Ch. 6 Cost Approach - Depreciation

Depreciation definition in the ________ Glossary: "i) In the context of asset valuation, depreciation refers to the adjustments made to the cost of reproducing or replacing the asset to reflect physical deterioration and functional (technical) and economic (external) obsolescence in order to estimate the value of the asset in a hypothetical exchange in the market when there is no direct sales evidence available. In financial reporting, depreciation refers to the charge made against income to reflect the systematic allocation of the depreciable amount of an asset over its useful life to the entity. It is specific to the particular entity and its utilization of the asset, and is not necessarily affected by the market. ii) The systematic allocation of the depreciable amount of an asset over its useful life."

IVS

A similar definition for functional obsolescence comes from the ________ Glossary: "A ________ in value within a structure due to changes in tastes, preferences, technical innovations, or market standards. Functional obsolescence includes excess capital costs and excess operating costs."

IVS, loss

_____________ deterioration and __________________ obsolescence both occur within a property. __________________ obsolescence, however, occurs _______ the site.

Physical, functional, within, external, off

__________-lived items may still have ___________ life at the time of the appraisal and would not need to be replaced immediately. Examples would include: ---Roof covering ---Water heaters ---Carpeting ---Furnaces

Short, some

How many kinds of depreciation are there? How many methods of depreciation are there?

Three, Three,

True or False: A building may be obsolete and valueless even though it is still standing and is physically sound.

True

True or False: External obsolescence can be shared between building and land.

True

True or False? Some wear and tear is normal and expected in every structure

True

Physical deterioration is _________ and tangible.

real

In the definition of _____________________ cost, it referred to the cost to replace a structure "using modern materials and current standards, design and layout."

replacement

The ______________________ method is the most ______________ and _________________________ way to measure _____________________. It breaks down depreciation into its ___________________ parts of _______________ deterioration, _________________ obsolescence and __________________ obsolescence and measures each ________________.

breakdown, detailed, comprehensive, depreciation, component, physically, functionally, externally, individually

As a _____________ gets __________, it is more likely to exhibit functional obsolescence. This could be evident in an older kitchen or bath that no longer meets market expectations or tastes.

building, older,

The most common _______________ of functional obsolescence are ____________ problems, _____moded items, ___adequacies, ________adequacies, and __typical or ___usual items.

causes, layout, out, in, super, a, un

Another problem with identifying functional obsolescence lies in the fact that it is subject to ___________ over time.

change

Preferences ____________ in and out and trends ___________, like the length of hemlines on dresses or the width of lapels on suit jackets. What was fashionable today may become out of date or old-fashioned tomorrow.

cycle, change

The formal definition of ___________________ maintenance is: "Items of _________ and ________ on a property that should be ___________ now to ______________ the value or income- producing ability of the property, such as a broken window, a dead tree, a leak in the roof, or a faulty roof that must be completely replaced. These items are almost always curable." Deferred maintenance items are __________________ (but _____ always) relatively ___________________ items and will vary according to the type of building. They are things that a conscientious owner would take care of on a regular basis. They are items that a prudent purchaser would recognize and say "If I were to buy that property, the first thing I would do is fix the ..."

deferred, wear, tear, fixed, protect, generally, not inexpensive

It is a type of _____________________, or loss in _____________. It happens because of some negative influence up the street, around the corner, or somewhere in the neighborhood or market area. It may not even be directly visible from the subject property. It may take some research on your part.

depreciation, value

Remember, physical ___________________ items are ________ and they are part of the _____________ structure. It can be divided into __________ categories: ---Deferred maintenance ---Short-lived items ---Long-lived items ________________ maintenance is considered to be ______________ Conversely, depreciation charged to the _________-lived and _________-lived items is _________________.

deterioration, real, physical, three, deferred curable, short, long, incurable,

The ___________________ in ___________-lived items is measured by an age-life ratio applied to the cost of each item. A 15-year-old boiler with an expected life of 25 years will have experienced depreciation of 15 / 25 or 60%. If the replacement cost of the boiler is $8,000, the amount of short-lived depreciation attributable to the boiler would be: $8,000 x .60 = $4,800

deterioration, short

If a property is not worth as much now as it was when it was new, the ____________________ is depreciation.

difference

For _______________, let's assume a total replacement cost of $200,000. A portion of that is accounted for by the cost of the short-lived items (the roof, furnace, water heater, etc.) and any deferred maintenance. The rest, by default, must be the cost of the long-lived items. It's process of elimination, like the old saying goes, "If it isn't one thing‚ it's got to be the other!" If we identify the total cost new of the short-lived items to be $50,000 (assume no deferred maintenance), then the cost of the long-lived items has to be $150,000 ($200,000 - $50,000). Then, remember that the cost of the long-lived items will be depreciated over the remaining economic life of the whole structure. If we estimate the remaining economic life to be 45 years out of a total of 60 years, then the long-lived items have incurred a total depreciation, at this point in their lives, of 15/60 or 25%. In this example, long-lived depreciation is therefore equal to 0.25 X $150,000, or $37,500.

example

Layout problems can sometimes be corrected, but often at considerable ___________________. When a project involves moving or removing walls, raising ceilings, or adding a bedroom or bathroom, the costs may become prohibitive.

expense

The IVS Glossary defines ________________ _____________________ as: "A loss in value due to factors outside the subject asset. External obsolescence is also called economic, environmental, or locational obsolescence. Examples of external obsolescence are changes in competition or in surrounding land uses like an industrial plant near a residential area. It is deemed incurable as the expense to cure the problem is impractical."

external obsolescence

___________________ obsolescence can be measured by _____________ data analysis. This involves analysis of _______________ sales. Here is an example of how this might be done. The subject property is a house adjoining a busy interstate highway. A vacant lot next door recently sold for $60,000 and a similar lot with the same zoning, in a quiet location, recently sold for $65,000. These two sales indicate there is a premium of $5,000 for less traffic noise. A house along the interstate in the next block recently sold for $340,000, and a similar house away from the interstate sold for $360,000. Thus, the property located along the interstate suffered a $20,000 loss for the location. The external obsolescence attributable to the whole property is $20,000 ($360,000 - $340,000). Pairing the two land sales indicates a loss of $5,000 for the land portion. Therefore, the external obsolescence attributable to the building is $15,000 ($20,000 - $5,000).

external, market, comparable,

There are ___________ types of functional obsolescence: Curable caused by a deficiency requiring an addition Curable caused by a deficiency requiring substitution or modernization Curable caused by a superadequacy Incurable caused by a deficiency Incurable caused by a superadequacy

five

The ___________ dining room was an important component of housing in the 19_____s. By the 19_____s, formal dining rooms were being replaced by ____________ rooms. _____________, some new houses are being built without living rooms and the "___________ __________" concept is in vogue.

formal, 50, 70, family, Today, great room

Functional obsolescence means that the building improvements do not "_____________" as well as they should.

function

___________________ obsolescence: "The impairment of functional capacity of improvements according to market tastes and standards.

functional

_______________________ obsolescence may be curable or incurable depending on whether the cost to cure will result in a value increment that is at least equal to the cost to cure, or not.

functional,

Superadequacies Functional Obsolescence As the word implies, these are things that are more than adequate for their intended purpose. Someone paid more for something than was necessary. They will not be able to recoup the additional expense in the marketplace. An example would be ________-______________ faucets. They might look pretty, but the typical purchaser wouldn't be willing to pay for that extra expense. Good old chrome-plated faucets can turn the water on and off just as well. Another example might be a house with a four-foot thick foundation wall where most people have a one-foot thick foundation wall. Maybe the original owner was concerned about earthquakes or tornadoes and wanted to make sure the house would be secure. Anything above and beyond the normal and typical cost to produce a solid foundation will be irretrievable in the marketplace. We talked earlier about the necessities of adequate insulation. In some northern climates the typical roof insulation today might be R-30. R-40 would be better and would probably give a reasonable return on investment in terms of energy conservation. But if someone were to carry this to an extreme and decided to install R-90 insulation, it would be classified as a superadequacy.

gold-plated

There may be ________ unemployment or recent factory closings that will exacerbate the situation and make it even worse. There may be an _______supply situation due to job losses or net population migration out of an area.

high, over

Functional obsolescence is defined as "The ___________________ of functional capacity of improvements according to market tastes and standards."

impairment

External obsolescence can also be created by ________________ access, unusually heavy traffic, or a remote location too far away from supporting services. There are myriad possibilities.

inadequate

In 19__0, a bathtub on legs was new and modern. In the 19_____s and 19_____s, people were dragging those ugly things off to the dump. _____________ they are _______________ and fashionable again.

3, 60, 70, Today, desirable

Inadequacies Functional Obsolescence Sometimes, elements of a structure are simply _______________ For example, the heating system is not large enough or the insulation is inadequate. Some of these things were installed that way right from the beginning. Perhaps a certain structure should have a furnace with an output of 100,000 BTUs but it was built with a 60,000 BTU unit. Sometimes inadequacies occur when standards change. A house that was built in the 1950s was insulated minimally but met the standards that were in effect at the time. After the oil crisis of 1973, insulation standards increased sharply. The 20-year-old house, at that point, was woefully inadequate in terms of insulation and energy efficiency. Think of the changes that have occurred in window design and construction in northern climates over the last 30 years. Single-pane glass became functionally obsolete and dual-pane glass was expected. Then we had the advent of triple-pane glass, Argon-filled glass and low-E glass with insulated framework. Inadequacies are really based in the ____________ components of the structure, but the measure is whether or not that component is lacking in functional utility according to today's tastes and standards of the buying public.

inadequate, physical

Functional obsolescence is sometimes called functional ______________. There is a loss in basic __________ that may cause a loss in ___________,

inutility, utility, value

Outmoded Items Functional Obsolescence These are the type of things that readily come to mind when discussing functional obsolescence. This would include the old-fashioned ______________, old-fashioned __________________, etc. We said earlier that certain things go out of fashion just because there's something newer in the public consciousness. It doesn't necessarily mean that an item is no longer useful and has lost all its utility; it's just that _______________ purchasers want the _____________ and greatest. Depending on where you live, these things could be: ----Ten-foot ceilings ----Media rooms ----Granite or quartz countertops ----Bamboo flooring ----Composite decking ----Fiber-cement siding ----Three-car garages ----Gas fireplaces

kitchen, bathroom, typical, latest

We will also define and discuss other _________________ of _________________________ such as: Actual age Effective age Economic life Useful life Physical life Remaining economic life

measures, depreciation

Then we will address three ________________ of estimating depreciation: Age-life method Modified age-life method Breakdown method

methods

From the _________________ a building is ____________________ to its very end, things wear out physically. Every time someone walks on the floor or runs their hand along the wall, it wears away some of the finish.

moment, constructed,

Physical deterioration is a ____________-ending process that is occasioned by forces of ______________ and ______________ habitation

never, nature, human,

For example, let's say a house is 15 years old and it has its ________________ furnace, which has been maintained properly and is currently working. The useful life of a furnace might be 20 years. The existing furnace is not completely worn out, but it will likely need to be replaced within the next several years. At this time, it is 75% depreciated (15/20) however it would not make economic sense to replace it right now and throw away the 5 years or so that remain of its life. This is an example of an item of short-lived physical depreciation. Think of all the things that die out in a house between the first 15 and 20 years or so. Depending on the materials, a roof covering might have an expected life of 15 to 30 years. (Although some roof coverings, such as slate or metal, might have an indefinite life.)

original

In 19_____ the typical new house had ______ bedrooms. In 19____, ___________ bedrooms were the norm. In the 19_____s, most new home buyers were looking for _________ bedrooms, or more. ________, three-bedroom houses are making a _______________.

50, two 70, three 90, four Now, comeback

External obsolescence can be A) marketwide B) based on an outdated finish item C) the result of a layout deficiency D) the result of a construction defect

A) marketwide

Another reason that functional obsolescence is hard to get a handle on is that it may occur in various forms. The most common causes of functional obsolescence are layout problems, outmoded items, inadequacies, superadequacies, and atypical or unusual items.

Another, hard, various forms

__________________ will lose value over time just because of age. A) Land B) Buildings C) Both land and buildings D) Land, buildings, and chattel items

B) Buildings

Deferred maintenance applies to items that are in need of immediate repair. These are items that should have been taken care of in the normal course of maintenance. Deferred maintenance is measured by the cost to cure. Examples would include: ---_____________ windows ---_____________ paint ---_____________ shingles on a roof ---_______________ air conditioning system

Broken, peeling, missing, inoperable

Which type of depreciation is generally considered to be incurable? A) physical deterioration B) functional obsolescence C) external obsolescence D) all of these

C) external obsolescence

"The impairment of functional capacity of improvements according to market tastes and standards" is the definition of A) depreciation B) physical deterioration C) functional obsolescence D) external obsolescence

C) functional obsolescence

A new building is expected to remain standing for 80 years. This period is the building's ____________ life. A) useful B) maximum C) physical D) effective

C) physical

___________________ ________________________: "Items of physical deterioration or functional obsolescence that are economically feasible to cure. Curing an item of depreciation is economically feasible if the cost to cure is equal to or less than the anticipated increase in the value of the property that would result after curing the depreciation."

Curable Depreciation

A building has an effective age of 18 and a total economic life of 60 years. It cost $520,000 new and its site value is $125,000. What is the indicated percentage of age-life depreciation? A) 15% B) 18% C) 25% D) 30%

D) 30%

Physical deterioration is best described as A) factors outside a property that diminish its value B) always incurable C) outmoded items D) wear and tear

D) wear and tear

Physical deterioration, Functional obsolescence, External obsolescence are known as the three basic kinds of ____________________________

Depreciation

________________________________: "1. In appraisal, a loss in property value from any cause; the difference between the cost of an improvement on the effective date of the appraisal and the market value of the improvement on the same date. See also external obsolescence; functional obsolescence; physical deterioration. 2. In accounting, an allocation of the original cost of an asset, amortizing the cost over the asset's life; calculated using a variety of standard techniques."

Depreciation

_______________ life: "The period over which improvements to real estate contribute to property value."

Economic

__________________ life is a ______ indicator. It implies that building improvements are a _____________ asset. Over time, building improvements lose ___________, and will eventually reach a point where the improvement contributes _____ value to the __________. Land is _______________ capable of retaining its ______________ value. Land may suffer physical damages such as washing away in a storm.

Economic, key, wasting, value, no, land, deemed, intrinsic,

___________ time rain or snow hits a roof or sand blows against siding, it causes some physical wear and tear. As a building ______________ over time, nails pop, beams twist as they dry out, and joists sag.

Every, settles

__________________ obsolescence is defined as: "A type of depreciation; a diminution in value caused by negative external influences and generally incurable on the part of the owner, landlord, or tenant. The external influence may be either temporary or permanent."

External

___________________ obsolescence can be caused by a number of factors, including: ---High unemployment ---Building moratoriums ---Recessions ---Traffic noise ---Road ---Rail line or airport ---Location near hazardous influences ---Air or water pollution, smog or odor ---Toxic wastes ---Abandoned landfills ---High tension power lines ---Above or below ground high pressure gas lines ---Unsightly views ---Abandoned or boarded up buildings nearby ---High crime rate or unsafe living conditions ---Poor access

External

_____________________ obsolescence is defined as: "A type of depreciation; a diminution in value caused by negative external influences and generally incurable on the part of the owner, landlord, or tenant. The external influence may be either temporary or permanent."

External

_________________ obsolescence is often market-wide and may impact all properties in a market area equally. An example of this might be a loss in value created by adverse __________________ influences in an area.

External, economic

__________________ obsolescence may be _______________ by: ---_____________ of ______________ data ---______________________ of income ________ The _________ method (analysis of market data) is the most commonly employed in __________________ appraising. It looks at ____________________ sales. The ______________ method (capitalization of income loss) is most commonly used in the appraisal of income-___________________ properties.

External, estimated, analysis, market, capitalization, loss, first, residential, comparable second, producing,

Example of __________________ Obsolescence would be: Your property may be the ________ one suffering the noise pollution, air pollution, or water pollution.

External, only,

Atypical or Unusual Functional Obsolescence Functional obsolescence may also be caused by any item that strays far enough from the norm. An item may be, in the abstract, relatively typical and normal on its own. However, when placed in another setting it may become atypical and unusual enough to cause a loss in value. A bright pink contemporary-style house may be right at home in South Beach in Miami, but jarringly ______ of place in a neighborhood of traditional colonial homes on a quiet street in New England. A new log house might work on a wooded lot in a rural area, but would probably not be appreciated on a 40-foot lot in an urban location. As another example, functional obsolescence could be the result of constructing an in-ground swimming pool in northern Maine. The pool, by itself, has intrinsic value but in that market with the short swimming season it becomes superfluous. The value added, if any, would typically be less than its cost. The difference between cost and contributory value would be attributable to functional obsolescence. For example, if the pool cost $30,000 to construct and it only adds $5,000 to property value, then the $25,000 difference between the cost of the pool and its contributing value is functional obsolescence. The market might decide that the swimming pool actually creates a loss in value in that situation due to the diminished utility and the expense of maintenance and upkeep, plus the increased liability that stems from the presence of a pool. Conversely, that same pool in Southern California or Arizona could theoretically add more in value than its initial cost.

out

Outmoded Items Functional Obsolescence The problem is knowing where to draw the line, because _________-improving a home can also result in functional obsolescence. A typical purchaser might say (or think), "It's a nice house. I like it. But if I were going to buy it, the first thing I would do would be to rip out that entire kitchen and put in a new one. Therefore, I'm going to offer $20,000 less." That would demonstrate functional obsolescence and should dictate a deduction from cost new in the cost approach, and a corresponding adjustment for functional obsolescence in the sales comparison approach.

over

It is ________________ for a brand-new structure to have built-in functional obsolescence. A brand-new structure could be constructed up front with a __________ floor plan or _______________ storage space.

possible, poor, inadequate

The formal definition of __________-lived items states the following: "1. A building component with an expected remaining economic life that is shorter than the remaining economic life of the entire structure. 2. An item that will probably be replaced one or more times during the life of the improvements, such as painting or flooring."

short

Let's look at another example of ________-lived depreciation, and we will work with some numbers. A roof on a house has an expected life of 20 years. If the economic life of the house is 60 years, the roof might have to be replaced three or more times during the life span of the houses. So the roof covering would be a short-lived item. Now suppose we were appraising that house when it was 15 years old. We might estimate the cost to replace the roof at $4,000. That roof has lost a lot of its life, but there might be 5 years left in it. There is no need to replace it now, because we would just be throwing away money. However, in the cost approach, we will have to measure its loss of utility and subtract that amount. Fifteen out of 20 years means it has lost .75 or 75% of its value. However, it still retains 25% of its original value. $4,000 x .75 = $3,000 depreciation. The roof still has a remaining value of $1,000, but the short-lived depreciation charged to the roof is $3,000.

short,

External obsolescence may even be caused by _________-wide or ________________ influences. Perhaps people are leaving a state because of unreasonably high taxes. If the national economy is in _____________ or if interest rates are unusually ___________, this could also create a ______ of value on a broad scale.

state, national, recession, high, loss,

The _______________ property is _________ in location, and you can't just pick it up and move it to a more favorable location.

subject, fixed

These kinds of negative influences may be _______________ or subject to fluctuation or _______________ influences. A temporary, but real, external cause for a loss of value could be a natural ________________ such as a hurricane or tornado. External obsolescence can also be caused by a confluence of various negative features as a market area or neighborhood ages. Buyers may be drawn to newer, more desirable, competing neighborhoods or retail centers.

temporary, cyclic, disaster

In this chapter we will examine the _____________ basic _______ of depreciation: Physical deterioration Functional obsolescence External obsolescence

three, kinds

Layout ______________________ in the layout are often easy to spot. This would include such items as a ______________ floor plan. ----Perhaps there are not enough hallways, or too many hallways, or the hallways are not wide enough. ----Maybe you have to go through one bedroom to reach another. ----Perhaps a bathroom opens directly off the living room. ....These would all be examples of inutility or functional problems in the layout. Layout problems could also include a _______________ of closet or storage space. Or, perhaps there are six bedrooms but only one bathroom!

Inadequacies, peculiar, scarcity,

When ________________ up the _______________ depreciation in a structure utilizing the _________________ method, we first address any deferred maintenance items. There may be none identified. If deferred maintenance items are identified, we subtract the cost to cure these items. They need to be addressed. If there is some trim painting that needs to be done that will cost $250, then that is the cost to cure, and that is the amount of depreciation charged. Next, we identify any depreciation attributable to ________-lived items. Unless the building is new or just completely renovated, there will be some short-lived depreciation. Then we subtract the amount of deferred maintenance and the cost (not the depreciation) allocated to the short-lived items from the reproduction or replacement cost new. That's the way we identify the portion of the cost that is allocated to the long-lived items. The short-lived depreciation is then calculated based on the cost allocated to the short-lived items and the long-lived depreciation is calculated based on the cost allocated to the long-lived items.

totaling, physical, breakdown, short

However, the _________________ test is whether it is ____________ or __________________. It becomes a test of economic _________________. Would a prudent person make such an investment, or not? If a repair or improvement will ________ more than its cost - let's _____ it! If I spend the money and then wind up ____________ value - who needs it!

ultimate, curable, incurable, feasibility, add, do, losing,

Physical deterioration is "The _________ and _________ that begins when a building is completed and placed into service."

wear, tear

___________-lived items are defined this way: "A building component or site improvement expected to have the same useful life as the entire structure." These items are only replaced under extraordinary circumstances. Examples would include: ---Framing ---Foundation ---Insulation ---Underground pipes Long-lived items are often referred to as part of the "bone structure" of the building. They may be wearing out, but you typically don't jack up the house and replace the foundation, unless it has sustained severe damage due to an unusual event (e.g., a flood). When we depreciate these items, we depreciate them over the entire length of the expected economic life of the building, because we expect them to last that long.

Long,

_____________________ ____________________________: "The wear and tear that begins when a building is completed and placed into service."

Physical Deterioration

______________ life: "1. An estimate of how old a building or improvement will be when it is worn out. 2. The total period a building lasts or is expected to last as opposed to its economic life."

Physical,

_______________ problems are relatively _________________forward. Conversely, __________________ problems can be more nebulous and ____________ to detect.

Physical, straight, functional, harder

True or False: Functional obsolescence may be present in a brand-new structure. For example, it could be constructed up front with a poor floor plan or inadequate storage space.

True

True or False? Deferred maintenance is measured by the cost to cure.

True

True or False? External obsolescence can be temporary or permanent

True

True or False? External obsolescence is almost always incurable.

True

True or False? External obsolescence may be more local or site specific

True

True or False? The tastes and standards of the buying public are subject to change.

True

True or False? There always is physical deterioration present in a structure.

True

True or False? depreciation is a loss in value.

True

_____________ 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."

Useful

____________ life and _____________ life are somewhat nebulous and hard to ____________. They are used infrequently by appraisers.

Useful, physical, gauge,

Functional ____________: "The ability of a property or building to be useful and to perform the function for which it is intended according to current market tastes and standards; the efficiency of a building's use in terms of architectural style, design and layout, traffic patterns, and the size and type of rooms."

Utility

Some elements of a structure may also encounter __________________ amounts or types of physical deterioration. This may come from defective materials, improper installation, or unexpected occurrences in the physical atmosphere around the property.

abnormal

An ___________________ method is the _________________ age-life method. Many appraisers feel this is a _________________ method when there are substantial items of deferred maintenance in a property. The ________ of the _________________ items is __________________ first. This would be more reflective of the way a typical purchaser would consider the property. They would _____________ the costs by ___________ the deferred maintenance items right up front.

alternate, modified, preferable, cost, deferred, subtracted, modify, fixing