Economic Theory Understanding the cost approach requires learning some new meanings for old words. Cost, price and value are good examples. Cost refers to construction and development costs, price refers to listing and selling prices, and value is always an estimate or opinion. The cost approach reflects market behavior because buyers and sellers relate value to cost. The economic principle of substitution holds that a well-informed buyer will not pay more for a property than the cost to buy a similar piece of land and construct a similar building.
Buyers often do some kind of cost analysis when making the decision to buy or build.
Developers usually do a cost analysis before they decide to begin a new project. The cost approach forces you to think about real estate as having two separate parts land and improvements. Land value is based on its highest and best use as if vacant. For example, an old house on a commercial lot reduces value because the buyer has to demolish the house to build a new office building. The cost approach pulls out the components of real estate value land , replacement costs , depreciation and entrepreneurial incentive and then adds them up.