Depreciation: Concepts and Market Extraction

1. Introduction to Depreciation in real estate❓ Appraisal

Depreciation, in the context of real estate appraisal, represents the loss in value of a property’s improvements from the cost new, as of the effective date of the appraisal. It’s a crucial element in the cost approach to value. Understanding the underlying principles and methods for estimating depreciation is essential for accurate appraisals. Depreciation stems from various factors, which can be broadly categorized as:

Physical Deterioration: This is the loss in value due to wear and tear, deferred maintenance, and the effects of aging on the physical components of the property.
Functional Obsolescence: This refers to the loss in value due to inadequacies in the property’s design, layout, or features, making it less desirable or efficient compared to current market standards.
External Obsolescence (Economic or Locational Obsolescence): This is the loss in value caused by factors external to the property itself, such as changes in the surrounding neighborhood, economic conditions, or government regulations.

2. Scientific Theories and Principles Underlying Depreciation

The concept of depreciation is rooted in the economic principle of Diminishing Returns❓❓ and the laws of thermodynamics.

Diminishing Returns: As a property ages and deteriorates, the marginal return on investment in its maintenance and upkeep decreases. Eventually, the cost of maintaining the property may outweigh the benefits derived from it.
Thermodynamics (Specifically Entropy): In a closed system (like a building), entropy (disorder) tends to increase over time. This translates to the physical deterioration of the building’s components as they are subject to natural forces (weather, gravity, etc.).

Mathematically, we can think of depreciation as a function of time, usage, and external factors:

Depreciation (D) = f(Age, Usage, External Factors)

Where:

Age is the chronological or effective age of the property.
Usage represents the intensity of use and maintenance practices.
External Factors include economic conditions, environmental influences, and regulatory changes.

3. Age and Life Relationships

Accurately assessing age and life expectancies is vital for quantifying depreciation, which depends on how improvements contribute to property value.

Actual Age: The chronological age of the improvement, measured from the date of construction to the effective appraisal date.
Effective Age: An appraiser’s estimate of the age of an improvement, based on its condition, utility, and remaining life relative to comparable properties. This acknowledges that a well-maintained building may function as if it were newer than its actual age, while a poorly maintained building may function as if it were older.
Total Economic Life: The estimated period during which a building is expected to generate income or contribute to property value. This is affected by location and the degree of maintenance carried out.
Useful Life: The estimated period during which a specific component or system within the building is expected to function effectively.
Remaining Economic Life: The estimated period remaining for the improvements to add value to the site.

The relationship between these terms can be expressed as:

Effective Age + Remaining Economic Life = Total Economic Life
Total Economic Life - Effective Age = Remaining Economic Life

4. Curable vs. Incurable Depreciation

A key distinction is whether depreciation is curable or incurable.

Curable Depreciation: Refers to items that are economically feasible to repair or replace. The cost to cure must be less than the resulting increase in the property’s value.
Incurable Depreciation: Refers to items that are either physically impossible or economically infeasible to repair or replace. The cost to cure would exceed the resulting increase in value.

5. Methods for Estimating Depreciation

Several methods are used to estimate depreciation. The document presented concentrates on the Market Extraction Method❓❓.

5.1 The Market Extraction Method

The market extraction method is considered the most direct and potentially the most accurate way to estimate total depreciation. This technique extracts depreciation directly from market data, by comparing comparable sales.

5.1.1 Procedure:

The market extraction method involves the following steps:

Identify and Verify Sales of Improved Comparables: Select comparable sales with similar depreciation characteristics as the subject property, ensuring similarity in quality, age, location, and market conditions. If the comparable sales do not suffer from the same losses, adjustments may have to be made to compensate.
Adjust Sale Prices: Adjust the sale prices of the comparables for factors such as property rights conveyed, seller financing concessions, and conditions of sale.
Subtract Land Value: Deduct the estimated land value at the time of the sale from the adjusted sale prices of each comparable. This isolated the depreciated value of the improvements. Land value should be estimated based on its highest and best use.
Estimate Reproduction or Replacement Cost: Determine the cost new of the improvements for each comparable, as of the effective date of the appraisal.
Calculate Total Depreciation (Dollar Amount): Subtract the depreciated value of the building (Step 3) from its cost new (Step 4) to arrive at the total dollar amount of depreciation.

Total Depreciation ($) = Reproduction/Replacement Cost - Depreciated Building Value

Calculate Percentage Depreciation: Divide the dollar amount of depreciation by the cost new of the structure to express depreciation as a percentage.

Percentage Depreciation = (Total Depreciation ($) / Reproduction/Replacement Cost) * 100

Develop an Annual Depreciation Rate: If there is a significant difference in the actual ages of the comparables and the subject property, calculate an annual depreciation rate by dividing the percentage depreciation by the actual age of the comparable.

Annual Depreciation Rate = Percentage Depreciation / Actual Age

5.1.2 Example:

Refer to Exhibit 29.1 (provided in the document) which illustrates the application of the Market Extraction method, and analyzes three comparable sales to estimate depreciation rates. The data shows that the rate of depreciation per year is higher for the newer improvement.

5.1.3 Mathematical Representation:

Let:

SP = Sale Price
VR = Rights Conveyed Adjustment
SC = Seller Concessions Adjustment
CS = Conditions of Sale Adjustment
LV = Land Value
SIV = Site Improvement Value
DBV = Depreciated Building Value
RC = Reproduction Cost
TD = Total Depreciation
PD = Percentage Depreciation
AA = Actual Age
ADR = Annual Depreciation Rate

Then:

Net Sale Price = SP + VR + SC + CS
DBV = Net Sale Price - LV - SIV
TD = RC - DBV
PD = (TD / RC) * 100
ADR = PD / AA

5.1.4 Strengths and Weaknesses of the Market Extraction Method:

Strengths: Directly reflects market perceptions of depreciation, considered the most accurate method for estimating total depreciation.
Weaknesses: Requires reliable comparable sales data with similar depreciation characteristics, does not isolate individual types of depreciation (physical, functional, external), and relies on accurate estimates of land value and reproduction/replacement costs. It is possible to make adjustments for atypical problems needed to make the property functional.

Case Study: Appraise a commercial building using the cost approach. Utilize the market extraction method to estimate depreciation, comparing sales of similar commercial buildings in the area. Analyze the extracted depreciation rates and compare them with depreciation estimates derived using other methods (e.g., the age-life method) to assess the reasonableness of the market extraction result.
Sensitivity Analysis: Conduct a sensitivity analysis on the key variables in the market extraction method (e.g., land value, reproduction cost, adjustments to comparable sales) to assess the impact of changes in these variables on the final depreciation estimate.
Hypothetical Experiment: Create a hypothetical dataset of comparable sales with varying levels of physical deterioration, functional obsolescence, and external obsolescence. Apply the market extraction method to the dataset and analyze the results to understand how the method captures the combined effects of these different types of depreciation.

7. Conclusion

Depreciation is a critical element in real estate appraisal, and its accurate estimation is essential for reliable property valuations. The market extraction method offers a direct, market-driven approach to estimating total depreciation. However, it requires careful analysis of comparable sales data and a thorough understanding of the factors that influence property value. By combining the market extraction method with other depreciation estimation❓ techniques, appraisers can develop well-supported and defensible opinions of value.

Chapter Summary

This chapter, “Depreciation: Concepts and Market Extraction,” from the “Mastering Depreciation in real estate❓ Appraisal” training course, focuses on understanding and quantifying depreciation in real estate appraisal, particularly within the cost approach.

Main Scientific Points and Concepts:

Definition of Depreciation: Depreciation is defined as the difference between the cost new of improvements and their current value as of the appraisal’s effective date.
Types of Depreciation: Depreciation is categorized into three types:
- Physical Deterioration: Loss in value due to wear and tear and the passage of time.
- Functional Obsolescence: Loss in value due to outdated design, layout, or features that are no longer desirable in the market. This means the market wants something different than what the subject offers.
- External Obsolescence: Loss in value due to factors outside the property itself. This can be locational (e.g., proximity to nuisances) or economic (e.g., changes in market conditions or interest rates).
Curable vs. Incurable Depreciation: Depreciation can be curable (the cost to cure is less than the resulting increase in value) or incurable (the cost to cure exceeds the resulting increase in value).
Age and Life Relationships:
- Actual Age: The chronological age of the improvement.
- Effective Age: The age of the improvement based on its condition and utility relative to comparable properties. Effective age can be higher or lower than actual age depending on maintenance and remodeling. The condition of the improvements are always based on the competition in the marketplace.
- Total Economic Life: The period over which the improvements contribute to the property’s value. This is affected by location and maintenance.
- Useful Life: The period of time over which a component of the property may reasonably be expected to perform the function for which it was designed.
- Remaining Economic Life: The estimated remaining period that the improvements will continue to add value to the site. (Effective Age + Remaining Economic Life = Total Economic Life).
Long-Lived vs. Short-Lived Components: Building components are classified as long-lived (e.g., structural framing, foundation) or short-lived (e.g., roof coverings, floor coverings, windows). Short-lived components depreciate more rapidly and condition adjustments in appraisals often reflect short-lived items.
Methods of Estimating Depreciation: The chapter outlines three primary methods for estimating depreciation:
- market extraction method❓: Uses comparable sales to extract the total amount of depreciation from the market.
- Economic Age-Life Method
- Breakdown Method
Market Extraction Method 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. Only adjustments for those repairs needed to make the property functional should be made. Market condition adjustments are not needed.
3. Subtract the value of the land at the time of sale from the sale price of each comparable. If the improvement does not represent the highest and best use of the land, the extracted amount of depreciation reflects functional obsolescence.
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.

Conclusions and Implications:

accurate depreciation estimation❓ is crucial for reliable cost approach valuations.
The market extraction method is presented as the most direct and accurate method for estimating depreciation as it uses market data. It deals only with the total amount of depreciation and does not segregate depreciation estimates into categories.
The market extraction method relies on identifying comparable sales with similar depreciation characteristics❓ and making appropriate adjustments.
Understanding the different types of depreciation and their causes is essential for accurate analysis.
Distinguishing between curable and incurable depreciation guides decisions about potential renovations and their impact on value.
The concepts of economic life and useful life are important for determining the appropriate depreciation period.
Appraisers must recognize the dynamic nature of depreciation, considering factors such as location, maintenance, and market conditions.

Overall, the chapter emphasizes the importance of a thorough understanding of depreciation concepts and the application of market-derived data to accurately estimate depreciation in real estate appraisal.

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Depreciation: Concepts and Market Extraction