Consumption and its Estimation Methods

VI. Types of Depreciation

Depreciation in real estate appraisal refers to the decrease in property value due to various factors, categorized into:

A. Physical Deterioration:

• Definition: Wear and tear of the property over time due to use, weather, neglect, and other factors.
• Examples: Cracks in walls or foundations, roof or pipe leaks, paint or flooring erosion, and deterioration of mechanical and electrical systems.
• Assessment: Direct inspection, component evaluation, and estimation of repair costs.
• Influencing Factors: Construction quality, materials, maintenance level, climate, and usage intensity.

B. Functional Obsolescence:

• Definition: Reduction in value due to inefficient design, outdated features, or incompatibility with current standards or market needs.
• Examples: Outdated kitchen or bathroom design, insufficient bathrooms, low ceilings, small rooms, lack of central air conditioning or parking.
• Types:
  • Curable: Can be overcome with renovations.
  • Incurable: Cannot be easily or affordably rectified.
• Assessment: Comparison to modern properties, estimation of upgrade costs, or deduction from property value.

C. External (Economic) Obsolescence:

• Definition: Decrease in value due to external factors unrelated to the property itself, such as economic, environmental, social, or legal changes in the surrounding area.
• Examples: Area degradation due to increased crime or pollution, closure of a major local employer, zoning or property tax changes, highway or airport construction nearby.
• Assessment: Analysis of external factors’ impact, comparison to properties in unaffected areas, and estimation of lost rental income or value.

VII. Methods of Estimating Depreciation

Several methods exist for estimating depreciation, each with advantages and disadvantages:

A. Economic Age-Life Method:

• Principle: Depreciation is proportional to the ratio of the property’s actual age❓❓ to its total economic life.
• Actual Age: Years since construction.
• Economic Life: Period the property contributes to income or benefit.
• Remaining Economic Life: Remaining period of economic life.
• Formula:
  • Total Depreciation = (Actual Age / Economic Life) * Cost New
  • Present Value = Cost New - Total Depreciation
• Example: Actual age 20 years, economic life 50 years, cost new $500,000:
  • Total Depreciation = (20 / 50) * 500,000 = $200,000
  • Present Value = 500,000 - 200,000 = $300,000
• Advantages: Simple to apply and understand.
• Disadvantages: assumes constant❓ depreciation rate and ignores market changes.

B. Sales Comparison Method:

• Principle: Comparing the subject property to similar properties recently sold, adjusting sales prices for differences in characteristics, location, and conditions, including depreciation.
• Steps: Identify comparable sales, analyze differences, adjust sales prices to reflect depreciation, and determine the subject property’s value based on adjusted comparable sales.
• Example: A comparable property sold for $400,000 and is five years newer, a $10,000 discount might be applied.
• Advantages: Reflects actual market conditions.
• Disadvantages: Requires sufficient and reliable sales data. Adjusting for depreciation can be difficult.

C. Capitalization Method:

• Principle: Estimating depreciation by analyzing its impact on property income.
• Steps: Estimate Net Operating Income (NOI), estimate the capitalization rate, calculate value (Value = NOI / Capitalization Rate), and compare the estimated value to the property’s cost new to determine depreciation.
• Example: NOI is $50,000, the capitalization rate is 10%:
  • Value = 50,000 / 0.10 = $500,000
  • If the cost new is $600,000, then depreciation is $100,000.
• Advantages: Considers the impact of depreciation on property income.
• Disadvantages: Requires accurate NOI and capitalization rate estimates and may not suit non-income-generating properties.

D. Cost to Cure Method:

• Principle: Estimating the cost of repairing physical or functional defects.
• Steps: Identify defects, estimate the repair cost for each, and sum repair costs to estimate total depreciation.
• Example: Roof repairs at $5,000 and kitchen renovation at $10,000 result in an estimated depreciation of $15,000.
• Advantages: Easy to apply for properties needing specific repairs.
• Disadvantages: Does not consider incurable depreciation (e.g., external obsolescence).

E. Observed Condition Method:

• Principle: Direct inspection to assess the condition of various components and estimate depreciation.
• Steps: Inspect the property, classify the condition of each component (excellent, good, average, poor), estimate depreciation for each component, and sum the estimated depreciation for each.
• Advantages: Considers the actual property condition.
• Disadvantages: Relies on the appraiser’s experience and judgment.

VIII. Uniform Residential Appraisal Report (URAR)

The URAR is a standard form used for residential property appraisals, including a section to estimate depreciation.

IX. Chapter Summary

Depreciation is a critical factor in property valuation.