When is it appropriate for an appraiser to calculate an annual depreciation rate using the market extraction method?

Chapter Title:

Market Extraction & Age-Life: Depreciation Calculation

Introduction:

Chapter Introduction: Market Extraction & Age-Life: Depreciation Calculation

The accurate assessment of depreciation is critical in real estate appraisal, influencing value estimations derived through the cost approach. This chapter focuses on two fundamental methodologies for quantifying depreciation: the market extraction method and the age-life method. These methods represent distinct yet complementary approaches to estimating the diminution in value of a property's improvements due to physical deterioration, functional obsolescence, and external obsolescence.

The market extraction method, grounded in comparative market analysis, infers depreciation by analyzing sales data of comparable properties. This method leverages the principle of substitution, extracting depreciation estimates directly from observed market transactions. Scientifically, it relies on rigorous statistical analysis to isolate the impact of depreciation from other value-influencing factors. The validity of this method hinges on the availability of robust and reliable sales data, the accurate estimation of land value, and the defensible estimation of replacement cost for comparable properties.

Conversely, the age-life method, also known as the economic age-life method, employs a simplified mathematical model based on the relationship between a property's effective age and its total economic life. This method estimates total depreciation by calculating the ratio of the effective age of the property to its economic life expectancy and applying this ratio to the property's total cost. While mathematically straightforward, the accuracy of this method is contingent upon the appraiser’s ability to accurately estimate effective age and economic life, and the method's inherent assumption of straight-line depreciation may not accurately reflect the complex decay patterns observed in real property. Variations on the Economic Age-Life Method, such as the modified economic age-life method, incorporate cost to cure estimates to provide a more nuanced depreciation calculation.

The scientific importance of understanding these methods lies in their ability to provide a quantifiable framework for assessing a key component of property value. By systematically estimating depreciation, appraisers can arrive at more accurate and defensible value opinions, contributing to the efficiency and stability of real estate markets.

The educational goals of this chapter are threefold: (1) to provide a comprehensive understanding of the theoretical underpinnings of both the market extraction and age-life methods; (2) to equip participants with the practical skills necessary to apply these methods in real-world appraisal scenarios, including proper data collection and analysis techniques; and (3) to foster critical thinking regarding the limitations of each method and the appropriate circumstances for their application, ensuring a scientifically sound approach to depreciation estimation. Furthermore, this chapter aims to provide a deep dive into variations on the age-life method, providing an understanding of when and how to utilize different calculations depending on specific property characteristics.

Topic:

Market Extraction & Age-Life: Depreciation Calculation

Body:

Chapter: Market Extraction & Age-Life: Depreciation Calculation

Introduction

This chapter delves into two fundamental methods used in real estate appraisal to estimate depreciation: the Market Extraction method and the Age-Life method. Depreciation, the loss in value of an improvement over time, is a critical factor in the cost approach to value. Accurately estimating depreciation is essential for deriving a credible opinion of value. We will explore the theoretical underpinnings, practical applications, and limitations of each method.

I. Market Extraction Method

The Market Extraction method, also known as the sales comparison or abstraction method, directly analyzes market data to derive depreciation estimates. It relies on identifying comparable sales and isolating the value attributable to depreciation.

A. Scientific Principles and Theory

The Market Extraction method is based on the principle of substitution and the concept of paired data analysis. The principle of substitution states that a rational buyer will pay no more for a property than the cost of acquiring a substitute of equal utility. Paired data analysis involves comparing similar properties, one with depreciation and one without, to quantify the difference in value attributable to depreciation.

B. Steps in the Market Extraction Method

The Market Extraction method typically involves the following steps:

1. Identification and Verification of Comparable Sales: Identify several recently sold properties that are similar to the subject property in terms of:

   • Size
   • Location
   • Construction quality
   • Design
   • Intended use
     Verify sales data to ensure accuracy and arms-length transactions. It is not essential that the comparable sales be current sales or be located in the subject property's area. They can be from a market that is comparable (i.e., similar age, design, quality, functionality, and external influences).

2. Adjustments to Comparable Sales Prices: Adjust the sale prices of comparable properties for differences between them and the subject property. Crucially, adjustments are made only for factors that are not sources of depreciation. This includes:

   • Property rights conveyed
   • Expenditures made immediately after purchase
   • Financing terms
   • Conditions of sale.
     An adjustment for market conditions is not made because the appraiser is estimating cost and depreciation at the time of the sale. No adjustments are made for physical, functional, or external impairments because these factors are the source of the depreciation that is being measured, and the comparable sales should be selected because they reflect similar depreciation-related influences, the very items being measured here.

3. Land Value Subtraction: Subtract the estimated land value of each comparable property from its adjusted sale price. This yields the depreciated cost or contributory value of the improvements. It is critical that the land value estimate is accurate and reflective of market conditions at the time of the comparable sale.

4. Cost Estimation: Estimate the cost of the improvements for each comparable property as of the date of sale. This estimate should be based on either reproduction cost or replacement cost. Typically replacement cost is used because an appraiser may not have sufficient information on all the sales to develop a credible opinion of reproduction cost. Replacement cost is the estimated cost of constructing a new building with equivalent utility, using modern materials and design, while reproduction cost is the estimated cost of constructing an exact replica of the existing building. The cost estimate must include all direct costs (labor, materials), indirect costs (permits, insurance), and entrepreneurial incentive.

5. Depreciation Calculation: Calculate the total dollar amount of depreciation for each comparable property by subtracting the depreciated cost of the improvements (from Step 3) from the cost of the improvements (from Step 4).

   • Depreciation ($) = Cost of Improvements - Depreciated Cost of Improvements

6. Depreciation Percentage Calculation: Convert the dollar amount of depreciation into a percentage of the cost.

   • Depreciation (%) = (Depreciation ($) / Cost of Improvements) * 100

7. Annual Depreciation Rate (if needed): If the ages of the comparable properties vary significantly, calculate an annual depreciation rate by dividing the total depreciation percentage by the age of the improvement (either actual or effective age, but be consistent). This step expands the analysis to calculate annual rates of depreciation and to support an estimate of the total economic life expectancy of the subject property.

   • Annual Depreciation Rate = Depreciation (%) / Age of Improvement
   • Total Economic Life = 100% / Annual Depreciation Rate

8. Subject Property Depreciation Estimation: Apply the reconciled depreciation percentage or annual rate to the cost of the subject property's improvements to estimate its total depreciation.

   • Subject Property Depreciation = Subject Property Cost * Depreciation (%) (or Age * Annual Depreciation Rate)

C. Mathematical Formulas

• Total Depreciation ($) = Cost New - Depreciated Value
• Depreciation Rate (%) = Total Depreciation ($) / Cost New * 100
• Annual Depreciation Rate (%) = Depreciation Rate (%) / Actual Age
• Economic Life = 1 / Annual Depreciation Rate (%)

D. Examples and Practical Applications

Example: (using values similar to Table 31.1 in your text)

• Subject Property Cost (Replacement Cost New): $250,000

Comparable Sales Data:

Sale	Sale Price	Land Value	Cost New	Age
1	$225,000	$70,000	$240,000	10
2	$175,000	$50,000	$200,000	12
3	$375,000	$130,000	$390,000	9

Calculations:

Sale	Depreciated Cost of Improvements (Sale Price - Land)	Total Depreciation ($) (Cost New - Depreciated Cost)	Depreciation (%) (Total Depreciation / Cost New)
1	$155,000	$85,000	35.42%
2	$125,000	$75,000	37.50%
3	$245,000	$145,000	37.18%

Reconciliation:

The depreciation percentages are relatively close. A reconciled rate of 36.7% is selected.
Subject Property Depreciation: $250,000 * 0.367 = $91,750

E. Related Experiments

A simple experiment to demonstrate the market extraction method could involve analyzing recent sales of identical model homes in a new development. Some homes might be slightly older or have minor wear and tear. By isolating the value difference between nearly identical properties, one can infer the market's perception of depreciation.

F. Applicability and Limitations

• Applicability: When sufficient sales data of similar properties exists and accurate land value estimates are available. This depreciation method is market-based and easy to understand, and for these reasons provides meaningful market-supported results when it can be appropriately supported.
• Limitations: Heavily reliant on accurate land value and cost estimates. Difficult to apply when comparable properties have significantly different functional or external obsolescence. The comparable properties should ideally have physical, functional, and external characteristics similar to the subject property, and they should have incurred similar amounts and types of depreciation. Market extraction considers all types of depreciation in a lump sum and does not break down the estimate into the various components of depreciation. It also cannot effectively isolate different types of depreciation such as physical, functional, or external obsolescence.

II. Age-Life Method

The Age-Life method is a simplified approach that estimates depreciation based on the ratio of a property's effective age to its total economic life.

A. Scientific Principles and Theory

The Age-Life method is rooted in the concept that properties depreciate linearly over their economic life. It assumes that value decreases proportionally to age until the end of the economic life. This linearity is a simplification of the real-world depreciation process, but it offers a convenient and easily understood approximation.

B. Steps in the Age-Life Method

1. Economic Life Estimation: Research and determine the total economic life of similar structures in the market area. Economic life represents the period over which a property is expected to be physically sound and economically viable. Data used in the market extraction method would also be applicable in the economic age-life method.
2. Effective Age Estimation: Estimate the effective age of the subject building. Effective age is an appraiser's judgment of the age of a building based on its condition, maintenance, and overall desirability. Effective age may be higher or lower than the actual age.
3. Depreciation Calculation: Calculate the depreciation percentage by dividing the effective age by the total economic life.
   • Depreciation (%) = (Effective Age / Total Economic Life) * 100
4. Dollar Depreciation Calculation: Multiply the depreciation percentage by the total cost new of the improvements to arrive at the total lump-sum dollar depreciation.
   • Depreciation ($) = Depreciation (%) * Total Cost New
5. Value Indication: Subtract the lump-sum depreciation from the total cost new of the subject improvement to arrive at the improvement's contribution to property value.

C. Mathematical Formulas

• Depreciation (%) = (Effective Age / Economic Life) * 100
• Depreciation ($) = Cost New * Depreciation (%)
• Indicated Value = Cost New - Depreciation ($) + Land Value

D. Examples and Practical Applications

Example: (using values similar to the first example in your text)

• Total Cost New: $700,000
• Land Value: $200,000
• Effective Age: 20 years
• Economic Life: 50 years

Calculations:

• Depreciation (%) = (20 / 50) * 100 = 40%
• Depreciation ($) = $700,000 * 0.40 = $280,000
• Indicated Value = $700,000 - $280,000 + $200,000 = $620,000

E. Related Experiments

A thought experiment can be conducted to assess the sensitivity of the Age-Life method to variations in effective age and economic life. By systematically adjusting these parameters and observing the resulting depreciation estimates, appraisers can gain a better understanding of the method's limitations.

F. Applicability and Limitations

• Applicability: Simplest way to estimate depreciation and allows appraisers to estimate total depreciation, which can subsequently be allocated among its various causes using breakdown procedures. Easy to apply and understand, particularly when there is limited market data.
• Limitations: The straight-line pattern of depreciation is only an approximation of the total depreciation of a property at a specific point in time. The economic age-life method, like the market extraction method, does not divide depreciation into its various categories—physical deterioration and functional and external obsolescence. In other words, obsolescence must be included in the estimate of effective age or economic life. The economic age-life method, like the market extraction method, does not recognize the difference between short-lived and long-lived items of physical deterioration. A single figure reflects all the depreciation in the structure as a whole, varying amounts of deterioration in short-lived items are not directly indicated in the age-life method. It is not always as accurate as other techniques and is problematic when the linear depreciation assumption does not hold. It requires subjective estimates of effective age and economic life. Is difficult to justify in market areas where comparable properties incur types and amounts of depreciation that differ from the subject property. For instance, when a property has significant existing deferred maintenance it may not be inhabitable in its current condition. This makes any estimate of economic age or remaining economic life unreliable.

III. Variations of the Economic Age-Life Method

A. Modified Economic Age-Life Method: The cost to cure the curable items of depreciation (both physical and functional) is known. Deducting curable items of depreciation from the cost of improvements before the age-life ratio is applied mirrors what typical purchasers consider when deciding on whether to invest in a property. That is, a potential buyer will first consider what items need to be fixed (and their hard and soft costs plus an appropriate entrepreneurial incentive) before judging the price he or she would be willing to pay given the wear and tear on the long-lived items.

B. External Obsolescence Considerations: If external obsolescence is affecting the subject property and sales of properties in the subject market have incurred the same external obsolescence, an appraiser should use the total economic life extracted from these sales in the economic age-life ratio. However, if external obsolescence is affecting the subject property but there are no sales in the subject market similarly affected, an appraiser can estimate total depreciation and economic life without the external obsolescence using the market extraction or economic age-life method and then estimate external obsolescence using techniques from another approach (e.g., the income capitalization approach). The estimated depreciation from the economic age-life method and the estimated external obsolescence from the breakdown method would be added together to arrive at an estimate of total depreciation.

Conclusion

Both the Market Extraction and Age-Life methods are valuable tools for estimating depreciation. The Market Extraction method offers a market-derived estimate, while the Age-Life method provides a simplified, age-based assessment. The choice of method depends on the availability of data, the complexity of the property, and the specific appraisal assignment. A thorough understanding of the scientific principles, practical applications, and limitations of each method is essential for appraisers to derive credible and defensible depreciation estimates.

ملخص:

Scientific Summary: Market Extraction & Age-Life: Depreciation Calculation

This chapter focuses on two primary methods for estimating depreciation in real estate appraisal: the Market Extraction Method and the Economic Age-Life Method. Both methods aim to quantify the loss in value of an improved property due to various factors, ultimately impacting the cost approach to value.

Market Extraction Method:

• Core Principle: This method derives depreciation estimates by analyzing sales of comparable properties. It posits that by isolating the contributory value of improvements in comparable sales and comparing it to their current cost, the total depreciation can be extracted.
• Scientific Basis: The method is empirically grounded in market data. It assumes that the market reflects depreciation through the sale prices of comparable properties.
• Procedure: The process involves: 1) Identifying comparable sales; 2) Adjusting sale prices for non-depreciation factors; 3) Subtracting land value to isolate the depreciated cost of improvements; 4) Estimating the current cost of the improvements; 5) Calculating total depreciation as the difference between current cost and depreciated cost; 6) Converting depreciation to a percentage of cost; 7) Deriving an annual depreciation rate if comparable ages differ significantly from the subject property to develop the total economic life expectancy.
• Conclusions/Implications: The method yields a market-derived estimate of total depreciation and total economic life expectancy. This market supported depreciation data is critical for real estate appraisal.
• Limitations: Accurate site value and cost estimates for comparables are crucial. Dissimilarities in property characteristics (design, quality), types of depreciation, or external factors, special financing, and unusual motivation can significantly affect the results. The method also analyzes all types of depreciation lump sum and does not break down the estimate into its various components.

Economic Age-Life Method:

• Core Principle: This method uses the relationship between a property's effective age and its total economic life expectancy to estimate depreciation.
• Scientific Basis: This method relies on the assumption that depreciation occurs linearly over the economic life of a property.
• Procedure: The method involves: 1) Estimating the effective age and total economic life of the improvements; 2) Calculating the ratio of effective age to total economic life; and 3) Applying this ratio to the total cost to derive the depreciation estimate.
• Conclusions/Implications: This method provides a simplified approach to estimating total depreciation. The method is easy to understand and easy to use, but total obsolescence must be included in the estimate of effective age or economic life.
• Limitations: The straight-line depreciation assumption is a simplification and may not accurately reflect the actual depreciation pattern. This method does not differentiate between physical, functional, and external obsolescence unless a modified version is used. This method can be unreliable with significant existing deferred maintenance.

Variations of the Economic Age-Life Method:

• Modified Economic Age-Life Method: This variation addresses curable depreciation by deducting the cost to cure these items from the total cost before applying the age-life ratio. This is meaningful when the subject property has curable depreciation not typically found in the market at the time of appraisal.
• Addressing External Obsolescence: This variation allows for the separate estimation and inclusion of external obsolescence in situations where the subject property is affected by external factors not reflected in comparable sales.

Overall Implications:

Both methods provide tools for appraisers to estimate depreciation within the cost approach. The Market Extraction Method is grounded in market data but can be challenging to apply when data is limited or comparability is questionable. The Economic Age-Life Method is simpler but relies on assumptions about depreciation patterns and requires careful estimation of effective age and economic life. Understanding the applicability and limitations of each method is crucial for accurate and credible appraisal results.