When applying the cost-to-cure method to functional obsolescence, what is the primary determinant of whether an item should be classified as 'incurable'?

Estimating Physical & Functional Depreciation

Estimating Physical & Functional Depreciation: A Scientific Introduction

The accurate assessment of real estate value necessitates a rigorous understanding and quantification of depreciation, representing the diminution in value from all causes. This chapter focuses on the methodologies for estimating physical and functional depreciation, two primary components of overall depreciation, from a scientific and analytical perspective. Physical depreciation, or deterioration, represents the loss in value resulting from the physical wear and tear, age, and deferred maintenance of a property's components. Functional depreciation, or obsolescence, arises from inadequacies in a property's utility and efficiency, stemming from design deficiencies, outdated features, or superadequacies relative to prevailing market standards. The estimation of both physical and functional depreciation requires the application of specific appraisal techniques, including the age-life method, cost-to-cure analysis, and market extraction. This chapter will explore these methods and their underlying scientific rationale.

The scientific importance of accurately estimating physical and functional depreciation lies in its direct impact on the reliability and defensibility of real estate appraisals. An imprecise depreciation estimate can lead to significant valuation errors, potentially affecting investment decisions, mortgage lending practices, and property tax assessments. By employing sound scientific principles and data-driven approaches, appraisers can minimize subjectivity and enhance the accuracy of their depreciation estimates. Such accuracy is critical for maintaining transparency and integrity within the real estate market.

The educational goals of this chapter are threefold: (1) to provide a comprehensive understanding of the scientific principles underpinning the estimation of physical and functional depreciation; (2) to equip participants with the analytical tools and techniques necessary to accurately quantify these forms of depreciation in various real estate contexts; and (3) to foster critical thinking skills required to select and apply the most appropriate depreciation estimation methods based on specific property characteristics and market conditions. By mastering these skills, participants will be able to perform credible and defensible depreciation analyses, ultimately contributing to more accurate and reliable real estate valuations.

Estimating Physical & Functional Depreciation

Estimating Physical & Functional Depreciation

1. Estimating Physical Depreciation

   Physical depreciation, also known as physical deterioration, refers to the loss in value of a property due to wear and tear, aging, and exposure to the elements. It directly impacts the structural integrity and operational efficiency of the property. Estimating physical depreciation accurately is crucial for a reliable real estate appraisal.

   1. Methods for Estimating Physical Depreciation
      Several methods are available to estimate physical depreciation, each with its own advantages and limitations. The most common methods include:

      • Age-Life Method: This method is based on the relationship between the effective age of the property and its total economic life.
      • Cost-to-Cure Method (Observed Condition Method or Breakdown Method): This method involves identifying and quantifying each item of physical deterioration and estimating the cost to repair or replace it.

      • Market Extraction Method: This method extracts depreciation from comparable sales data by analyzing price differences between similar properties with varying levels of physical condition.

        2. Age-Life Method: A Detailed Examination
           The age-life method assumes that depreciation occurs at a constant rate over the economic life of the property.
           The formula for calculating depreciation using the age-life method is:

      • Depreciation = (Effective Age / Total Economic Life) * Reproduction Cost New

      Where:
      * Effective Age: The age of the property based on its condition, not necessarily its chronological age.
      * Total Economic Life: The estimated period during which the property will continue to generate income or provide utility.
      * Reproduction Cost New: The cost of constructing an exact replica of the property at current prices.

      Example:

      Consider a building with a reproduction cost new of $800,000, an effective age of 25 years, and a total economic life of 100 years.
      *   Depreciation = (25 years / 100 years) * $800,000 = $200,000
      *   The estimated physical depreciation is $200,000.
      3.  Cost-to-Cure Method (Observed Condition Method or Breakdown Method): A Detailed Examination
      

      The cost-to-cure method, also known as the observed condition method or breakdown method, is a more detailed approach to estimating physical depreciation. It involves identifying and quantifying each item of physical deterioration and estimating the cost to repair or replace it.
      The cost-to-cure method classifies physical deterioration into curable and incurable items. Curable items are those that are economically feasible to repair or replace, while incurable items are not.
      The formula for calculating depreciation using the cost-to-cure method is:

      • Total Depreciation = Σ (Cost to Cure Curable Items) + Σ (Depreciated Value of Incurable Items)

      Where:
      * Cost to Cure Curable Items: The estimated cost to repair or replace each curable item of physical deterioration.
      * Depreciated Value of Incurable Items: The estimated loss in value due to each incurable item of physical deterioration.
      The cost-to-cure method can be further broken down into short-lived and long-lived items.
      * Short-lived items are those that have a relatively short remaining economic life, such as paint, carpeting, and appliances.
      * Long-lived items are those that have a relatively long remaining economic life, such as the roof, foundation, and structural components.
      Step 1: Identify the curable short-lived items, the incurable short-lived items, and the incurable long-lived items.
      Step 2: An age-life ratio is calculated for each allocated cost item
      Step 3: The appropriate age-life ratio is applied to the estimated cost of each item.
      Step 4: The individual items of physical deterioration are added together to develop an estimate of total physical deterioration.

      Example:

      Consider a 25-year-old industrial building in average condition, overall cost $800,000. One overhead door damaged beyond repair, which will cost $5,000 to replace. (In this case, the $5,000 cost to cure is the original cost of the installation of the door, i.e., there is no excess cost to cure.) The roof was replaced five years ago and has a 20-year guarantee, which indicates that it is 25% depreciated. The cost to replace it is $60,000. The original HVAC components should last another five years, which indicates they are 83% deteriorated (25/30). The cost to replace the HVAC components is $72,000. The offices were just completely redecorated at a cost of $10,000. An appraiser estimates that the offices will not have to be redecorated for another five years. Based on an analysis of demolition permits, the appraiser concludes that the total useful life expectancy of the long-lived items is 100 years.
      
      A $800,000 Overall Cost
      B $5,000 Curables Overhead Door
      B $60,000 Curables Roof Cover
      B $72,000 Curables HVAC Components
      B $10,000 Curables Decorating
      B $653,000 Curables Long-lived Items
      D 100% Overhead Door Age-Life Ratio
      D 25% Roof Cover Age-Life Ratio
      D 83% HVAC Components Age-Life Ratio
      D 0% Decorating Age-Life Ratio
      D 25% Long-lived Items Age-Life Ratio
      E $5,000 Overhead Door Deterioration
      E $15,000 Roof Cover Deterioration
      E $60,000 HVAC Components Deterioration
      E $0 Decorating Deterioration
      E $163,250 Long-lived Items Deterioration
      F $243,250 Total Physical Deterioration
      
      The total physical deterioration is the sum of the individual deterioration calculations, or $243,250. On an age-life basis, the total depreciation is about 30%. The average annual physical depreciation is 1.2% per year and the economic life is 83 years (assuming that the improvements do not suffer from functional or external obsolescence). The total depreciation of short-lived items is $80,000 and the current cost of these items is $147,000.
      
      A summary of the depreciated cost of the improvements is shown below:
      Total current cost of all improvements $800,000
      Less depreciation
      Short-lived components $80,000
      Long-lived components + $163,250
      Total depreciation — $243,250
      Depreciated value of building improvements $556,750
      

      Damage or Vandalism requires special treatment in the estimation of depreciation. The measure of damage is the cost to cure, but damage or vandalism must be treated separately from other forms of physical deterioration because, unlike deferred maintenance, damage is not considered in the estimate of cost new. When damage or vandalism is cured, the life of the damaged component is neither renewed nor prolonged. It is simply restored to its condition prior to the damage.
      4. Market Extraction Method: A Detailed Examination
      The market extraction method involves analyzing comparable sales data to isolate the effect of physical depreciation on property values. This method requires a sufficient number of comparable sales with varying levels of physical condition.
      The formula for calculating depreciation using the market extraction method is:

      • Depreciation = Sale Price of Similar Property - Sale Price of Subject Property

      Where:
      * Sale Price of Similar Property: The sale price of a comparable property with similar characteristics but in excellent condition.
      * Sale Price of Subject Property: The sale price of the subject property.

      Example:

      Consider two similar properties in the same neighborhood. Property A is in excellent condition and recently sold for $600,000. Property B is in fair condition and recently sold for $500,000.
      *   Depreciation = $600,000 - $500,000 = $100,000
      *   The estimated physical depreciation for Property B is $100,000.
      

      Limitations: The market extraction method is highly dependent on the availability of reliable comparable sales data. It also requires careful analysis to isolate the effect of physical depreciation from other factors that may influence property values.

2. Estimating Functional Depreciation (Functional Obsolescence)

   Functional depreciation, also known as functional obsolescence, refers to the loss in value of a property due to inadequacies in its design, layout, or features. It arises when a property fails to meet current market standards or buyer preferences.

   1. Types of Functional Obsolescence

      • Deficiencies: These are shortcomings in the property's design or features, such as inadequate room sizes, outdated layouts, or lack of modern amenities.

      • Superadequacies: These are features that exceed market demand or contribute little or no value to the property, such as excessive ornamentation or specialized equipment.

        2. Curable vs. Incurable Functional Obsolescence
           Like physical deterioration, functional obsolescence can be curable or incurable. Curable obsolescence is economically feasible to correct, while incurable obsolescence is not.
        3. Methods for Estimating Functional Depreciation
           Several methods are available to estimate functional depreciation, including:

      • Cost-to-Cure Method: This method involves estimating the cost to correct the functional deficiency or remove the superadequacy.

      • Capitalized Income Method: This method involves estimating the loss in income due to the functional obsolescence and capitalizing it to determine the loss in value.
      • Market Extraction Method: This method involves analyzing comparable sales data to isolate the effect of functional obsolescence on property values.
        4. Cost-to-Cure Method: A Detailed Examination

      The cost-to-cure method involves estimating the cost to correct the functional deficiency or remove the superadequacy.

      • For curable deficiencies, the cost to cure is the estimated cost to add the missing feature or modernize the outdated one.
      • For curable superadequacies, the cost to cure is the estimated cost to remove the excess feature or convert it to a more useful purpose.
      • If the cost to cure the item will not result in a value increment greater than the loss in value caused by the item or building component, then the item is incurable.
      • Functional obsolescence can be corrected in two ways:
        • The functional obsolescence is cured by the property owner when this is economically feasible. or
        • Market norms change, eliminating the cause of the functional obsolescence. In other words, the functional obsolescence no longer exists.

      Example:

      A subject property has functional obsolescence because it does not have an addition something that other properties in the market do have. Because the item is not present, the property cannot be penalized for any deterioration that the item would have incurred if it had been included in the original construction. However, because it usually costs more to add an item to an existing property than to include it when the property was originally built, the excess cost to cure is the appropriate measure of functional obsolescence.
      

      Example:

      A curable deficiency requiring substitution or modernization is caused by something that is present in the subject property but is either substandard compared to other properties in the market or is defective and thereby prevents some other component or system in the property from working properly. The measure is the excess cost to cure. In addition, the depreciated or remaining cost of the existing item, which is now worthless, must be deducted.
      

      Example:

      A superadequacy is a type of functional obsolescence caused by something in the subject property that exceeds market requirements but does not contribute to value an amount equal to its cost. The superadequacy may have a cost to carry (i.e., higher operating costs) that must be considered. A superadequacy is only curable if it can be removed and the value that is added (or costs reduced), including any salvage value for its removal, is greater than the cost to cure.
      

      Example:

      The subject property has functional obsolescence because it is missing a building component or design feature (e.g., a warehouse with unusually low ceilings) that is not economically feasible to correct.
      

      Example:

      An item of incurable functional obsolescence caused by a superadequacy is a property component that exceeds market requirements. It represents a cost without any corresponding increment in value or a cost that the increment in value does not meet. Note that in some applications of the cost approach, the need to estimate the functional obsolescence attributable to an incurable superadequacy is eliminated by using replacement cost instead of reproduction cost because superadequacies are not replicated in a replacement cost estimate. Nevertheless, whether replacement or reproduction cost is used, any extraordinary expense of ownership associated with the superadequacy is quantified and deducted as a penalty from the value of the property. Essentially, the property loses value through the added costs of ownership over time because the component is incurable. However, if the cost of ownership increases over time, the obsolescence may become curable.
      

   2. Capitalized Income Method: A Detailed Examination

      The capitalized income method involves estimating the loss in income due to the functional obsolescence and capitalizing it to determine the loss in value.

      The formula for calculating depreciation using the capitalized income method is:

      • Depreciation = (Potential Market Rent - Actual Rent) / Capitalization Rate

      Where:
      * Potential Market Rent: The estimated rent that the property could generate if it did not have the functional obsolescence.
      * Actual Rent: The actual rent that the property is generating.
      * Capitalization Rate: The rate of return that investors require for similar properties.

      Example:

      Consider an apartment building with outdated layouts that generate $200,000 in annual rent. Similar apartment buildings with modern layouts generate $250,000 in annual rent. The capitalization rate for apartment buildings in the area is 8%.
      
      *   Depreciation = ($250,000 - $200,000) / 0.08 = $625,000
      *   The estimated functional depreciation is $625,000.
      6.  Market Extraction Method: A Detailed Examination
      

      The market extraction method involves analyzing comparable sales data to isolate the effect of functional obsolescence on property values.
      The formula for calculating depreciation using the market extraction method is:

      • Depreciation = Sale Price of Similar Property - Sale Price of Subject Property

      Where:
      * Sale Price of Similar Property: The sale price of a comparable property with similar characteristics but without the functional obsolescence.
      * Sale Price of Subject Property: The sale price of the subject property.

      Example:

      Consider two similar office buildings in the same area. Building A has a modern design and recently sold for $1,500,000. Building B has an outdated design and recently sold for $1,200,000.
      
      *   Depreciation = $1,500,000 - $1,200,000 = $300,000
      *   The estimated functional depreciation for Building B is $300,000.
      

      3. Procedure for Estimating All Forms of Functional Obsolescence

   Step 1. Estimate amount of component included in cost $XXX,XXX
   Step 2. Subtract any physical deterioration charged — $X, XxX
   Step 3. Add whichever is less:
   a. cost to cure (all costs) + $XXX,XXX
   or
   b. value added (or value of loss) + $XXX,XXX
   Step 4. Subtract cost as if included in new construction or value* — $XXX,XXX
   Step 5. Equals depreciation from functional obsolescence $X, XX
   * Sometimes an existing item has value unrelated to cost.

Scientific Summary: Estimating Physical & Functional Depreciation

This chapter focuses on the methods used to estimate physical and functional depreciation in real estate appraisal, crucial for accurate valuation. It distinguishes between these two primary forms of depreciation and outlines procedures for their quantification.

Physical Depreciation:

• Age-Life Method: This method is highlighted as a systematic approach to estimating physical deterioration. It involves:
  • Allocating costs to building components (curable short-lived, curable long-lived, and incurable long-lived items).
  • Calculating age-life ratios for each component (Effective Age / Total Expected Life).
  • Applying the age-life ratio to the component's cost to determine its depreciation.
  • Summing the depreciation of all components to estimate total physical depreciation.
• Cost to Cure: Curable physical deterioration is measured by the cost to cure the defect. If an item is damaged, the cost to cure damage or vandalism is included as a separate item, but not subtracted from the overall cost new calculation.
• Damage vs. Deferred Maintenance: A distinction is made between damage (e.g., vandalism) and deferred maintenance. Damage is treated as a cost to cure, but does not extend or renew the life of the component.

Functional Obsolescence:

• Definition: Functional obsolescence arises from deficiencies or superadequacies in a property's design, materials, or structure compared to current market standards and the ideal improvement for its highest and best use. It's attributable to factors within the property lines.
• Curability Tests: Curability is determined by comparing the cost to cure the functional issue with the resulting increase in property value (value added). An item is curable if the value added equals or exceeds the cost to cure, or if curing it maintains existing value.
• Types of Functional Obsolescence:
  • Curable Deficiency Requiring Addition: The property lacks something present in comparable properties. Obsolescence is measured by the excess cost to cure (the difference between adding the item now versus incorporating it in new construction).
  • Curable Deficiency Requiring Substitution/Modernization: An existing component is substandard or defective. Obsolescence is measured by the excess cost to cure, minus the depreciated cost of the replaced item.
  • Curable Superadequacy: An element exceeds market needs. It is curable only if removal adds value greater than the cost to cure.
  • Incurable Deficiency: A missing component or design is not economically feasible to correct.
  • Incurable Superadequacy: An element exceeds market needs without a corresponding value increase. The cost approach may use replacement cost (eliminating the need to value the superadequacy) or quantify and deduct the extraordinary cost of ownership associated with the superadequacy.
• Procedure for Estimating Functional Obsolescence: A systematic procedure is presented involving identifying the functional problem, the component causing it, corrective measures and their costs, selecting the most appropriate measure, quantifying the loss, determining curability, and finally calculating depreciation.
  • The procedure ensures that items are not double-counted (already depreciated as physical deterioration) and accounts for the cost of the existing item, any previous physical depreciation, the cost to cure (or value of loss, whichever is less), and subtracts the cost as if it were included in new construction (or the item's value independent of its cost).

Implications and Conclusions:

• Accurate estimation of physical and functional depreciation is essential for reliable cost approach valuations.
• Understanding the difference between physical deterioration (wear and tear) and functional obsolescence (design inadequacies or superadequacies) is crucial.
• The age-life method, while simplified, provides a structured framework for quantifying physical depreciation.
• Curability analysis is fundamental in assessing functional obsolescence.
• A step-by-step procedure ensures consistent and accurate calculation of functional depreciation, avoiding double-counting and accounting for all relevant costs and value changes.
• The choice between reproduction cost and replacement cost impacts the treatment of superadequacies.