Estimating Total Depreciation

Chapter: Estimating Total Depreciation

Introduction

Depreciation, in the context of real estate appraisal, represents the loss in value of a property’s improvements from all causes. It’s a crucial element in the cost approach to value. Accurately estimating depreciation is vital for deriving a credible value opinion. This chapter delves into the scientific and practical aspects of estimating total depreciation, covering various methods and their underlying principles. Depreciation is the difference between the cost new of the improvements and their value as of the effective date of appraisal. Depreciation can be classified as physical, functional, or external.

1. Understanding the Components of Depreciation

Total depreciation is typically categorized into three main types:

• Physical Deterioration: This refers to the loss in value due to wear and tear, age, and the physical breakdown of building components.
• Functional Obsolescence: This arises from deficiencies or inadequacies in the property’s design, layout, or features, making it less desirable or efficient compared to current market standards.
• External Obsolescence: This is the loss in value caused by factors external to the property itself, such as unfavorable neighborhood conditions, economic downturns, or changes in zoning regulations. These can be categorized further as locational and economic losses. Locational losses are caused by the proximity of adverse factors, such as a noisy railroad track next to a residential property. Economic losses are 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. Key Concepts: Age and Life Relationships

Accurate depreciation estimation requires understanding the relationship between age and life expectancy of a property.

• Actual Age: The chronological age of the building, calculated from the date of construction❓ to the effective date of the appraisal.
• Effective Age: An appraiser’s estimate of the age of a building based on its condition, quality, and utility, relative to comparable properties. A well-maintained older building may have a lower effective age than its actual age, while a poorly maintained building may have a higher effective age.
• Total Economic Life: The estimated period during which the improvements contribute value to the property. This is influenced by factors such as location, maintenance, and market conditions.
• 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❓❓: The estimated remaining period over which the improvements will continue to contribute value to the property.

  The relationship can be expressed as:
  Effective Age + Remaining Economic Life = Total Economic Life
Total Economic Life − Effective Age = Remaining Economic Life

3. Methods for Estimating Total Depreciation

Several methods are employed to estimate total depreciation. Each method has its strengths and weaknesses, and the choice depends on data availability and the complexity of the property. There are typically three recognized methods of estimating depreciation:
* the market extraction method❓❓❓
* the economic age-life method
* the breakdown method

3.1. The market extraction method❓

This method is considered the most direct, using market data to extract depreciation rates. It does not segregate the depreciation estimate into categories. Instead, it deals only with the total amount of depreciation.

Scientific Principle: The market extraction method relies on the principle of paired data analysis. By comparing the sale prices of similar properties with varying levels of depreciation, the market-derived loss in value due to depreciation can be isolated.

Procedure:
1. Find and verify sales of improved properties that reflect the same losses as the subject. The comparables can be from outside the subject’s market area but should reflect similar losses.
2. Make adjustments to the sale prices of the comparable properties for property rights conveyed, seller financing assistance, and conditions of sale. Adjustments for expenditures immediately after sale can and should be made if there are atypical problems that will skew the depreciation percentages. This doesn’t mean that other condition adjustments should be made; only adjustments for those repairs needed to make the property functional should be made. Consistency is always important. Market condition adjustments are not needed because the goal is to measure the loss as of a specific date rather than from one date to the next. Making market conditions adjustments will skew the depreciation rates.
3. Subtract the value of the land (VL) at the time of sale from the sale price of each comparable.
* Building Value = Sale Price - Land Value
4. Estimate the reproduction or replacement cost of the improvements as of the effective date of appraisal. If reproduction cost is used as the cost basis in the cost approach, it must also be used as the basis of the market extraction method and vice versa.
5. Subtract the calculated value of the building from the estimated reproduction or replacement cost of the improvements to determine the amount of depreciation.
* Depreciation = Reproduction Cost - Building Value
6. Convert this amount of depreciation to a percentage by dividing the dollar amount of depreciation by the cost new of the structure.
* Percentage Depreciation = (Depreciation / Reproduction Cost) * 100
7. Develop an annual depreciation rate if there is a difference between the ages of the comparable properties and the subject.

Example:

Consider two similar houses in the same neighborhood. House A, in excellent condition, sold for $500,000. House B, with deferred maintenance, sold for $400,000. The land value for both is $100,000, and the reproduction cost of the improvements is $450,000.

• House A: Depreciation = $450,000 - ($500,000 - $100,000) = $50,000
  Percentage Depreciation = ($50,000 / $450,000) * 100 = 11.11%
• House B: Depreciation = $450,000 - ($400,000 - $100,000) = $150,000
  Percentage Depreciation = ($150,000 / $450,000) * 100 = 33.33%

Practical Application: This method is most reliable when there are ample comparable sales with similar characteristics and depreciation patterns as the subject property.

3.2. The Economic Age-Life Method

This is a simple and widely used method that estimates depreciation based on the ratio of the effective age to the total economic life.

Scientific Principle: The age-life method assumes a straight-line depreciation pattern, meaning that the property depreciates at a constant rate over its economic life.

Formula:

Depreciation Percentage = Effective Age / Total Economic Life
Total Depreciation = Reproduction Cost * Depreciation Percentage

Example:

A building has a reproduction cost of $600,000, an effective age of 20 years, and an estimated total economic life of 60 years.

• Depreciation Percentage = 20 / 60 = 0.3333 (or 33.33%)
• Total Depreciation = $600,000 * 0.3333 = $200,000

Practical Application: This method is easy to apply but may not accurately reflect the actual depreciation pattern of a property, especially if the straight-line assumption doesn’t hold true.

3.3. The Breakdown Method

This method involves estimating depreciation for each category (physical, functional, and external) separately and then summing them up to arrive at the total depreciation.

Scientific Principle: The breakdown method allows for a more detailed and nuanced analysis of depreciation, recognizing that different factors contribute to value loss in different ways.

Procedure:

1. Physical Deterioration: Estimate depreciation due to curable and incurable physical defects.
   • Curable Physical Deterioration: Items that are economically feasible to repair or replace. The depreciation is the cost to cure. The simple test for “curability” is the financial feasibility of the cost to repair the item in question, which can be anything from fixing a broken window to repairing a cracked foundation wall. If the item costs less to replace or repair than the increase in value as a result of that action, the item is considered curable.
   • Incurable Physical Deterioration: Items that are not economically feasible to repair or replace. Depreciation is often estimated using the age-life method applied to the specific component.
2. Functional Obsolescence: Estimate depreciation due to curable and incurable functional deficiencies.
   • Curable Functional Obsolescence: Items that can be replaced or modified to meet current market standards. Depreciation is the cost to cure plus any entrepreneurial incentive.
   • Incurable Functional Obsolescence: Design or layout deficiencies that cannot be easily remedied. Depreciation can be estimated using the loss of income due to the deficiency (capitalization of income loss).
3. External Obsolescence: Estimate depreciation due to external factors. This is often estimated by analyzing the impact of the external factor on property values in the market (paired data analysis or income loss capitalization).

Example:

A commercial building has a reproduction cost of $1,000,000.

• Physical Deterioration:
  • Curable (roof repairs): $10,000
  • Incurable (structural aging): $50,000
• Functional Obsolescence:
  • Curable (outdated HVAC system): $20,000
  • Incurable (poor layout leading to lower rents): $30,000
• External Obsolescence:
  • Decreased property values due to nearby industrial plant: $40,000

Total Depreciation = $10,000 + $50,000 + $20,000 + $30,000 + $40,000 = $150,000

Practical Application: The breakdown method is the most comprehensive but also the most time-consuming and requires the most detailed data.

4. Considerations and Refinements

• Curable vs. Incurable Depreciation: Depreciation may be curable or incurable. The simple test for “curability” is the financial feasibility of the cost to repair the item in question, which can be anything from fixing a broken window to repairing a cracked foundation wall. If the item costs less to replace or repair than the increase in value as a result of that action, the item is considered curable.
• Component Depreciation: For complex properties, appraisers may use component depreciation, where each major building component (e.g., roof, HVAC, plumbing) is analyzed separately.
• Remaining Useful Life Estimation: Remaining useful life depends on the design, the durability of the item, and its utility. An I-beam in the superstructure of an office building will have a very long useful life. However, if the I-beam is in an office building in an undesirable neighborhood, that I-beam may not be around very long because the owner will not be able to maintain the rest of the property enough to keep it viable.
• Market Conditions: Consider the impact of current market conditions on depreciation. A declining market may accelerate depreciation, while a strong market may mitigate it.

5. Conclusion

Estimating total depreciation is a complex process that requires careful analysis and judgment. By understanding the different types of depreciation, employing appropriate methods, and considering relevant factors, appraisers can arrive at a credible depreciation estimate, which is essential for accurate property valuation.

Practical Exercises

1. Market Extraction Experiment: Collect sales data for similar properties in your area, some with varying levels of visible depreciation. Apply the market extraction method to derive market-based depreciation rates. Compare your results to age-life estimates.
2. Breakdown Method Case Study: Select a property and conduct a detailed inspection. Estimate depreciation for each category (physical, functional, and external) using the breakdown method. Compare your total depreciation estimate to a single age-life estimate.
3. Sensitivity Analysis: Using the age-life method, perform a sensitivity analysis by varying the total economic life and effective age assumptions. Observe the impact on the depreciation estimate. This demonstrates the importance of accurate age and life estimates.