Estimating Depreciation: Methods and Age-Life Relationships

Estimating Depreciation: Methods and Age-Life Relationships

Introduction

Depreciation, in the context of real estate appraisal, represents the loss in value of a property’s improvements from its reproduction or replacement cost new as of the effective date of the appraisal. This loss can stem from various factors and is crucial to accurately❓ estimating the value of a property using the cost approach. This chapter will delve into the methods used to estimate depreciation and explore the critical relationship between a property’s age and its expected lifespan.

I. Classifying Depreciation

Depreciation is broadly categorized into three types:

• Physical Deterioration: This refers to the loss in value resulting from wear and tear, deferred maintenance, and the effects of aging on the physical components of the building. These are tangible losses.
• Functional Obsolescence: This type of depreciation arises from inadequacies in the building’s design, materials, or layout that make it less desirable or efficient compared to current market standards. It represents a loss in utility and desirability.
• External Obsolescence: Also known as economic obsolescence, this category encompasses losses in value due to factors external to the property itself. These factors can be locational (e.g., proximity to undesirable land uses) or economic (e.g., changes in market demand due to economic downturns).

II. Age and Life Relationships

Understanding the relationship between a property’s age and lifespan is crucial for estimating depreciation.

A. Actual Age vs. Effective Age

• Actual Age: This is simply the chronological age of the building, measured as the difference between the date of construction and the effective date of the appraisal.

  Example: A building constructed in 1990, appraised in 2024, has an actual age of 34 years.
  * Effective Age: This is an estimate of the building’s age based on its condition and utility, relative to comparable properties in the market. A well-maintained building might have a lower effective age than its actual age, while a poorly maintained one might have a higher effective age.

  Example: A 30-year-old building with significant deferred maintenance might have an effective age of 40 years. Conversely, a 30-year-old building that has been substantially remodeled might have an effective age of 20 years.

  The effective age is determined by considering factors such as:

  • Condition of the building’s components (roof, HVAC, plumbing, etc.)
  • Level of maintenance and repairs
  • Modernization and upgrades
  • Overall appeal and desirability relative to competing properties
  • Mathematical Relationship: This can be represented in a basic form:
    E = A +/– M
    Where:
    E = Effective Age
    A = Actual Age
    M = Modifier reflecting maintenance and modernization.

B. Total Economic Life, Useful Life, Remaining Economic Life, and Remaining Useful Life

• Total Economic Life (TEL): This is the estimated period over which the improvements contribute to the property’s value. It is influenced by location, market conditions, maintenance, and modernization. This is the point where the cost of upkeep and repairs surpasses the income or benefit derived from the property.
• Useful Life: The period of time over which a structure or a component of a property may reasonably be expected to perform the function for which it was designed.
• Remaining Economic Life (REL): This is the estimated remaining period over which the improvements will continue to contribute to the property’s value.

• Remaining Useful Life: The time period that a component of the building is expected to function.

  • Mathematical Relationships:

    • TEL = Effective Age + REL
    • REL = TEL – Effective Age
      Example:
      A building has an effective age of 20 years. The appraiser estimates its total economic life to be 60 years. The remaining economic life is, therefore, 40 years.

C. Curable vs. Incurable Depreciation

• Curable Depreciation: This refers to depreciation that can be economically corrected. The cost of repairing or replacing the item is less than the resulting increase in the property’s value. This is often addressed as part of the cost-to-cure when assessing depreciation.

• Incurable Depreciation: This refers to depreciation where the cost of repair or replacement exceeds the resulting increase in value, making the correction economically unfeasible.

  • Simple Test for Curability: Cost of Repair/Replacement < Increase in Value.

III. Depreciation Estimation Methods

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

A. market extraction method❓❓

This is the most direct method. It involves extracting depreciation data from comparable sales.

• Principle: This method relies on analyzing comparable sales to determine the market’s perception of depreciation for similar properties.

• Steps:

  1. Identify Comparable Sales: Find sales of improved properties similar to the subject property in terms of age, quality, location, and obsolescence factors.
  2. Adjust Sale Prices: Make necessary adjustments to the sale prices of the comparables for differences in property rights, financing terms, market conditions (carefully, to avoid skewing the depreciation rate), and conditions of sale.
  3. Determine Land Value: Estimate the land value of each comparable at the time of sale.
  4. Calculate Depreciated Building Value: Subtract the land value from the adjusted sale price to arrive at the depreciated value of the building.
  5. Estimate Reproduction/Replacement Cost New (RCN): Estimate the RCN of the improvements for each comparable as of the effective date of the appraisal.

  6. Calculate Total Depreciation: Subtract the depreciated building value from the RCN to determine the total depreciation in dollar terms.

     Equation: Total Depreciation = RCN – Depreciated Building Value
     7. Calculate Percentage Depreciation: Divide the total depreciation by the RCN to express depreciation as a percentage of the new cost.

     Equation: Percentage Depreciation = (Total Depreciation / RCN) * 100
     8. Develop an Annual Depreciation Rate (Optional): If there are differences in the ages of the comparable properties and the subject, divide the percentage depreciation by the age of the comparable to derive an annual depreciation rate.
     * Example:

  Comparable Sale:

  • Sale Price: $500,000
  • Land Value: $150,000
  • Adjusted Sale Price for land: $350,000
  • Estimated RCN: $400,000
  • Total Depreciation: $400,000 - $350,000 = $50,000
  • Percentage Depreciation: ($50,000/$400,000) * 100 = 12.5%

• Limitations: This method is highly dependent on the availability of comparable sales with similar depreciation characteristics. It does not explicitly identify the individual components of depreciation (physical, functional, external). Care must be taken to avoid circular reasoning.

B. Economic Age-Life Method

This is a relatively simple and widely used method for estimating depreciation.

• Principle: This method assumes a linear relationship between a property’s age and its depreciation. It calculates depreciation based on the ratio of the effective age to the total economic life.

• Steps:

  1. Estimate Effective Age: Determine the effective age of the improvements.
  2. Estimate Total Economic Life: Estimate the total economic life of the improvements.

  3. Calculate Depreciation Percentage: Divide the effective age by the total economic life.

     Equation: Percentage Depreciation = (Effective Age / Total Economic Life) * 100
     4. Calculate Total Depreciation: Multiply the percentage depreciation by the RCN.

     Equation: Total Depreciation = Percentage Depreciation * RCN

Example:

*   Effective Age: 25 years
*   Total Economic Life: 60 years
*   Percentage Depreciation: (25/60) * 100 = 41.67%
*   RCN: $500,000
*   Total Depreciation: 0.4167 * $500,000 = $208,350

• Limitations: This method assumes a linear depreciation pattern, which may not always be accurate. It does not explicitly account for functional and external obsolescence.
• Supporting data considerations: It is important to use supporting data to justify the determination of TEL.

C. Breakdown Method

This is the most comprehensive and complex method, but it also offers the most detailed and accurate depreciation estimate.

• Principle: This method involves estimating depreciation for each component of the building separately, considering physical deterioration, functional obsolescence, and external obsolescence.

• Steps:

  1. Identify Building Components: Divide the building into its major components (e.g., foundation, framing, roof, HVAC, plumbing, electrical).

  2. Estimate Depreciation for Each Component: For each component, estimate the amount of depreciation due to:

     • Physical Deterioration: Estimate the cost to cure curable physical deterioration and the percentage of incurable physical deterioration based on the component’s age and condition.
     • Functional Obsolescence: Identify any functional inadequacies and estimate the loss in value due to these inadequacies.
     • External Obsolescence: Assess the impact of external factors on the component’s value.
       3. Calculate Total Depreciation for Each Component: Sum the depreciation from physical deterioration, functional obsolescence, and external obsolescence for each component.
       4. Calculate Total Depreciation: Sum the total depreciation for all components to arrive at the overall depreciation for the building.
     • Types of Breakdown Method:
  • Observed Condition Method: Focuses on directly observing and quantifying the physical deterioration of building components.
  • Cost-to-Cure Method: Estimates the cost to repair or replace curable items of depreciation and combines this with an estimate of incurable depreciation.
  • Limitations: This method is time-consuming and requires significant expertise in building construction and market analysis.

IV. Practical Application and Related Experiments

• Example Scenario:
  Appraising a 30-year-old office building in a declining industrial area.

  • Market Extraction: Analyze sales of similar office buildings in the area to extract a depreciation rate.
  • Age-Life Method: Estimate the effective age and total economic life to calculate depreciation.
  • Breakdown Method: Assess depreciation for individual components, considering physical deterioration (e.g., worn roof), functional obsolescence (e.g., outdated HVAC system), and external obsolescence (e.g., declining tenant demand).

• Experiment: Depreciation and Maintenance:

  • Compare two similar properties with different maintenance histories.
  • Estimate depreciation using the age-life method for both properties.
  • The property with better maintenance should have a lower effective age and, consequently, a lower depreciation estimate.

• Software Applications:
  Utilize appraisal software to streamline depreciation calculations and component-based analysis.

V. Conclusion

Estimating depreciation is a complex but essential task in real estate appraisal. The appropriate method❓ for estimating depreciation depends on the availability of data, the complexity of the property, and the appraiser’s expertise. A thorough understanding of the different types of depreciation, age-life relationships, and estimation methods is crucial for producing accurate and reliable appraisal results. The interplay between age and condition is crucial, and appraisers must meticulously account for how these factors contribute to the overall depreciation of a property.