Introduction to Depreciation Concepts in Appraisal

Chapter: Introduction to Depreciation Concepts in Appraisal

Introduction

Depreciation, in the context of real estate appraisal, represents the loss in value of an improvement (building or other structure) from its reproduction or replacement cost new as of the effective date of the appraisal. It’s crucial to understand that depreciation in appraisal isn’t necessarily the same as accounting depreciation for tax purposes. Appraisers are concerned with actual loss in market value, regardless of accounting practices. This chapter introduces the fundamental concepts of depreciation, its causes, methods of estimation, and its importance in the cost approach to value.

1. The Concept of Depreciation

Depreciation is the difference between the cost new of the improvements and their value as of the effective date of appraisal. This value loss can stem from various factors, broadly categorized as physical deterioration❓❓, functional obsolescence, and external obsolescence. Essentially, depreciation reflects the market’s perception of the property’s reduced utility and desirability compared to a brand-new equivalent.

2. Causes of Depreciation

Depreciation is not a single phenomenon but rather a collection of value-reducing forces. These forces can be classified into three main categories:

• 2.1 Physical Deterioration: This refers to the wear and tear on a structure due to age, use, and the elements. It is the easiest type of depreciation to understand and often the easiest to observe.

  • 2.1.1 Curable Physical Deterioration: This refers to physical defects that are economically feasible to correct. The cost of the repair is less than the increase in value that results from the repair.

  • 2.1.2 Incurable Physical Deterioration: This refers to physical defects that are either physically impossible to correct or economically unfeasible to correct. The cost of the repair exceeds the increase in value that results from the repair. Incurable deterioration can further be divided into:

    • Short-lived Items: These are building components with a shorter lifespan than the entire structure (e.g., roof coverings, floor coverings, HVAC systems, windows, plumbing, electrical fixtures, furnaces, air-conditioners).
    • Long-lived Items: These are structural components of the building that are typically not replaced during the building’s lifespan (e.g., structural framing, roof structure, floor systems, foundation, soft costs associated with construction)

  • Example: Peeling paint on a house (curable) versus a cracked foundation (potentially incurable).

• 2.2 Functional Obsolescence: This arises from inadequacies in the design, layout, or utility of a building that make it less desirable compared to modern standards. It relates to the functionality and efficiency of the structure. Functional obsolescence indicates that the market wants something other than what the subject offers.

  • 2.2.1 Curable Functional Obsolescence: An example would be a readily remedied design flaw, such as outdated fixtures, that can be updated.

  • 2.2.2 Incurable Functional Obsolescence: This is often associated with fundamental design flaws that are too costly or impractical to correct (e.g., a poor floor plan, inadequate ceiling height).

    • Example: A house with only one bathroom compared to similar houses with two or more, or a commercial building with insufficient parking spaces.

• 2.3 External Obsolescence: This is caused by factors external to the property itself, typically economic or locational. It is often beyond the control of the property owner. These factors cause losses attributed to factors outside the subject property.

  • 2.3.1 Economic Obsolescence: Factors related to market supply and demand. For example, when mortgage interest rates rise and demand falls off rapidly, the prices paid for real estate will be affected.

  • 2.3.2 Locational Obsolescence: Factors caused by the proximity of adverse factors, such as a noisy railroad track next to a residential property.

    • Example: A factory emitting pollution near a residential neighborhood, or a significant increase in property taxes in a specific area.
      A decline in the local economy leading to decreased demand for commercial space is another example.

3. Age and Life Concepts

Understanding age and life relationships is crucial for accurate depreciation estimation.

• 3.1 Actual Age: The chronological age of the building, measured from the date of construction to the effective date of the appraisal.

• 3.2 Effective Age: An estimate of the building’s age based on its condition and utility, which can be different from its actual age. This is a subjective assessment made by the appraiser. An improved property that is 20 years❓ old but has deferred maintenance may have an effective age of 30 years. A property with a 30-year-old improvement that has been substantially remodeled may have an effective age of only 20 years. The effective age rating is always measured in relation to competitive properties in the market.

• 3.3 Total Economic Life: The estimated period during which the improvement will contribute value to the property. This is affected greatly by the location of the property and the amount of maintenance and renovation that is done to it.
• 3.4 Useful Life: The period of time over which a structure or component of a property may reasonably be expected to perform the function for which it was designed.

• 3.5 Remaining Economic Life: The estimated remaining period during which the improvement will continue to contribute value to the property.

  • Relationship: Effective Age + Remaining Economic Life = Total Economic Life
  • Total Economic Life - Effective Age = Remaining Economic Life

4. Methods of Estimating Depreciation

There are three primary methods for estimating depreciation in real estate appraisal:

• 4.1 Market Extraction Method: The market extraction method is the most direct and probably the most accurate method of estimating depreciation. It does not segregate the depreciation estimate into categories. Instead, it deals only with the total amount of depreciation.

  • Requires finding comparable sales❓ with similar losses as the subject to ensure that the extracted depreciation rates are applicable to the subject.
    • Steps:
      1. Find and verify sales of improved properties that reflect the same losses as the subject.
      2. Make adjustments to the sale prices of the comparable properties for property rights conveyed, seller financing assistance, and conditions of sale.
      3. Subtract the value of the land (VL) at the time of sale from the sale price of each comparable.
      4. Estimate the reproduction or replacement cost of the improvements as of the effective date of appraisal.
      5. Subtract the calculated value of the building from the estimated reproduction or replacement cost of the improvements to determine the amount of depreciation.
      6. Convert this amount of depreciation to a percentage by dividing the dollar amount of depreciation by the cost new of the structure.
      7. Develop an annual depreciation rate if there is a difference between the ages of the comparable properties and the subject.

• 4.2 Economic Age-Life Method: This method assumes that depreciation occurs at a constant rate over the building’s economic life. It’s a simple but less precise method.

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

  • Example: A building with an effective age of 20 years and a total economic life of 50 years would have a depreciation percentage of (20/50) = 40%. If the reproduction cost new is $500,000, the estimated depreciation is $200,000.

• 4.3 Breakdown Method: This is the most detailed and comprehensive method, where depreciation is estimated separately for physical deterioration, functional obsolescence, and external obsolescence.

  • 4.3.1 Physical Deterioration:
    • Curable: Cost to cure.
    • Incurable: Estimated based on remaining economic life or component-specific analysis.

  • 4.3.2 Functional Obsolescence:

    • Curable: Cost to cure, plus any entrepreneurial incentive.

    • Incurable: Difficult to quantify, often estimated by analyzing the cost of a substitute or the loss in income due to the deficiency.

      • Example: The loss in rent due to the absence of central air conditioning can be capitalized to estimate the depreciation.
        • 4.3.3 External Obsolescence: Often requires market research and analysis to isolate the impact of external factors on property values. Can be estimated by comparing the sales prices of similar properties in affected and unaffected areas.
          • Example: If properties near a noisy highway sell for 10% less than comparable properties, this 10% discount can be attributed to external obsolescence.

  • Equation Total Depreciation = Physical Depreciation + Functional Obsolescence + External Obsolescence

    • DT = PD + FO + EO

5. Practical Applications and Experiments

• 5.1 Paired Data Analysis: A crucial technique for isolating and quantifying depreciation due to specific factors. By comparing the sales prices of nearly identical properties with only one difference (e.g., one with and one without a swimming pool), the appraiser can estimate the market’s reaction to that specific feature. This can be used to quantify functional obsolescence.

• 5.2 Survey of Local Contractors: For curable physical deterioration and functional obsolescence, obtaining cost estimates from local contractors is essential for determining the economic feasibility of repairs and renovations.

• 5.3 Market Surveys and Interviews: Conducting surveys of buyers, sellers, and real estate agents in the subject’s market area can provide valuable insights into the perceived impact of various forms of depreciation.

6. Conclusion

Understanding depreciation concepts is fundamental to accurate real estate appraisal, particularly when employing the cost approach. A thorough assessment of physical, functional, and external factors, coupled with appropriate depreciation estimation methods, is crucial for developing a credible opinion of value. The following chapters will delve into more advanced aspects of depreciation analysis and application.

Key Terms

• Depreciation
• Physical Deterioration
• Functional Obsolescence
• External Obsolescence
• Actual Age
• Effective Age
• Total Economic Life
• Remaining Economic Life
• Useful Life
• Market Extraction Method
• Economic Age-Life Method
• Breakdown Method
• Curable Depreciation
• Incurable Depreciation
• Long-lived items
• Short-lived items