In the context of external obsolescence, what does the 'Income Loss' variable represent when using the capitalization of income loss method?

Breakdown Method: Analyzing Components of Depreciation

Introduction: Breakdown Method: Analyzing Components of Depreciation

Depreciation, the reduction in the value of an asset over time, is a multifaceted phenomenon influenced by physical deterioration, functional obsolescence, and external obsolescence. Accurate assessment of depreciation is critical in various fields, including asset management, financial accounting, and real estate appraisal. The "Breakdown Method," a detailed approach to depreciation analysis, is the focus of this chapter. This method involves dissecting total depreciation into its constituent components, allowing for a more precise and comprehensive understanding of value loss. Scientifically, the breakdown method allows for the isolation and quantification of distinct drivers of value decline, offering insights into the specific vulnerabilities of assets and the relative impact of different obsolescence factors. It provides a framework for analyzing the interactions between these components, which is crucial for informed decision-making regarding maintenance, renovation, or asset replacement. This chapter aims to equip the student with the knowledge and skills necessary to: (1) identify and differentiate between the various components of depreciation (physical deterioration, functional obsolescence, and external obsolescence); (2) apply appropriate methodologies for quantifying each component; (3) understand the cumulative nature of the breakdown method and its application in both allocating a known total depreciation and developing an independent estimate of total depreciation; and (4) critically evaluate the applicability and limitations of the breakdown method in different valuation scenarios, thereby enabling a more nuanced and accurate assessment of depreciation and asset value.

Breakdown Method: Analyzing Components of Depreciation

Chapter 3: Breakdown Method: Analyzing Components of Depreciation

3.1 Introduction
The breakdown method is a comprehensive approach to depreciation analysis that dissects total depreciation into its fundamental components. This detailed analysis provides a more accurate and nuanced understanding of the factors contributing to the decline in an asset's value. Unlike simpler methods, the breakdown method is particularly useful when dealing with properties exhibiting multiple forms of depreciation or when a more rigorous analysis is required.

3.2 Theoretical Foundation
The breakdown method is rooted in the understanding that depreciation is not a monolithic entity but a composite of various factors. It leverages cost accounting principles, engineering economics, and market analysis to quantify these factors independently. The underlying principle is the additive nature of depreciation components:

Total Depreciation = Physical Deterioration + Functional Obsolescence + External Obsolescence

Where:

• Physical Deterioration: The loss in value due to physical wear and tear, aging, and damage.
• Functional Obsolescence: The loss in value due to inadequacies in the asset's design or functionality, rendering it less efficient or desirable compared to modern alternatives.
• External Obsolescence: The loss in value due to factors external to the property itself, such as changes in market conditions, neighborhood decline, or regulatory changes.

3.3 Components of Depreciation

3.3.1 Physical Deterioration
Physical deterioration is further categorized into:

• Curable Physical Deterioration (Deferred Maintenance): Represents items in need of immediate repair or replacement on the appraisal date. These are typically items that are 100% physically deteriorated. Examples include broken windows, leaky roofs, or malfunctioning HVAC systems.

  • Measurement: Cost to cure (CtC), which represents the cost to restore the item to a new or reasonably new condition. This cost may exceed the original cost due to inflation, labor costs, or the complexity of the repair.
  • Mathematical representation: Depreciation = CtC
  • Incurable Physical Deterioration: Physical deterioration that is not economically feasible to cure. It is subdivided into short-lived and long-lived items.
  • Short-lived Items: Components with a remaining useful life shorter than the overall property's economic life. Examples include roof coverings, flooring, and mechanical equipment.
    • Measurement: Age-life ratio applied to the replacement cost. Depreciation = (Effective Age / Total Useful Life) * Replacement Cost
      Where:
    • Effective Age: The estimated age based on condition and maintenance, which can differ from the actual age.
    • Total Useful Life: The expected lifespan of the component when new.
    • Replacement Cost: The current cost to replace the component with a new one.
  • Long-lived Items: Components with a useful life comparable to the overall property's economic life. Examples include structural framing, foundation, and exterior walls.
    • Measurement: Age-life ratio applied to the replacement cost. Depreciation = (Effective Age / Total Useful Life) * Replacement Cost
      3.3.2 Functional Obsolescence
      Functional obsolescence results from deficiencies or superadequacies within the property itself.
  • Deficiency: Lack of a desired feature that would increase the value of the property
  • Superadequacy: A feature in excess of what a typical user would require or desire in the market.
    Functional obsolescence is categorized as curable or incurable.

• Curable Functional Obsolescence: Modifications or additions to improve the property are economically feasible.

  • Measurement: cost to cure is the most typical way to account for curable functional obsolescence, with the cost to cure not able to exceed the value added by the cure.

• Incurable Functional Obsolescence: The modification to improve a property is not economically feasible.

  • Measurement: Capitalization of income loss or excess operating costs can be used to estimate incurable functional obsolescence.
    3.3.3 External Obsolescence
    External obsolescence arises from factors outside the property that negatively affect its value. Examples include neighborhood decline, proximity to undesirable land uses, or adverse economic conditions. External obsolescence is typically incurable.

• Measurement:

  • Paired Data Analysis: Comparing the sales prices of similar properties in different locations or market conditions to isolate the impact of the external factor.
  • Capitalization of Income Loss: Estimating the reduction in income due to the external factor and capitalizing that loss into a value reduction.

  Depreciation = Income Loss / Capitalization Rate

  Where:

  • Income Loss: The estimated annual reduction in net operating income due to the external factor.
  • Capitalization Rate: The rate of return an investor would require for a similar property in that market.

3.4 Procedure for Applying the Breakdown Method

The breakdown method can be applied in two primary ways:

1. Allocating a Known Total Depreciation:

   • Estimate total depreciation using the market extraction or economic age-life method.
   • Calculate all items of physical deterioration, add them up, and subtract the total from the lump-sum depreciation estimate. The residual amount, if any, represents depreciation attributable to functional and external obsolescence.
   • Calculate all items of functional obsolescence, add them up, and subtract that total from the total amount of obsolescence. Any residual represents the depreciation attributable to external obsolescence.

2. Developing an Estimate of Total Depreciation:

   • Calculate all items of physical deterioration, including deferred maintenance, using appropriate techniques and then add up all the estimates to arrive at total physical deterioration.
   • Calculate all items of functional obsolescence, again using appropriate techniques, and add these estimates together to arrive at total functional obsolescence.
   • Calculate external obsolescence, either through analysis of market data or by capitalization of income loss.
   • Add together all physical deterioration (including the cost to cure deferred maintenance), functional obsolescence, and external obsolescence to arrive at an estimate of total depreciation.

3. 5 Example of Breakdown Method in Practice

Assume an industrial building with the following characteristics:
* Total Replacement Cost New (RCN): $1,000,000
* Age: 20 years
* Remaining Economic Life: 50 years
* Deferred Maintenance: $10,000 (painting, minor repairs)
* Short-Lived Items:
* Roof: RCN $50,000, Remaining Life 15 years
* HVAC: RCN $80,000, Remaining Life 10 years
* External Obsolescence: Located near a new competing industrial park, resulting in a 5% reduction in market rent, total loss = $50,000

1. Physical Deterioration:
   • Deferred Maintenance: $10,000
   • Short-Lived Items:
     • Roof: Depreciation = ($50,000 * 5/30) = $8,333
     • HVAC: Depreciation = ($80,000 * 10/20) = $40,000
   • Long-Lived Items:
     • RCN of Long-Lived Items = $1,000,000 - $10,000 - $50,000 - $80,000 = $860,000
     • Depreciation = ($860,000 * 20/70) = $245,714

Total Physical Deterioration = $10,000 + $8,333 + $40,000 + $245,714 = $304,047

2. External Obsolescence: Loss in value = $50,000

Total Depreciation = $304,047 + $50,000 = $354,047

3.6 Experiment

To test the effectiveness of the breakdown method, an experiment can be designed involving multiple appraisers evaluating the same property using both the breakdown method and the economic age-life method. The variances in the depreciation estimates and the time required for each method can be statistically analyzed.

3.7 Applicability and Limitations

The breakdown method is primarily used when the scope of work of an appraisal assignment requires that each form of depreciation be accounted for in the appraisal. In addition to allocating lump-sum estimates of total depreciation among their various components, the breakdown method is used when the market extraction and economic age-life methods cannot be applied. The breakdown method may also be used when the economic age-life method is too simplistic to account for the varied forms of depreciation present.

When using the breakdown method, appraisers should keep several cautions and considerations in mind:

1. If the sum of all items of physical deterioration estimated using the breakdown method is equivalent to the total depreciation derived from the market extraction or economic age-life methods, then no functional obsolescence or external obsolescence is present.
2. If the sum of all items of physical deterioration and all items of functional obsolescence estimated with breakdown techniques is equivalent to the total depreciation derived from the market extraction or economic age-life methods, then no external obsolescence is present.
3. If the sum of the items of depreciation estimated by the breakdown method substantially differs from the total depreciation derived from the market extraction or economic age-life methods, all the methods applied should be reviewed as a test of reasonableness.
   The results obtained from the breakdown method and from the market extraction or economic age-life methods may differ for a variety of reasons. The total depreciation derived using the market extraction or economic age-life methods might not accurately reflect the characteristics of the depreciation in the subject property.
   3.8 Conclusion
   The breakdown method offers a robust and detailed approach to depreciation analysis, allowing for a more accurate assessment of an asset's value. By independently quantifying the components of depreciation, it provides a comprehensive understanding of the factors affecting value decline. While more complex than simpler methods, the breakdown method is essential for appraisals requiring a high level of accuracy and detail.

The chapter "Breakdown Method: Analyzing Components of Depreciation" in the "Mastering Depreciation Analysis: A Comprehensive Approach" training course details a comprehensive methodology for dissecting total depreciation into its constituent parts: physical deterioration, functional obsolescence, and external obsolescence.

The breakdown method serves two primary purposes: (1) to allocate a pre-determined estimate of total depreciation (derived from market extraction or economic age-life methods) among its various components and (2) to develop an estimate of total depreciation by aggregating individual estimates for each type of depreciation. This detailed approach is particularly useful when the scope of an appraisal requires explicit accounting for each form of depreciation, or when simpler methods are inadequate due to atypical elements or complexities in the subject property.

The methodology relies on a cumulative process, where each step builds upon the previous one. Key techniques employed include: cost-to-cure estimations for curable physical deterioration (deferred maintenance) and curable functional obsolescence, extraction method or age-life ratios for incurable physical deterioration of both short-lived and long-lived components, functional obsolescence procedures, and market data analysis (paired data, statistical analysis) or capitalization of income loss/excess operating costs for functional and external obsolescence.

Physical deterioration is further categorized into deferred maintenance (curable), short-lived incurable, and long-lived incurable items. Deferred maintenance is measured by the cost to cure, reflecting the expense to restore items to a new or reasonably new condition. Short-lived items, while not requiring immediate replacement, are expected to be replaced within the remaining economic life of the property; their depreciation is calculated using an age-life ratio applied to their replacement cost. Long-lived items, with an age and life expectancy mirroring that of the overall structure, are treated collectively, with depreciation calculated as an age-life ratio applied to the remaining replacement cost after accounting for deferred maintenance and short-lived items.

The chapter emphasizes the importance of reconciling the results of the breakdown method with other depreciation estimation methods (market extraction, economic age-life) as a test of reasonableness. Discrepancies may arise due to the inability of simpler methods to capture the unique depreciation characteristics of the subject property, or from errors in applying the breakdown techniques, leading to double-counting or inappropriate assumptions.