Real Estate Depreciation

Real Estate Depreciation

Depreciation of real estate is a loss in value to a property due to any cause. Accrued depreciation is depreciation that has already occurred. This loss in value is equal to the difference between the replacement cost new of the improvements and their market value. Depreciation may be due to the physical wearing out of a building, functional problems of the building, or locational problems that affect the property. After estimating the accrued depreciation you can then deduct it from the replacement (or reproduction) cost of the building(s) on a property. The resulting figure is the depreciated cost of the improvements.

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Types of Depreciation

Adverse physical, functional, and locational influences cause property improvements to depreciate. There are three types of depreciation: physical deterioration, functional obsolescence, and external obsolescence. Physical deterioration of a building and its equipment includes physical wear and tear, disintegration, decay or rot, or physical damage of any kind caused by the elements. Functional obsolescencerefers to deficiencies, superadequacies, or simply undesirable features found in a building. External obsolescence is attributable to external adverse conditions that affect a property.

A property may suffer from any combination of the three types of depreciation, or it may not suffer from any depreciation at all. However, unless brand new, a building will probably have incurred some degree of depreciation. Like a brand new car driven off the showroom floor, a structure begins to lose value the moment it is built.

Physical deterioration and functional obsolescence are further divided into two-sub categories: curable and incurable depreciation.

Curable depreciation refers to a loss in value that is economically feasible to correct. In other words, the cost to fix the problem is less than the loss in value, so fixing the problem makes economic sense.

Incurable depreciation refers to items of depreciation that either are physically impossible to cure or are too expensive to be worth curing. If the cost to fix the problem exceeds the loss in value caused by the problem, then it does not make economic sense to repair it.

Physical Deterioration

Physical deterioration is the loss in value from all causes of age and action of the elements. It is caused by a number of sources ? wear and tear, disintegration, decay or rot, or physical damage by the elements.

The wear and tear from these various elements on a building accounts for the physical deterioration affecting that building. For example, walking on carpeting eventually wears it out. Heating and cooling systems eventually wear out too. Sometimes naturally occurring elements, such as ultraviolet sunlight, wind, and water wear on a property. Storms, extreme temperatures, earthquakes, termites, carpenter ants, and floods all work in varying degrees to affect properties physically. Fire, explosion, vandalism, and neglect also have a detrimental physical effect upon properties.

Property components that exhibit curable physical deterioration can be repaired or replaced economically. This includes deferred maintenance and easily repairable items. Deferred maintenance refers to items that are in need of repair due to lack of upkeep. Items such as roof repair or replacement, painting, building maintenance, floor covering replacement, and forced air heater replacement are items that are typical examples of curable physical deterioration.

Physical items that are incurable cannot be replaced or repaired economically. Incurable physical deterioration typically occurs with structural components that are expected to last for the life of the entire building. Structural components such as foundations, framework, walls, masonry, and ductwork usually are considered incurable. When incurable physical deterioration is evident, it may make more sense from an economic standpoint to tear down the building rather than to try to repair it.

Appraisers classify physical deterioration of components based on economic considerations. Since structural components rarely depreciate at similar rates, appraisers classify them on the length of time they are expected to last ? either as short-lived or long-lived. Short-lived items are components that are expected to be replaced during the improvement?s economic life. Long-lived items are components of the improvement that are expected to last as long as the building itself. Paint, floor coverings, and fixtures are examples of short-lived items, whereas the building foundation is an example of a long-lived component.

Functional Obsolescence

Functional obsolescence is depreciation that is attributable to an item or feature within the subject property that is no longer useful or functional. This impaired feature results in loss of value (depreciation) for the entire property. Functional obsolescence is caused in part by changing market requirements and can appear in several different forms, including outdated architectural design, layout problems, lack of modern facilities, and superadequacy.

Outdated Architectural Design. Historically, some interesting construction style changes have taken place. A house built 50 years ago may have been appealing to people at that time, but today, the style may be considered outdated and tiresome. Ornate molding and sculpting, once considered desirable, may be outdated today.

Layout Problems. Appraisers must recognize that the tastes and preferences of society change over time. At one time, the living areas were completely separate from the kitchen and the concept of the Great Room or the open flow was an unusual concept. Not too long ago, a one-car garage was perfectly adequate because families typically owned one car. Today, older homes with one-car garages can still be found, but often sell for less than similar homes with two-car garages.

Lack of Modern Facilities. Outmoded features and equipment also are examples of functional obsolescence. Today, computers dominate every aspect of our lives, and the Internet is here to stay. Any house built without computer and Internet capabilities would be considered functionally obsolete.

Lack of modern facilities most often is curable, but the cost to cure must be measured against the benefit to property value. When adding modern facilities that are valued in the marketplace, usually the enhancement to value offsets the cost of installation.

Today?s marketplace demands certain modern kitchens and bathrooms to maximize value. For example, older homes often do not have a dishwasher. A house without a dishwasher will sell, but will sell for less. If installation costs are less than what the dishwasher will contribute, then the obsolescence is curable. If more, it is incurable.

Air conditioning, as a modern convenience, must be measured within the context of its marketplace. In the desert, a house lacking air conditioning is definitely at a disadvantage. However, at the beach, air conditioning is not as essential.

Superadequacy. A superadequacy (or over-improvement) is a feature that is too large or of a higher quality than needed for a property. The cost to add the feature is more than the value contributed by the feature. Examples of superadequacies include a 10,000 square foot home in the middle of a tract of homes ranging in size from 1,200 to 1,800 square feet, an excessive number of bedrooms, or 1-foot thick, wood-framed exterior walls.

External Obsolescence

External obsolescence takes place when influences that are external to a property adversely affect that property. These external influences can be locational or economic.

Locational obsolescence is caused by the physical location of the subject property and its proximity to a negative influence. Heavy traffic noise, such as that generated by freeways and airports, may cause locational obsolescence. Recurring smoke, dust, and noxious odors from sources external to a property, like a dairy farm or sewage plant, also tend to have an adverse influence on the value of a property.

Economic obsolescence occurs when changes in the local economy affect the subject property?s value. Some cities rely on one major industry or employer. If the industry shuts down or the employer ever moves, a devastating impact on real estate values could result.

Unfavorable zoning ordinances, environmental restrictions, or other legislative decisions that restrict use can also cause external obsolescence. Since these factors originate externally to the property itself, they are considered external obsolescence.

External obsolescence is incurable in virtually all cases since the adverse condition(s) affecting the property are exterior to the subject and few owners are willing or able to spend money to change adverse conditions that are not located on their own property. Changes such as relocating a freeway or a nearby airport simply make no economic sense and are well beyond the financial means of most property owners.

Methods of Calculating Accrued Depreciation

Methods of calculating accrued depreciation include the cost to cure method, economic age/life method, modified age/life method, breakdown method (or observed condition method), market extraction using sales comparison techniques, and income capitalization method.

Remember that accrued depreciation is calculated for improvements only, because land does not depreciate. Land is factored into the cost approach at its market value. Since the value of the land is already at market value, making additional deductions to the land value would cause it to be doubly penalized for any condition adversely affecting value.

Cost to Cure Method

The cost to cure method is the most basic and straightforward method to calculate accrued depreciation. It is based on observed deferred maintenance and the application of current building costs at the time of the appraisal. Its basic premise states that the cost required to replace an item is the amount lost due to accrued depreciation.

It is relatively easy to estimate physical deterioration using this method. If certain items such as the floor coverings wear out, estimating the cost to repair or replace these items often gives a credible estimate of the physical deterioration. If a stairway needs to be replaced, the amount of accrued depreciation is the cost to accomplish that. If a roof needs to be replaced, the amount of accrued depreciation is the cost to do it, including labor and materials.

This method is used to calculate curable functional obsolescence. Generally, if the functional problem involves a new or newer property, the cost to cure the functional problem is used as the estimate. In an older property, the cost to cure minus the remaining value of the item being replaced is a way to determine the loss.

Limitations of this Method

This simplistic method only allows for a 100% depreciation of any item. The cost to cure method is not very useful when dealing with items that have partial depreciation, like a roof that is not brand new but still has years left before it needs replacement.

Economic Age/Life Method

The economic age/life method of calculating accrued depreciation compares a structure?s effective age to its economic life. Also known as the straight-line method or age/life method, this method is used most frequently by residential appraisers. With this method, an equal amount of accrued depreciation is attributed to each year of the economic life of the structure. An effective age is estimated and assigned to the structure, and the remaining economic life is determined.

In the age/life method, the ratio of the improvements? effective age to its total economic life is multiplied by the current reproduction or replacement cost of those improvements. The resulting number is the accrued depreciation of the subject property.

The equation to calculate accrued depreciation using this method is Accrued Deprecation = Effective Age divided by Economic Life times Replacement/Reproduction Cost.

With an effective age of 15 years, and an economic life of 70 years, despite the chronological age of 50 years, the structure can be said to have a remaining economic life of 55 years. This structure still has a long, useful life remaining.

Limitations of this Method

Although the economic age/life method is relatively simple to calculate, it tends to obscure the overall accrued depreciation estimate since it lumps all items of accrued depreciation together. A significant weakness in this method is that curable items of accrued depreciation are not treated separately from incurable items of accrued depreciation. It also does not recognize that certain items in a building have a shorter remaining economic life than the total economic life of the structure. This method accounts for physical, functional, and locational obsolescence, but it does not differentiate among the different kinds of accrued depreciation.

Modified Age/Life Method

In the modified age/life method, curable physical and functional items of accrued depreciation are identified. The cost to cure all these items is deducted from the reproduction or replacement cost of the improvements. The ratio derived from the age/life method is then multiplied by the remaining cost to arrive at an estimate of accrued depreciation from all other causes.

Limitations of this Method

Although curable items are recognized by this method, it still does not account for differences in the remaining economic life of the other building components. This method is a little more accurate, but it is based upon the same assumption as the economic age/life method. Both methods assume that a single age/life ratio can be applied to every component of the improvements.

Breakdown Method

In the breakdown or observed condition method, an appraiser analyzes each type of accrued depreciation separately, measures the amount of each, and totals the individual estimates to determine the total accrued depreciation. Then, the total accrued depreciation is deducted from the reproduction or replacement cost.

If the accrued depreciation is deducted from the replacement cost, some kinds of functional obsolescence, such as that attributable to outdated equipment or materials, are not to be deducted since, upon replacement, current equipment and materials would be used.

As the name implies, an appraiser observes the condition of various component parts of the structure and observes the percent of deterioration (or loss in value as-is) in comparison to a new properly planned structure not suffering from any loss in value.

Physical deterioration and functional obsolescence can be measured in this way, although success with this method requires experience and an up-to-date knowledge of current building costs.

Market Extraction using Sales Comparison Techniques

Appraisers use market extraction using sales comparison techniques, such as the sale-resale analysis, paired-sales analysis, and the extraction method to estimate accrued depreciation. They must be sure that the sales prices of all the sales are truly indicative of the market. Seller incentives such as loan discount points, prepaid homeowner?s association fees, rebates, seller-paid closing costs, personal property included in the sale, etc., usually have an effect upon sales prices and can affect the results.

Sale-Resale Analysis

In a sale-resale analysis, a property that sells and resells in a relatively short period of time is analyzed. By finding properties in a stable market that had two open market, arm?s-length sales in a relatively short period of time, any difference in price could be attributable to changes to that property.

Paired Sales Analysis

In a paired sales analysis, two similar properties that sell during the same time period in the same market are analyzed. If the sales are open market, arm?s-length transactions, any difference in price could be attributable to physical differences between the two properties. If that physical difference can be identified, the market reaction to that difference may be identified.

Extraction

Similar to the method of the same name used for calculating land value, extraction enables appraisers to determine the depreciated value of the improvements of the subject property by estimating the cost new of recently sold comparables, minus the sales price of those comparables, and minus the value of the land in the transaction.

Extraction is an accurate way of reading the marketplace, because arm?s-length transactions reveal the amount of accrued depreciation recognized by purchasers. The more samples that can be extracted from the marketplace, the more reliable the assembled data. Among the comparable sales that are analyzed, correlations should be made to arrive at appropriate percentages. With similar comparable sales, the percentage of accrued depreciation can be directly applied to the subject property.

Because an appraiser is simply reading the marketplace with this method, all sources of accrued depreciation are included ? physical deterioration, functional obsolescence, and economic obsolescence. If it were necessary to separate out one source of accrued depreciation, a further application of the abstraction method could be used. An appraiser could estimate accrued depreciation attributed to two of the sources by other appropriate methods, and then subtract the amount of accrued depreciation attributed to those sources from the total amount of accrued depreciation. The difference will be the accrued depreciation belonging to one isolated source.

Income Capitalization Method

Depreciation is calculated differently for income-producing properties. Instead of totaling dollar amounts of depreciation and then subtracting that amount from the estimated cost new, appraisers formulate an estimate based upon a loss of income attributable to the item(s) causing the depreciation. In order for this technique to work, the subject needs to be an income-producing property.

The income capitalization method is like the market extraction method because it is necessary to find similar income-producing properties both with and without the same influencing defects. Once these properties are isolated, the influence of the defects can be analyzed to determine how it causes the accrued depreciation. This method takes it a step further, though, by applying a market-derived capitalization rate to that income to estimate the overall loss in value.

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