar lot in a similar condition.  It is calculated as follows:

Cost of reconstruction - Depreciation + Value for land = Property Value

 Example:

The subject house is similar in size, design and quality of construction to a new house that cost $150,000 to build.  The subject house has depreciated by ten percent due to normal wear and tear and is on a lot valued at $40,000.  Using the cost approach, the estimated value of the home is:

$150,000 - (10% x $150,000) + $40,000 = Property Value

$150,000 - $15,000 + $40,000 = $175,000