Estimating Total Depreciation: Market Extraction Method

Chapter: Estimating Total Depreciation: Market Extraction Method

Introduction

Depreciation is a critical concept in real estate appraisal, representing the loss in value of a property’s improvements over time. Understanding and accurately estimating depreciation is essential for the cost approach to value. This chapter focuses on the Market Extraction Method, a direct and market-oriented technique for estimating total depreciation.

1. Understanding Depreciation in Real Estate

Depreciation represents the difference between the reproduction cost (or replacement cost) new of an improvement and its present value. It arises from three primary sources:

• Physical Deterioration: Wear and tear from use, exposure to the elements, and lack of maintenance.
• Functional Obsolescence: Loss in value due to deficiencies in design, layout, or utility compared to current market standards.
• External Obsolescence: Loss in value caused by factors external to the property itself, such as adverse environmental conditions, economic downturns, or zoning changes.

The market extraction method directly addresses the combined effect of all these forms of depreciation.

2. Theoretical Foundation of the Market Extraction Method

The market extraction method relies on the principle of substitution, a cornerstone of appraisal theory. The principle states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. In this context, the substitute is a comparable property that has experienced similar forms and amounts of depreciation as the subject property.

The underlying scientific theory is based on observed market behavior and the empirical relationship between sale price, Land Value❓❓, and improvement cost. The core idea is that the market reveals depreciation through the price differences between new and used properties, accounting for location and other market-driving variables.

3. Steps in the Market Extraction Method

The market extraction method involves a systematic procedure to isolate and quantify depreciation:

1. Identify and Verify Comparable sales❓:

   • The first step involves identifying recent sales of improved properties that are similar to the subject property in terms of:
     • Physical Characteristics: Size, quality of construction, design, and age.
     • Location: Neighborhood, access, and environmental factors.
     • Market Conditions: Economic conditions, supply and demand.
     • Crucially: Similar types and degrees of depreciation. If the subject has a defect such as an outdated floor plan, the comparable properties must also have that feature in order to provide good data.
   • Verification is vital to ensure data accuracy and the terms of the sales.

2. Adjust Sale Prices for Non-Property Items:

   • Adjust the sale prices of the comparable properties to reflect cash equivalency. Common adjustments include:
     • Property Rights Conveyed: Adjustments may be needed for the bundle of rights conveyed such as leasehold versus fee simple.
     • Seller Concessions: Deduct the value of any seller-paid closing costs or other financial concessions from the sale price.
     • Conditions of Sale: Adjust for atypical circumstances that may have influenced the sale price (e.g., duress sale, related-party transaction).
     • Post-Sale Expenditures for Functionality: Adjust for immediate post-sale repairs that restore the property to functionality.
   • Important Note: Avoid making condition adjustments at this stage, as the goal is to measure total depreciation, not individual components of it. market condition adjustments❓❓ are also not appropriate, since the analysis is concerned with the loss of value as of a specific date.

3. Isolate the Depreciated Value of the Improvements:

   • Subtract the estimated land value (VL) from the adjusted sale price of each comparable property.
   • $$\text{Depreciated Building Value} = \text{Adjusted Sale Price} - \text{VL} - \text{Site Improvements Value}$$
   • Land value should be estimated based on its highest and best use, as if vacant. If the existing improvement does not represent the highest and best use, the extracted depreciation will reflect functional obsolescence.
   • Site improvement value is also to be subtracted. Site improvements might include items such as driveway, sidewalks, landscaping.

4. Estimate Reproduction/Replacement Cost New:

   • Estimate the reproduction cost (CR) or replacement cost new (CN) of the comparable property’s improvements as of the effective date of the appraisal. Use the same cost basis as will be used in the cost approach.
   • This estimate can be derived using cost manuals, quantity survey, or comparative unit method.
   • It’s crucial to maintain consistency in the costing methodology.

5. Calculate Total Depreciation (D):

   • Subtract the depreciated value of the building from the estimated reproduction or replacement cost new to arrive at the total depreciation.
   • $$\text{Total Depreciation (D)} = \text{CR or CN} - \text{Depreciated Building Value}$$

6. Calculate Percentage Depreciation:

   • Divide the dollar amount of depreciation by the reproduction or replacement cost new to express depreciation as a percentage.
   • $$\text{Percentage Depreciation} = \frac{\text{Total Depreciation (D)}}{\text{CR or CN}} * 100\%$$

7. Develop an annual depreciation rate❓❓ (if applicable):

   • If the comparable properties have different ages than the subject, divide the percentage depreciation by the comparable property’s age to derive an annual depreciation rate.
   • $$\text{Annual Depreciation Rate} = \frac{\text{Percentage Depreciation}}{\text{Age of Comparable}}$$
   • This annual rate can be applied to the subject property’s age to estimate its total depreciation (assuming similar depreciation patterns).

4. Practical Applications and Examples

Example:

Assume we are appraising a 20-year-old office building. We find a comparable office building that sold for \$1,000,000 one year ago. After adjustments for cash equivalency, the adjusted sale price is \$980,000. The estimated land value is \$200,000. Site improvements (sidewalks) are valued at \$10,000. The reproduction cost new of the improvements is estimated to be \$1,200,000.

1. Adjusted Sale Price: \$980,000
2. Land Value (VL): \$200,000
3. Site Improvement Value: \$10,000
4. Depreciated Value of Improvements: \$980,000 - \$200,000 - \$10,000 = \$770,000
5. Reproduction Cost New (CR): \$1,200,000
6. Total Depreciation (D): \$1,200,000 - \$770,000 = \$430,000
7. Percentage Depreciation: (\$430,000 / \$1,200,000) * 100% = 35.83%
8. Age of Comparable: 22 years
9. Annual Depreciation Rate: 35.83%/22 years = 1.63% per year

Assuming a similar rate of depreciation applies to the subject property, with an age of 20 years, the estimated total depreciation for the subject would be 1.63% * 20 = 32.6%.

5. Strengths and Weaknesses

Strengths:

• Direct Market Evidence: Utilizes actual market transactions, reflecting buyer and seller behavior.
• Comprehensive Depreciation: Captures all forms of depreciation (physical, functional, and external) in a single estimate.
• Simplicity: Relatively straightforward to apply once suitable comparables are identified.

Weaknesses:

• Data Requirements: Relies on finding comparable sales with similar depreciation characteristics, which can be challenging.
• Subjectivity: Land value estimation and reproduction cost estimation can introduce subjectivity.
• Oversimplification: Does not explicitly identify or quantify different types of depreciation, which may be needed for more detailed analysis.

6. Related Experiments

Data Sensitivity Analysis:
Conduct sensitivity analysis by varying the land value estimates within a reasonable range (e.g., +/- 10%) and observing the impact on the extracted depreciation percentage. This helps assess the robustness of the result.

Comparable Property Matching:
Experiment with different criteria for selecting comparable properties. For example, analyze the impact of including comparables from a wider geographic area or with slightly different age ranges on the final depreciation estimate. This tests the sensitivity to market definition.

7. Conclusion

The market extraction method is a powerful tool❓ for estimating total depreciation by relying on direct market evidence. While it has limitations, its strength lies in capturing the combined effect of all forms of depreciation in a single, market-derived estimate. Appraisers should carefully consider the strengths and weaknesses of this method and ensure that the comparable sales are truly comparable to the subject property, especially in terms of depreciation characteristics, to produce reliable and accurate results.