Cost & Income Approaches
~12 min read · Run replacement-cost-minus-depreciation and GRM/cap-rate valuation.
Two more roads to value: the cost approach (land plus new construction minus depreciation) for unique or new properties, and the income approach (GRM and cap rate) for property that earns rent. The exam wants the formulas cold and the right approach matched to the right property.
The cost approach
Formula: land value (by sales comparison) + cost new of improvements − depreciation. Cost new splits into reproduction cost (exact replica) vs replacement cost (equivalent utility, modern materials — the usual choice). Depreciation has three species: physical deterioration (wear — curable or incurable), functional obsolescence (design defects: one bath in a five-bed house, obsolete layouts), and external (economic) obsolescence (value lost to outside forces — the rendering plant next door; ALWAYS incurable). Best use: new construction, insurance, and special-purpose properties (schools, churches) with no comps and no income.
- Value = land + cost new − depreciation
- Replacement (equivalent) vs reproduction (replica)
- Depreciation: physical, functional, external — external is never curable
- Strongest for new/unique/special-purpose properties
GRM: the shorthand income method
For rentals valued informally: Gross Rent Multiplier = sale price ÷ monthly rent, extracted from comparable rental sales; then value = market rent × GRM. (Annual-income versions use GIM.) GRM ignores expenses and vacancy — a blunt tool for houses and small residentials, not commercial analysis.
- GRM = price ÷ monthly rent (from comparables)
- Value = subject's market rent × GRM
- No expense analysis — the quick-and-dirty method
Direct capitalization
The commercial engine: Value = Net Operating Income ÷ Capitalization Rate (IRV: Income = Rate × Value). Build NOI top-down: potential gross income − vacancy & collection loss = effective gross income − operating expenses = NOI — where operating expenses EXCLUDE debt service, income taxes, and depreciation. The cap rate comes from comparable sales (NOI ÷ price). Rate and value move inversely: rising cap rates sink values. Higher risk demands higher rates.
Worked example
Value three properties: (a) a new church (no comps, no rent); (b) a rental house renting at $2,200/month where similar rentals sold at GRMs near 160; (c) a strip center with $310,000 potential gross income, 6% vacancy, $114,000 operating expenses, in a market where comparable centers trade at an 8% cap rate.
(a) The church: no market data, no income — cost approach by elimination: land value + replacement cost − depreciation (mostly physical; functional if the design is dated). (b) The rental house: 160 × $2,200 = $352,000 — GRM shorthand fits the property class. (c) The strip center: PGI $310,000 − vacancy $18,600 = EGI $291,400 − expenses $114,000 = NOI $177,400; value = 177,400 ÷ 0.08 = $2,217,500. Sensitivity check the exam loves: at a 9% cap rate the same NOI is worth $1,971,111 — one point of rate moved value nearly a quarter-million. Match the method to the property; then it's arithmetic.
Common exam pitfalls
Deducting mortgage payments as operating expenses.
NOI is debt-free: no debt service, no income taxes, no book depreciation in the expense column.
Curing external obsolescence.
Outside-the-property value loss is incurable by definition — you cannot renovate the neighbor's junkyard.
Mixing GRM bases.
GRM rides monthly rent; GIM rides annual income — keep the multiplier consistent with its extraction.
Land plus new minus worn-out; rent times the multiplier; income over the rate — IRV runs the show.
Recap
- Cost: land + replacement cost − (physical + functional + external) depreciation
- External obsolescence: always incurable
- GRM = price ÷ monthly rent; value = rent × GRM
- NOI = PGI − vacancy − operating expenses (no debt service)
- Value = NOI ÷ cap rate; rate up, value down
- Cost approach for new/special-purpose; income for earners
Prove it: 10 questions on this topic
Every lesson ends with a ten-question check in the free course — your progress syncs between the web and the EstatePass app.
Studying for the real estate licensing exam? Track every lesson free — progress syncs with the app.
Start freeMore in Valuation & Market Analysis
Study smarter in the free dashboard
- Every lesson tracked, synced with the iOS app
- Ten-question checks after each lesson
- Lesson videos, flashcards and mock exams
No credit card required.