The Cost Approach to Valuation: When Lenders Use Build Cost Methods

The cost approach, also known as the contractor's method or depreciated replacement cost method, values a property based on the cost of replacing it with an equivalent modern building. The calculation starts with the cost of constructing a new building that provides the same utility as the subject property, then deducts an allowance for physical deterioration, functional obsolescence, and economic obsolescence to arrive at a depreciated replacement cost. The land value is added separately, assessed using comparable evidence or the residual method. The sum of the depreciated building cost and the land value gives the total property value under the cost approach.

This method is one of the five recognised valuation approaches under the RICS Red Book and is used when the other methods, particularly the comparable and investment methods, are not applicable. It is most commonly applied to specialist properties that rarely trade in the open market and do not generate a measurable income stream, making both comparable sales analysis and investment capitalisation impractical. Examples include schools, hospitals, places of worship, public buildings, and purpose-built specialist facilities such as laboratories or data centres.

In the context of development finance, the cost approach has specific applications that developers should understand. While it is not the primary method for valuing standard residential or commercial development, it is used by lenders in certain situations, particularly for partially completed developments, specialist properties, and as a cross-check against the comparable or investment methods. Understanding when the cost approach applies and how it works helps developers anticipate the valuation outcome and prepare accordingly.

The most common application of the cost approach in development finance is for the valuation of partially completed schemes. When a development is mid-construction and a valuation is required, whether for a refinance, a lender switch, or a default scenario, the property cannot be valued on a completed comparable basis because it is not finished, and it cannot be valued on a pure land basis because significant construction has taken place. The cost approach provides a framework for valuing the site plus the works completed to date, known as the cost of works in place.

For example, consider a development with a site value of £600,000 and a total build cost of £1,200,000 where construction is 50% complete. The cost approach would value the property at the land value of £600,000 plus 50% of the build cost of £600,000, giving a total of £1,200,000. However, a prudent valuer would apply a discount to the cost of works in place to reflect the fact that a buyer of a partially completed development would require a discount for the risk and disruption of taking over a mid-build project. This discount might be 15-25%, reducing the value of the works in place from £600,000 to £450,000 to £510,000, and the total property value to £1,050,000 to £1,110,000.

The cost approach is also relevant for properties that are being converted from specialist use to residential or commercial use under refurbishment finance. A former church, school, or industrial building may have limited comparable sales evidence in its current form, and the cost approach provides an alternative valuation framework based on the replacement cost of the existing structure plus the value of the land. For these specialist conversions, the cost approach is typically used as a secondary check alongside the residual method, ensuring that the development scheme makes economic sense relative to the replacement value of the existing building.

The depreciated replacement cost calculation involves three steps: estimating the gross replacement cost, applying depreciation adjustments, and adding the land value. The gross replacement cost is the estimated cost of constructing a modern building that provides the same functional utility as the subject property. This is not necessarily an identical replica. The replacement building should offer equivalent accommodation and functionality using modern construction methods and materials that comply with current building regulations. The gross replacement cost is typically estimated using construction cost data from the BCIS or from quantity surveyor estimates.

Depreciation is then applied in three categories. Physical depreciation reflects the wear and tear, deterioration, and ageing of the building since its construction, and is typically calculated as a percentage based on the building's age relative to its expected useful life. A building that is 20 years old with an expected life of 60 years might attract physical depreciation of 33%. Functional obsolescence reflects features of the original design that reduce the building's utility compared to a modern equivalent, such as low ceiling heights, inefficient layout, poor insulation, or outdated mechanical systems. Economic obsolescence reflects external factors that reduce the building's value, such as changes in the local market, transport infrastructure, or planning policy.

For a practical example, consider a 1960s office building with a gross replacement cost of £2,800,000. Physical depreciation of 40% reduces the value by £1,120,000 to £1,680,000. Functional obsolescence of 15% for inefficient floor plate layout reduces it further by £252,000 to £1,428,000. Economic obsolescence of 10% for declining office demand in the area reduces it by £142,800 to £1,285,200. Adding the land value of £750,000 gives a total depreciated replacement cost of £2,035,200. This figure provides a useful cross-check against the investment valuation, which might produce a different figure depending on the current rental income and yield assumptions.

For new-build developments, the cost approach is rarely the primary valuation method because the comparable and residual methods are more appropriate and more reliable. However, it serves a useful secondary function as a sanity check on the viability of the development. If the total cost of developing a scheme exceeds the market value of the completed buildings assessed on a comparable basis, the development is economically irrational because you are spending more to create the asset than the asset is worth. This situation typically indicates either overpayment for the land, excessive build costs, or unrealistic GDV assumptions.

The cost approach cross-check is particularly valuable for schemes in areas where comparable evidence is limited. If the GDV has been assessed at £3,000,000 based on limited comparable evidence, and the total development cost including land is £2,700,000, the implied profit margin of £300,000 or 10% is thin but plausible. However, if the total development cost is £3,200,000 against a GDV of £3,000,000, the cost approach tells you that the scheme is unviable regardless of what limited comparable evidence might suggest. This negative residual is a clear signal that the assumptions need to be revisited.

For developments where the end product is a specialist property type such as student accommodation, care homes, or purpose-built rental, the cost approach may play a more significant role in the GDV assessment because comparable sales evidence for these property types can be limited. The valuer may use the cost approach to establish a floor value representing the minimum the property would be worth based on its physical replacement cost, while using the investment method to establish a ceiling value based on the income stream. The final valuation will sit between these two figures, weighted towards the method that the valuer considers most reliable for the specific property type and location.

When the cost approach is used as the primary or secondary valuation method, it can produce results that differ significantly from what the developer expects based on their own comparable analysis. The most common scenario is a partially completed development where the cost approach produces a lower value than the developer anticipated based on pro-rating the GDV. A scheme that is 60% complete with a GDV of £4,000,000 might be expected by the developer to be worth approximately £2,400,000, being 60% of the end value. However, the cost approach values it at the site value plus the depreciated cost of works in place, which might total only £1,800,000 after discounting for the risks of incomplete construction.

This valuation gap has practical consequences if the developer is seeking to refinance mid-build. A lender will only advance a percentage of the assessed value, and if the assessed value is £1,800,000 rather than £2,400,000, the available facility is correspondingly reduced. This is why refinancing partially completed developments is challenging and why development finance facilities are structured to run through to practical completion rather than requiring a mid-build refinance. If you do need to refinance mid-build, perhaps because your existing lender has defaulted on their commitment or because the project has changed materially, understanding that the cost approach will likely produce a conservative value helps you plan the equity requirements realistically.

The cost approach can also benefit developers in certain situations. If you have acquired a site with an existing building at a price that reflects the land value only, and you then invest in substantial refurbishment, the cost of works may add more value than the market might otherwise recognise through comparable evidence. The cost approach provides a framework for the valuer to credit the investment in construction even when comparable sales of refurbished properties are limited. For developers undertaking conversion projects in emerging areas where the market has not yet caught up with the quality of the product, this can result in a higher valuation than a purely comparable-based approach. To explore the best finance options for your project, submit your scheme through our deal room.

The quality of a cost approach valuation depends on the accuracy of the construction cost data used. The Building Cost Information Service, or BCIS, operated by RICS is the primary source of construction cost data in the UK. BCIS publishes detailed cost analyses based on actual tenders and completed projects, providing average costs per square metre by building type, location, and specification level. The data is updated quarterly and adjusted for regional cost variations using location factors. For a residential development in Central London, the BCIS location factor adds approximately 20% to the national average, while in areas such as Devon or Staffordshire the factor may reduce costs by 10-15%.

Quantity surveyor estimates provide scheme-specific cost data that is more accurate than BCIS averages for individual projects. A quantity surveyor will prepare a cost plan based on the specific design, specification, and site conditions of your development, producing a figure that reflects the actual expected construction cost rather than a statistical average. For development finance applications, lender's typically prefer scheme-specific cost data from a reputable quantity surveyor over generic BCIS benchmarks, as it provides a more reliable basis for assessing the adequacy of the build budget and the viability of the scheme.

When the cost approach is used for valuation purposes, the valuer will typically reference both BCIS data and any scheme-specific cost information provided by the developer. If the developer's actual build costs are significantly below the BCIS benchmark, the valuer may question whether the budget is adequate or whether the specification has been understated. Conversely, if actual costs are significantly above the benchmark, the valuer will investigate whether the premium is justified by site-specific factors such as restricted access, poor ground conditions, or a particularly high specification. Providing the valuer with a detailed breakdown of costs, supported by contractor tenders and a quantity surveyor cost plan, helps them apply the cost approach accurately and reduces the risk of an unexpected valuation outcome. For advice on how construction costs feed into the overall residual land valuation, see our detailed guide.

While developers typically focus on the comparable and residual valuation methods when planning a scheme, there are situations where considering the cost approach from the outset can add value. If you are developing a specialist property type for which comparable evidence will be limited, understanding the cost approach baseline helps you set realistic value expectations and structure the finance accordingly. A care home development, for example, might have limited comparable sales evidence, and the cost approach provides a floor value that helps you assess whether the scheme is viable before committing to the site.

For conversion projects involving listed or heritage buildings, the cost approach can flag potential issues with reinstatement costs and insurance requirements early in the planning process. If the cost of rebuilding a listed structure using traditional methods is significantly higher than the market value of the completed conversion, this affects both the insurance requirements and the lender's security assessment. Identifying this gap early allows you to plan for adequate insurance cover and ensures the finance application reflects the true cost profile of the project.

The cost approach also provides a useful framework for assessing whether value engineering has been effective. If your quantity surveyor has reduced the build cost from £2,200,000 to £1,900,000 through design optimisation, the cost approach confirms that this saving flows through to an improved residual land value and a stronger development appraisal. Conversely, if specification upgrades increase the build cost by £300,000, the cost approach helps you assess whether the additional construction expenditure is justified by a proportionate increase in the completed value. This cost-benefit analysis should be a continuous part of the design development process, informing decisions about where to spend money for maximum impact on value. Contact our team through the deal room for expert guidance on optimising your development scheme.