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Illinois exam glossary

Cost approach to value

The cost approach is not a contractor's invoice with a land number attached. It is a market valuation argument. You estimate what an equally useful substitute would cost now, recognize everything time and the market have taken away, add the land separately, and then test whether the result makes sense beside real buyer behavior.

Last updated: August 1, 2026

What does this exam area cover?

Short answer: The cost approach estimates property value as land value plus the current replacement or reproduction cost of improvements, less all accrued depreciation. Site improvements may be valued and depreciated separately. The analyst must support land value, direct and indirect costs, entrepreneurial incentive, and physical, functional, and external depreciation. It is often most persuasive for new, proposed, unique, or special-purpose property and less reliable when depreciation or land value is difficult to measure.

Official section
National III: Valuation
Broker weight
8% of the national broker portion
Expected scored items
Valuation accounts for about 8 of 100 items

This guide uses the current Illinois appraiser statute and agency resources, USPAP access from The Appraisal Foundation, the PSI Illinois exam outline, and Fannie Mae Selling Guide section B4-1.3-10 published through June 3, 2026, all checked through August 1, 2026. Fannie Mae's manufactured-home requirement and rule against sole reliance are labeled as program policy. Whether an approach is necessary in another assignment depends on the intended use, property, market, applicable standards, law, scope of work, and what is required for credible results.

What is on the official outline?

Topic
Define the valuation assignment
What to know
Client, intended user, intended use, subject, property interest, value definition, effective date, relevant characteristics, assignment conditions, scope of work, standards, and report
Best exam move
A cost indication is meaningful only when its site, costs, depreciation, and conclusion share the same assignment premise and date.
Topic
Apply substitution
What to know
Equivalent utility, alternative site, current construction, acquisition, time delay, risk, profit, buyer knowledge, supply, demand, feasibility, and upper-limit tendency
Best exam move
A rational buyer compares the existing property with the cost and inconvenience of creating an equally useful substitute.
Topic
Test highest and best use
What to know
Legally permissible, physically possible, financially feasible, maximally productive, as vacant, as improved, existing use, conversion, demolition, excess land, surplus land, and interim use
Best exam move
Do not add the cost of an improvement whose use is not financially supported by the site and market.
Topic
Value land separately
What to know
As if vacant, comparable land sale, allocation, extraction, subdivision development, land residual, ground rent capitalization, zoning, utilities, access, topography, flood risk, and site rights
Best exam move
Land value reflects its highest and best use as though vacant, not the original purchase price or assessed value automatically.
Topic
Choose replacement or reproduction
What to know
Equivalent utility, modern substitute, exact duplicate, historic fabric, outdated layout, craftsmanship, materials, code, energy standard, accessibility, functional obsolescence, and assignment purpose
Best exam move
Replacement recreates utility; reproduction recreates the existing improvement as nearly as possible.
Topic
Estimate direct costs
What to know
Labor, materials, equipment, contractor, excavation, foundation, framing, roof, systems, finishes, permits tied to construction, site work, utility connection, and construction overhead
Best exam move
Direct costs are closely connected to physically constructing the improvements.
Topic
Estimate indirect costs
What to know
Architecture, engineering, survey, legal, appraisal, financing, interest, tax during construction, insurance, permit, marketing, leasing, developer administration, carrying cost, and contingency
Best exam move
A complete cost estimate reaches beyond bricks, labor, and a contractor's visible invoice.
Topic
Recognize entrepreneurial incentive
What to know
Developer expectation, coordination, time, capital, risk, market reward, incentive, realized profit, feasibility, total development cost, and completed-property value
Best exam move
Market participants generally need compensation for undertaking the development, not merely reimbursement of invoices.
Topic
Select a cost-estimating method
What to know
Comparative-unit, square-foot, cubic-foot, unit-in-place, segregated-cost, quantity-survey, contractor estimate, cost service, local multiplier, location factor, current index, and historical cost trending
Best exam move
Greater detail can improve precision only when quantities, prices, date, and local market inputs are reliable.
Topic
Estimate physical deterioration
What to know
Wear, age, decay, damage, deferred maintenance, short-lived item, long-lived item, curable repair, incurable condition, observed condition, effective age, remaining life, and maintenance history
Best exam move
Chronological age is time since construction; effective age reflects observed condition and utility.
Topic
Estimate functional obsolescence
What to know
Outdated design, poor layout, deficiency, superadequacy, excess operating cost, low ceiling, inadequate bath count, overbuilt finish, cure cost, value gain, feasibility, and market reaction
Best exam move
The problem originates inside the property and reduces utility or market appeal.
Topic
Estimate external obsolescence
What to know
Traffic, airport, industrial influence, adverse land use, environmental condition, economic decline, oversupply, regulation, job loss, rent pressure, location, market, temporary influence, and permanent influence
Best exam move
The cause lies outside the property and is usually beyond the owner's power to cure.
Topic
Separate curable and incurable
What to know
Cost to cure, value added, economic feasibility, maintenance item, component replacement, remaining economic life, short-lived, long-lived, ownership control, and market evidence
Best exam move
A condition is curable when the expected value benefit justifies the cure under the applicable analysis.
Topic
Measure accrued depreciation
What to know
Age-life method, breakdown method, market extraction, observed condition, effective age, total economic life, remaining economic life, cost to cure, capitalization of loss, and paired market evidence
Best exam move
Accrued depreciation is the loss from all causes, not the same as tax or accounting depreciation.
Topic
Use the age-life relationship
What to know
Effective age divided by total economic life, depreciation percentage, cost new, remaining economic life, straight-line assumption, composite rate, limitations, and separate curable items
Best exam move
If effective age is 15 and total economic life is 60, the simple age-life fraction is 25 percent.
Topic
Handle site improvements
What to know
Driveway, walk, fence, landscaping, septic system, well, retaining wall, lighting, paving, pool, utility line, separate cost, useful life, depreciation, and contributory value
Best exam move
Site improvements can wear out even though the underlying land is not depreciated in the same manner.
Topic
Complete and reconcile the formula
What to know
Land value, cost new, accrued depreciation, depreciated improvement value, depreciated site improvements, indicated property value, sales comparison check, income check, feasibility, and rounding
Best exam move
Subtract depreciation from cost new before adding land; never depreciate the land value as though it were a building.
Topic
Know where reliability changes
What to know
New construction, proposed construction, special purpose, historic property, unique design, thin sales, older building, uncertain land, volatile material cost, hidden condition, external influence, and unsupported profit
Best exam move
The approach is only as strong as its weakest material input, especially land and depreciation on older property.
Topic
Separate appraisal and program rules
What to know
Credible assignment results, applicable approach, USPAP, Illinois credential, Fannie Mae manufactured home, no sole reliance, lender review, FHA handbook, insurance purpose, tax purpose, and broker limitation
Best exam move
Ask what the assignment and governing source require instead of treating one lender's policy as universal law.

Which distinctions produce the most mistakes?

Terms
Cost vs. value
Difference
Cost is an expenditure to create or acquire. Value is an economic opinion under a defined premise, rights, and effective date.
Question cue
Money spent versus economic worth.
Terms
Replacement cost vs. reproduction cost
Difference
Replacement cost creates equivalent utility with modern materials and design. Reproduction cost creates a virtual duplicate of the existing improvement.
Question cue
Same utility versus same replica.
Terms
Direct cost vs. indirect cost
Difference
Direct cost is closely tied to physical construction. Indirect cost supports development through professional, financing, administrative, carrying, or marketing activity.
Question cue
Build the structure versus enable the project.
Terms
Entrepreneurial incentive vs. entrepreneurial profit
Difference
Incentive is the expected reward required to motivate development. Profit is the market-recognized difference between completed value and total development cost when realized or estimated.
Question cue
Expected motivation versus resulting reward.
Terms
Chronological age vs. effective age
Difference
Chronological age is elapsed time since construction. Effective age reflects condition, modernization, utility, maintenance, and market perception.
Question cue
Calendar age versus condition age.
Terms
Economic life vs. physical life
Difference
Economic life is the period improvements contribute value. Physical life is how long they can remain standing or usable with maintenance.
Question cue
Value-producing period versus survival period.
Terms
Remaining economic life vs. total economic life
Difference
Remaining economic life runs from the effective date to the end of value contribution. Total economic life spans the improvement's full value-producing period.
Question cue
Time left versus whole useful value period.
Terms
Physical vs. functional depreciation
Difference
Physical deterioration results from wear, age, damage, or maintenance. Functional obsolescence results from layout, design, feature, or utility problems within the property.
Question cue
Condition loss versus internal utility loss.
Terms
Functional vs. external obsolescence
Difference
Functional obsolescence originates inside the property. External obsolescence originates outside its boundaries or ownership control.
Question cue
Inside cause versus outside cause.
Terms
Curable vs. incurable depreciation
Difference
Curable depreciation can be corrected with an economically justified action. Incurable depreciation is not feasible to correct or is beyond the owner's control.
Question cue
Economically fixable versus not economically fixable.
Terms
Accrued depreciation vs. tax depreciation
Difference
Accrued depreciation is appraisal loss in value from all causes. Tax depreciation is a statutory income-tax cost-recovery calculation.
Question cue
Market value loss versus tax deduction system.
Terms
Land vs. site improvements
Difference
Land is the underlying real estate valued as though vacant under the premise. Site improvements are additions such as paving, fencing, wells, or landscaping that can have finite lives and depreciation.
Question cue
Underlying site versus constructed additions to it.

The B-U-I-L-D cost approach

  1. Basis and boundaries: define the assignment, rights, value, effective date, highest and best use, scope, building and site components, applicable standards, and whether replacement or reproduction is appropriate.
  2. Underlying land: value the site as though vacant and available for its highest and best use using relevant land evidence, then separate excess land, surplus land, and site-improvement contributions when necessary.
  3. Improvements at cost new: estimate current direct costs, indirect costs, and market-supported entrepreneurial incentive through an appropriate method, local data, date, quality level, and code or design assumptions.
  4. Loss from every cause: identify physical deterioration, functional obsolescence, and external obsolescence, distinguish curable from incurable, and quantify loss through age-life, breakdown, market extraction, cure cost, or capitalization evidence.
  5. Develop the indication: subtract total accrued depreciation from cost new, add depreciated site improvements and land value, avoid depreciating land, round consistently, and show each component clearly.
  6. Defend and reconcile: test the indication against market behavior, feasibility, sales and income evidence, explain reliability limits, and apply assignment-specific Illinois, USPAP, lender, or program requirements.
Step
1. Land
Calculation
Estimate site value as though vacant
Exam check
Do not depreciate land like a building
Step
2. Cost new
Calculation
Direct + indirect cost + entrepreneurial incentive
Exam check
Use replacement or reproduction consistently
Step
3. Depreciation
Calculation
Physical + functional + external loss
Exam check
Capture all causes without double counting
Step
4. Improvements
Calculation
Cost new - accrued depreciation
Exam check
This is depreciated improvement value
Step
5. Site additions
Calculation
Add depreciated site-improvement value
Exam check
Separate finite-life items if needed
Step
6. Indication
Calculation
Land + depreciated improvements + site additions
Exam check
Reconcile with market evidence

How do the rules work in scenarios?

Complete the basic cost approach

Scenario: Land value is $120,000. Replacement cost new of the building is $560,000. Accrued depreciation is $84,000. Depreciated site improvements contribute $18,000.

  1. $560,000 - $84,000 = $476,000 depreciated building value.
  2. $120,000 land + $476,000 building + $18,000 site improvements = $614,000.
  3. The land was added without building-style depreciation.

Answer: The cost approach indication is $614,000.

Use the age-life method

Scenario: A building has an effective age of 12 years, total economic life of 60 years, and replacement cost new of $500,000. Assume simple straight-line age-life depreciation for the question.

  1. $12 / 60 = 20 percent accrued depreciation.
  2. $500,000 x 20 percent = $100,000 depreciation.
  3. $500,000 - $100,000 = $400,000 depreciated improvement value.

Answer: The age-life depreciation is $100,000 and the depreciated improvement value is $400,000.

Replacement does not copy an obsolete layout

Scenario: A 1910 residence has two inefficient rear staircases, obsolete plumbing layout, and custom trim. A modern home with the same utility would use one staircase and modern systems.

  1. Reproduction cost attempts to duplicate the existing design and materials.
  2. Replacement cost creates equivalent utility using current design and standards.
  3. Using replacement cost can avoid pricing some obsolete features into cost new, but remaining functional issues still require analysis.

Answer: Replacement cost is the modern equivalent-utility concept; reproduction cost is the replica concept.

A new roof changes effective age

Scenario: Two 30-year-old houses are identical by calendar age. One has a new roof, modern systems, and excellent maintenance. The other has original systems and substantial deferred maintenance.

  1. Both have the same chronological age.
  2. Their observed condition and remaining utility differ.
  3. The renovated house can have a lower effective age and less physical deterioration.

Answer: Chronological age stays 30, but effective age can differ materially.

The highway influence is external

Scenario: A well-maintained home loses buyer appeal after a high-traffic freight route opens beside the subdivision. The owner cannot relocate the highway.

  1. The cause is outside the property boundaries.
  2. Maintenance or internal remodeling will not remove it.
  3. The loss is external obsolescence and is usually incurable by the owner.

Answer: Recognize supported external obsolescence rather than physical or functional loss.

A repair can be economically curable

Scenario: Replacing worn flooring costs $14,000 and verified market evidence indicates the completed repair would add about $22,000 to value.

  1. The defect is within the property and can be corrected.
  2. The expected value gain exceeds the cure cost under the simplified facts.
  3. The item can be classified as curable physical deterioration.

Answer: Treat the $14,000 flooring condition as curable physical deterioration under the stated evidence.

Cost approach reliability falls on an older property

Scenario: A 95-year-old converted school has additions from four decades, a unique layout, uncertain renovation history, and no reliable vacant-site sales.

  1. Reproduction or replacement assumptions are difficult to align with the actual utility.
  2. Physical, functional, and external depreciation can overlap and be hard to quantify.
  3. Uncertain land value adds another major weakness.

Answer: Develop the approach if necessary, but disclose limits and give weight according to the evidence rather than the formula's apparent precision.

What are the common exam traps?

Trap
Calling cost value
Correction
Cost is an input. Value depends on utility, demand, supply, risk, time, feasibility, and market recognition.
Trap
Depreciating land
Correction
Value the land separately as though vacant. Depreciate the improvements and finite-life site additions.
Trap
Confusing replacement and reproduction
Correction
Replacement provides equivalent utility with modern design; reproduction seeks a virtual duplicate.
Trap
Leaving out indirect costs
Correction
Include supported professional, financing, carrying, administrative, marketing, and related development costs when relevant.
Trap
Ignoring entrepreneurial incentive
Correction
Development normally requires a market reward for time, coordination, risk, and capital.
Trap
Using original cost
Correction
The approach generally needs current cost at the effective date, not an old invoice without reliable trending and analysis.
Trap
Using chronological age as effective age
Correction
Condition, maintenance, renovation, utility, and market perception can make effective age higher or lower than calendar age.
Trap
Counting only physical wear
Correction
Accrued depreciation includes physical deterioration, functional obsolescence, and external obsolescence.
Trap
Calling every repair curable
Correction
Curability is an economic conclusion that compares cure cost, value benefit, feasibility, and ownership control.
Trap
Double counting loss
Correction
Do not deduct the same obsolete feature in replacement-cost assumptions and again as full functional obsolescence without analysis.
Trap
Ignoring excess or surplus land
Correction
Analyze whether extra land can be separately sold or only adds utility to the existing property.
Trap
Treating assessed value as land value
Correction
An assessment can be data but does not replace an effective-date market analysis of the subject site.
Trap
Assuming detailed math proves accuracy
Correction
Quantity detail cannot cure poor land evidence, wrong quality, stale cost data, or unsupported depreciation.
Trap
Calling Fannie policy universal law
Correction
Fannie Mae's manufactured-home and sole-reliance rules govern its program; other assignments require their own source analysis.
Trap
Using cost approach alone without reconciliation
Correction
Test the indication against market behavior and weigh all applicable approaches under the assignment.

Can you answer these original practice questions?

These questions are original study items aligned to the published outline. They are not copied, recalled, or predicted PSI questions.

1. Which formula best describes the cost approach?

  1. Land value + cost new - accrued depreciation
  2. Gross income x rent multiplier
  3. Sale price - mortgage balance
  4. Net income / debt service
Show answer and explanation

Answer: Land value + cost new - accrued depreciation

Depreciated site improvements may also be added when they are handled separately.

2. What does replacement cost estimate?

  1. Current cost of an improvement with equivalent utility
  2. Original construction cost
  3. An exact historic duplicate in every case
  4. The assessed value of land
Show answer and explanation

Answer: Current cost of an improvement with equivalent utility

Replacement uses modern materials, design, standards, and workmanship to provide equivalent usefulness.

3. Which depreciation originates outside the property?

  1. External obsolescence
  2. Physical deterioration
  3. Functional obsolescence
  4. Tax depreciation
Show answer and explanation

Answer: External obsolescence

Adverse location or broader market influences originate beyond the property's control.

4. A building is 20 years old but renovated to compete like a 10-year-old building. What is 10 years?

  1. Effective age
  2. Chronological age
  3. Physical life
  4. Original term
Show answer and explanation

Answer: Effective age

Effective age reflects condition and utility, while chronological age remains 20 years.

5. Effective age is 15 years and total economic life is 75 years. What is the simple age-life percentage?

  1. 20 percent
  2. 15 percent
  3. 50 percent
  4. 80 percent
Show answer and explanation

Answer: 20 percent

Divide 15 by 75 to obtain 0.20, or 20 percent.

6. Which item is usually an indirect cost?

  1. Architectural fee
  2. Framing lumber
  3. Concrete foundation
  4. Roof shingles
Show answer and explanation

Answer: Architectural fee

Professional design supports the project but is not a physical building component.

7. What is accrued depreciation in appraisal?

  1. Loss in value from all causes
  2. Land value only
  3. Mortgage amortization
  4. A tax deduction only
Show answer and explanation

Answer: Loss in value from all causes

It combines physical deterioration, functional obsolescence, and external obsolescence.

8. When is the cost approach often strongest?

  1. New or nearly new construction
  2. An old building with unknown condition and land value
  3. A business with no real estate
  4. A stock portfolio
Show answer and explanation

Answer: New or nearly new construction

Current cost is easier to estimate and accrued depreciation is usually smaller and more observable.

9. Which statement about land is correct in the cost approach?

  1. It is valued separately as though vacant under the applicable premise
  2. It receives the building's age-life depreciation
  3. Its original price always controls
  4. It is omitted whenever improvements exist
Show answer and explanation

Answer: It is valued separately as though vacant under the applicable premise

The analyst then adds the depreciated contribution of improvements and relevant site additions.

10. What does current Fannie Mae policy say about the cost approach?

  1. It is generally not required except for manufactured homes, and sole reliance is not acceptable
  2. It is prohibited for new construction
  3. It must be the sole approach for every house
  4. It never requires depreciation analysis
Show answer and explanation

Answer: It is generally not required except for manufactured homes, and sole reliance is not acceptable

The appraiser may still need the approach for credible results, and the policy is specific to Fannie Mae assignments.

How should you study this area?

Session
Session 1
Focus
Own the formula
Proof you are ready
Solve 25 land-plus-cost-minus-depreciation problems, including five with separately depreciated site improvements and five with missing variables.
Session
Session 2
Focus
Separate cost concepts
Proof you are ready
Classify 40 items as replacement, reproduction, direct cost, indirect cost, entrepreneurial incentive, land, or site improvement.
Session
Session 3
Focus
Diagnose depreciation
Proof you are ready
Classify 50 conditions as physical, functional, or external, then decide whether each is potentially curable and state why.
Session
Session 4
Focus
Master age and life
Proof you are ready
Complete 20 effective-age, total-economic-life, remaining-life, depreciation-rate, cost-new, and depreciated-value calculations.
Session
Session 5
Focus
Test reliability
Proof you are ready
Rank the cost approach's usefulness in 18 new, old, historic, unique, manufactured, proposed, renovated, and land-constrained scenarios.
Session
Session 6
Focus
Run B-U-I-L-D
Proof you are ready
Complete two full cost analyses, reconcile each with sales evidence, then score at least 90 percent and explain every missed question.

Do not count recognition as mastery. Close the notes and explain the rule, apply it to a new fact pattern, and identify why each distractor fails.

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Questions students ask about Cost Approach to Value: Illinois Exam Guide

What is the cost approach in real estate appraisal?

The cost approach develops a value indication by adding land value to the current cost of the improvements, then subtracting accrued depreciation. The logic is that a buyer generally will not pay substantially more for an existing property than the cost to obtain a similar site and build an equally useful substitute, allowing for time, risk, and depreciation.

What is the cost approach formula?

A practical exam formula is: property value equals land value plus replacement or reproduction cost new of improvements minus accrued depreciation. If site improvements are calculated separately, add their depreciated value too. Keep the components on the same effective date and under the same value premise.

What is replacement cost?

Replacement cost is the current cost to construct a building with equivalent utility using modern design, materials, standards, and workmanship. It does not require an exact replica. Because it can omit outdated features, replacement cost is often easier to estimate and may reduce the functional-obsolescence problem found in reproduction cost.

What is reproduction cost?

Reproduction cost is the current cost to create a virtual duplicate of the existing improvement using the same or highly similar design, materials, construction standards, layout, quality, and workmanship. It can be useful for historic or special-purpose properties but may reproduce obsolete features that buyers would not choose today.

Why is land valued separately in the cost approach?

Land is not treated as a depreciating improvement. The appraiser estimates the site as though vacant and available for its highest and best use, subject to the assignment's property rights and effective date. The site value is then combined with the depreciated contribution of improvements.

What are the three categories of accrued depreciation?

Physical deterioration, functional obsolescence, and external obsolescence. Physical deterioration comes from wear, age, damage, or deferred maintenance. Functional obsolescence comes from design or utility problems within the property. External obsolescence comes from influences outside the property, such as an adverse land use or broader market condition.

When is the cost approach most useful?

It is often strongest for new or nearly new construction, proposed construction, unique or special-purpose property, property with limited comparable sales, and assignments involving insurable or replacement cost. Reliability weakens when land value, current cost, entrepreneurial incentive, or depreciation cannot be supported credibly.

Is cost the same as value?

No. Cost is the amount required to create or acquire something. Value is an economic opinion under a defined premise and date. A feature can cost more than buyers are willing to pay, while scarcity, time, utility, or market conditions can also make value differ from current construction cost.

What is entrepreneurial incentive in the cost approach?

Entrepreneurial incentive is the amount an investor expects as compensation for coordinating the development, taking risk, and committing time and capital. Entrepreneurial profit is the market-recognized difference between total development cost and the completed property's value. The terms are related but not automatically identical.

Does Fannie Mae always require the cost approach?

No. Current Fannie Mae guidance does not generally require it except in the valuation of manufactured homes. It may be necessary for credible results in other assignments, including proposed or new construction. Fannie Mae does not accept an appraisal that relies solely on the cost approach as its market-value indicator. These are Fannie Mae program rules, not universal Illinois statutes.

Are these official PSI questions or a cost estimate?

No. The practice questions are original, and the primary sources were checked through August 1, 2026. This page teaches exam concepts and does not provide an appraisal, contractor bid, insurance replacement estimate, tax opinion, or investment recommendation. A live assignment requires current local land, cost, depreciation, market, property, legal, and standards analysis.

Primary sources

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