Identifying and Quantifying Depreciation: Physical, Functional, and External

Chapter 3: Identifying and Quantifying Depreciation: Physical, Functional, and External

Introduction

Depreciation, in the context of real estate appraisal, refers to the loss in value of a property from any cause. Accurately identifying and quantifying depreciation is crucial for the cost approach to value, as it allows appraisers to estimate the current value of a property by subtracting the accrued depreciation from the cost of replacing or reproducing it. This chapter delves into the three primary categories of depreciation: physical deterioration, Functional obsolescence❓❓, and External obsolescence❓❓, exploring their underlying causes, methods for identification, and techniques for quantification.

1. Physical Deterioration

1.1 Definition and Causes

Physical deterioration represents the loss in value resulting from the physical wear and tear of a property’s components. It is a function of age, use, exposure to the elements, and the quality of maintenance. Physical deterioration can affect both short-lived components (e.g., paint, carpeting) and long-lived components (e.g., foundations, structural framing).

1.2 Types of Physical Deterioration

• Curable Physical Deterioration: This type of deterioration can be economically remedied. The cost to cure is less than the resulting increase in the property’s value. Examples include painting, repairing a leaking roof, or replacing worn flooring. As stated in the Student Handbook to THE APPRAISAL OF REAL ESTATE, repairing a leaking roof will not usually significantly increase the property value. If a new roof is installed, a typical buyer should pay more for the property.
• Incurable Physical Deterioration: This type of deterioration is either physically impossible to correct or economically unfeasible to correct. The cost to cure exceeds the resulting increase in the property’s value. Incurable physical deterioration can be further divided into:
  • Short-lived items: components with remaining economic life that is shorter than the remaining economic life of the entire structure.
  • Long-lived items: components with remaining economic life that is equal to the remaining economic life of the entire structure.

1.3 Identifying Physical Deterioration

Identifying physical deterioration involves a thorough inspection of the property, noting the condition of various components and comparing them to their expected condition based on age and use. Common indicators include:

• Cracks in foundations or walls
• Roof leaks or damaged roofing materials
• Peeling paint or wallpaper
• Worn or damaged flooring
• Faulty plumbing or electrical systems
• Deteriorated siding or trim
• Evidence of pest infestation

1.4 Quantifying Physical Deterioration

Several methods can be used to quantify physical deterioration:

• Age-Life Method: This is the most common method, based on the principle that depreciation is a function of the property’s effective age relative to its total economic life.

  • Effective Age: The age of a property based on its condition and utility, which may differ from its actual chronological age.
  • Total Economic Life: The estimated period during which a property is expected to be economically productive.

  The formula for calculating depreciation using the age-life method is:

  Depreciation = (Effective Age / Total Economic Life) * Cost New

  Example: A building has a cost new of $500,000, an effective age of 20 years, and a total economic life of 50 years. The depreciation would be:

  Depreciation = (20 / 50) * $500,000 = $200,000

  The remaining value is $300,000.

  Age-life and market extraction methods give estimates of total depreciation that can be used as a basis for extracting the incurable physical deterioration.

• Breakdown Method: This method involves estimating the cost to cure all curable physical deterioration and adding an estimate of the loss in value due to incurable physical deterioration. The age-life method and market extraction methods can be used as a basis for extracting the incurable physical deterioration.

• Market Extraction Method: This method involves analyzing comparable sales to determine the market’s perception of depreciation for similar properties. This is the most reliable method when sufficient market data is available. If you can support the isolated depreciation by extraction from sales, you already know the total depreciation amount, which eliminates the need for interim steps involving age-life calculations. The obvious benefit of using this technique is that you will isolate depreciation in certain improvements and then use those conclusions in later assignments.

  Example: Two identical houses are located next to each other. House A is in excellent condition. House B has a deferred maintenance. House A sold for $400,000 and House B sold for $350,000. Therefore, the market has indicated that the physical depreciation is $50,000.

1.5 Experiment example of physical deterioration:
Take two identical pieces of wood. Treat one piece of wood with a sealant and leave the other piece untreated. Expose both pieces of wood to the same environmental conditions (sun, rain, temperature fluctuations) for a period of six months.
Observe and document the differences in condition between the two pieces of wood. The untreated piece will likely show signs of weathering, such as fading, cracking, and warping, due to the effects of the elements. The sealed piece, on the other hand, will be protected by the sealant and will show less degradation.
This experiment will demonstrate the importance of maintenance in mitigating physical deterioration.

2. Functional Obsolescence

2.1 Definition and Causes

Functional obsolescence is the loss in value resulting from deficiencies or superadequacies within the property itself, making it less desirable or useful compared to current market standards. This can stem from outdated design features, inefficient layouts, inadequate or excessive equipment, or changes in building codes or market preferences. When a property is at odds with the market, it loses value as a result of functional obsolescence. The losses can be classified as deficiencies or superadequacies. Functional obsolescence can be caused by problems like a poor floor plan, a house too large or small for the lot, or an ugly color scheme.

2.2 Types of Functional Obsolescence

• Curable Functional Obsolescence: This type of obsolescence can be economically remedied by alteration or modernization. The cost to cure is less than the resulting increase in the property’s value.

  • Deficiency Requiring an Addition: e.g. A three-story office building lacking an elevator in a market that demands an elevator for a multistory office building.
  • Deficiency Requiring Substitution or Modernization: e.g. A small office building lighted with four-tube, fluorescent 2-by-4-ft. ceiling light fixtures with magnetic ballasts.
  • Superadequacy: e.g. A one-story building that was built as a sit-down restaurant 10 years ago with a 300-gallon, 277-volt electric water heater that was designed for dishwasher use in the restaurant.

• Incurable Functional Obsolescence: This type of obsolescence cannot be economically remedied, either because the physical alteration is impossible or the cost to cure exceeds the resulting increase in the property’s value.

  • Deficiency: e.g. A small retail center that was built on a five-acre site near the center of the acreage. The market and legal requirements for parking only required this site to be three acres.
  • Superadequacy: e.g. A recently completed $175,000 residential property in International Falls, Minnesota, with a new $45,000 in-ground swimming pool where the market in this climatic area will generally not pay anything for an in-ground pool in a home of this price.

2.3 Identifying Functional Obsolescence

Identifying functional obsolescence involves comparing the property’s features and design to current market standards and identifying any elements that detract from its desirability or utility. This often requires market research and interviews with buyers, brokers, or real estate professionals. As stated in the Student Handbook to THE APPRAISAL OF REAL ESTATE, this step can be performed by interviewing typical buyers in the market or by interviewing brokers who work in the market, which is the next best thing. Common examples include:

• Outdated floor plans
• Inadequate closet space
• Insufficient electrical capacity
• Lack of modern amenities (e.g., central air conditioning, energy-efficient windows)
• Excessive or inadequate building size for the lot
• Poor traffic flow

2.4 Quantifying Functional Obsolescence

Quantifying functional obsolescence can be complex, as it often requires estimating the cost to cure or the economic impact of the deficiency or superadequacy. Several methods can be used:

• Cost to Cure Method: This method is used for curable functional obsolescence and involves estimating the cost to remedy the deficiency or superadequacy, less any physical depreciation already charged.
  • Step 1: Estimate the cost of the item.
  • Step 2: Less the depreciation already charged. Usually the appraiser’s estimate of the loss due to physical deterioration.
  • Step 3: Plus the cost to cure or the present value of the loss.
  • Step 4: Less the cost, if curable, or depreciated cost, if incurable, of the proper item if included in new construction.
  • Step 5: Equals the depreciation attributable to functional obsolescence.
• Capitalized Income Loss Method: This method is used when the functional obsolescence results in a loss of income. The loss in income is capitalized to determine the depreciation.
• Paired Data Analysis: This method involves analyzing comparable sales with and without the functional deficiency or superadequacy to determine the market’s perception of the value difference.

2.5 Experiment example of functional obsolescence:
Conduct a survey to gauge consumer preferences regarding floor plans in residential homes. Present participants with different floor plan options, some representing outdated designs (e.g., small, separate rooms) and others representing modern, open-concept designs.
Ask participants to rate the desirability and functionality of each floor plan, and to estimate the price they would be willing to pay for a home with each type of floor plan.
Analyze the survey results to identify any significant differences in preferences and perceived value between the different floor plan options. This experiment will provide insights into the market’s perception of functional obsolescence related to floor plan design.

3. External Obsolescence

3.1 Definition and Causes

External obsolescence is the loss in value resulting from factors outside the property itself. These factors can be economic, social, political, or environmental in nature. External obsolescence is the loss in value due to factors outside the property. These problems can be locational problems, like proximity to railroad tracks, or economic problems, like increases in mortgage interest rates that diminish demand and lower resale prices.

3.2 Types of External Obsolescence

• Economic Obsolescence: This type of obsolescence results from changes in the economic environment, such as increased competition, declining demand, or rising interest rates.
• Locational Obsolescence: This type of obsolescence results from undesirable location characteristics, such as proximity to pollution sources, high-crime areas, or excessive traffic noise.

3.3 Identifying External Obsolescence

Identifying external obsolescence requires an understanding of the surrounding environment and its impact on the property’s value. This may involve:

• Analyzing local economic trends
• Researching crime statistics
• Assessing environmental hazards
• Monitoring zoning regulations
• Considering neighborhood trends

3.4 Quantifying External Obsolescence

Quantifying external obsolescence can be challenging, as it often requires isolating the impact of external factors from other sources of depreciation. Methods include:

• Paired Data Analysis: This method involves analyzing comparable sales located in areas with and without the negative external influence to determine the market’s perception of the value difference. To estimate the loss attributable to external obsolescence, most appraisers use paired data analysis or capitalized income loss. Locational losses are simple to estimate using paired data analysis because sales with and without the locational problems can usually be found.
• Capitalized Income Loss Method: This method is used when the external obsolescence results in a loss of income. The loss in income is capitalized to determine the depreciation. Estimating losses using capitalized rent losses works well for income-producing properties when the typical buyer is an investor, but it does not work at all for houses or owner-occupied commercial properties.

3.5 Experiment example of external obsolescence:
Conduct a comparative analysis of property values in two similar neighborhoods, one located near a major highway and the other located in a quiet, residential area.
Collect data on recent sales prices, property characteristics, and other relevant factors for properties in both neighborhoods.
Compare the sales prices of similar properties in the two neighborhoods, controlling for other factors that may influence value. If there is a statistically significant difference in sales prices between the two neighborhoods, this could be attributed to external obsolescence caused by the proximity to the highway.
This experiment will demonstrate the impact of external factors on property values.

4. Allocation of Depreciation

An important factor in the calculation of external obsolescence is that the loss is usually extracted from the market. The extracted rate includes losses to the land and building, but in the cost approach the loss is only applied to the building. The appraiser must allocate the loss found in the market to the land and building values.

Example: Assume the paired sales analysis shows a loss of $50,000 because of the proximity to a negative influence. If the building represents 80% of the value of the property, it would be appropriate but not necessarily required that the loss of $50,000 be allocated to the building and land at an 80%:20% ratio. Therefore, the loss to the building value would be only $40,000, and it can be assumed that the land value was $10,000.

Conclusion

Accurately identifying and quantifying depreciation is a critical component of the cost approach to value. By understanding the causes, types, and methods for measuring physical deterioration, functional obsolescence, and external obsolescence, appraisers can develop credible and reliable value estimates. While depreciation estimates can be complex, especially when dealing with functional and external obsolescence, a thorough and systematic approach is essential for accurate real estate appraisal.