Chapter 6 Cost Approach - Depreciation

Physical life is defined as

"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."

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." We said earlier that external obsolescence can be temporary or permanent. In either case, we still have to deal with it. 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

Curable depreciation

"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."

Effective age is defined as

"The age of property that is based on the amount of observed deterioration and obsolescence it has sustained, which may be different from its chronological age."

Remaining economic life is defined as

"The estimated period over which existing improvements are expected to contribute economically to a property; an estimate of the number of years remaining in the economic life of a structure or structural components as of the effective date of the appraisal; used in the economic age-life method of estimating depreciation." That's pretty easy to calculate, once we make other judgments. If a total economic life is estimated to be 60 years and the current effective age is estimated to be 20 years, then by simple subtraction the remaining economic life is 40 years. (60 - 20 = 40) Remaining economic life can be an important indicator to lenders and other clients. This is the estimated length of time over which the improvements will add something to value over and above the value of the land. A lender doesn't want to lend money on a 30-year mortgage if the appraiser indicates the building only has 20 years left before it becomes worthless. Fannie Mae and Freddie Mac no longer require the appraiser to estimate remaining economic life, but FHA and VA still do. Other clients might desire to have that information supplied as well.

Actual age is defined as

"The number of years that have elapsed since construction of an improvement was completed; also called historical or chronological age."

Useful life is defined as

"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."

Economic life is defined as

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

Modified Age-Life Method

An alternate method is the modified age-life method. Many appraisers feel this is a preferable method when there are substantial items of deferred maintenance in a property. The cost of the deferred items is subtracted first. This would be more reflective of the way a typical purchaser would consider the property. They would modify the costs by fixing the deferred maintenance items right up front. When these deferred items are cured, it may reduce the effective age of the property. If so, then the new effective age is used in the age-life calculation. Example The cost new of the subject property is $235,000, the site value is $70,000 and the effective age is 25. The total economic life is estimated to be 60 years. The subject has deferred maintenance items that total $4,500. After these repairs, the effective age will be reduced to 20 years. $235,000 - $4,500 = $230,500 Remaining Improvement Cost 20 (effective age) / 60 (total economic life) = .333 (percent of depreciation) Cost Approach Remaining Improvement Cost $230,500 Minus Depreciation ($230,500 x .33) - 76,065 Depreciated Cost of Improvements $154,435 Plus Site Value $ 70,000 Value by Cost Approach $224,435 Rounded to $225,000

layout problems, outmoded items, inadequacies, superadequacies, and atypical or unusual items

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. We will cover these items individually on the next several pages, starting here with layout.

Superadequacies

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 gold-plated 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.

Physical Deterioration

As usual, let's begin with the exact definition from The Dictionary of Real Estate Appraisal, Sixth Edition (Appraisal Institute, 2015). Physical deterioration is "The wear and tear that begins when a building is completed and placed into service." Physical deterioration is real and tangible. It is something that you can touch and see. It goes on every day. From the moment a building is constructed 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. Every time rain or snow hits a roof or sand blows against siding, it causes some physical wear and tear. As a building settles over time, nails pop, beams twist as they dry out, and joists sag. It is a never-ending process that is occasioned by forces of nature and human habitation. Some wear and tear is normal and expected in every structure. Some elements of a structure may also encounter abnormal amounts or types of physical deterioration. This may come from defective materials, improper installation, or unexpected occurrences in the physical atmosphere around the property.

Before we look at market data analysis, remember that external obsolescence frequently affects both the land and building components. The current land value reflects the effect of external forces, as does the building value.

Before we look at market data analysis, remember that external obsolescence frequently affects both the land and building components. The current land value reflects the effect of external forces, as does the building value. For example, a property may be found to sustain $10,000 in external obsolescence because of nearby environmental pollution. However, let's assume that 75% of the value is in the improvements and 25% is in the land. Therefore, 25% or $2,500 is attributable to the land. This means that 75%, or $7,500 is attributable to the improvements. The total loss in value ($10,000) should be properly allocated between the two components. When we estimate land value, as part of the cost approach, we should make adjustments in our comparable land sales to reflect the diminished value of the land parcel. In other words, suppose the land would be worth $50,000 under normal circumstances. Because of the nearby pollution, the land value would now be reduced to $47,500. Then, we would only take a reduction of $7,500 against the cost new of the building improvements. If we were not careful, we could mistakenly charge off the entire $10,000 to the building improvements. Then we would be double-counting the $2,500 we should have already taken against the land value.

Deferred Maintenance

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: Broken windows Peeling paint Missing shingles on a roof Inoperable air conditioning system The formal definition of deferred maintenance is: "Items of wear and tear on a property that should be fixed now to protect 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 generally (but not always) relatively inexpensive 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 ..."

Estimating Depreciation

Depreciation analysis should identify all types of depreciation recognized by the market and treat each kind without duplication or double-counting. The three main methods of estimating depreciation are: Age-life method Modified age-life Breakdown method or observed condition Age-life calculations and modified age-life are the primary methods used by real property appraisers. These methods tend to deal with the whole property and are easier to understand. However, the limitations are that they calculate lump-sum depreciation from all causes and do not distinguish between long-lived and short-lived items. The age-life method is further limited in that it assumes a straight line pattern of depreciation. This may not be realistic as depreciation tends to occur less rapidly in the earlier years of a building's life and then accelerates towards the end. The breakdown method is more detailed and identifies and treats each item of depreciation separately. It is more accurate, but is more time-consuming and requires more research, analysis, and data. Therefore, this method is not generally employed by residential appraisers.

Ages

Effective age may differ significantly from actual age. For example, I may know that a house is actually 60 years old, but it has been well maintained. The kitchen is only 10 years old, the roof is only 8 years old, and the mechanical systems have been well maintained and were all replaced in the last 12 years. I might conclude that it is effectively as good as, and has the utility of, a house that is 15 or 20 years old. I might look at another 60-year-old house that has not been kept up and is in a deteriorating neighborhood, and conclude its effective age is 40 or 50 years old. Effective ages can be more than, less than, or the same as actual ages. It is a quick measure of the overall condition, utility, and desirability of a structure.

Market Data Analysis

External obsolescence can be measured by market data analysis. This involves analysis of comparable 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 Obsolescence

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." The IVS Glossary defines external obsolescence 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." Physical deterioration and functional obsolescence both occur within a property. External obsolescence, however, occurs off the site. It is a type of depreciation, or loss in value. 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. As stated in the definition, external obsolescence is almost always incurable. The subject property is fixed in location, and you can't just pick it up and move it to a more favorable location. (While it is theoretically possible to move most building improvements, it is usually not financially feasible to do so.) 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 economic influences in an area. There may be high unemployment or recent factory closings that will exacerbate the situation and make it even worse. There may be an oversupply situation due to job losses or net population migration out of an area. External obsolescence may even be caused by state-wide or national influences. Perhaps people are leaving a state because of unreasonably high taxes. If the national economy is in recession or if interest rates are unusually high, this could also create a loss of value on a broad scale. These kinds of negative influences may be temporary or subject to fluctuation or cyclic influences. A temporary, but real, external cause for a loss of value could be a natural disaster 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.

Calculation of External Obsolescence

External obsolescence may be estimated by: Analysis of market data Capitalization of income loss The first method is the most commonly employed in residential appraising. It looks at comparable sales. We will explore ways of estimating external obsolescence on the next several pages and give examples. The second method is most commonly used in the appraisal of income-producing properties.

Functional Obsolescence

Functional obsolescence is defined as "The impairment of functional capacity of improvements according to market tastes and standards." A similar definition for functional obsolescence comes from the IVS Glossary: "A loss 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." There always is physical deterioration present in a structure, unless it is brand new. Conversely, there may or may not be functional obsolescence present. As a building gets older, 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. However, it is possible for a brand-new structure to have built-in functional obsolescence. For example, it could be constructed up front with a poor floor plan or inadequate storage space. Functional obsolescence means that the building improvements do not "function" as well as they should. Functional obsolescence is sometimes called functional inutility. There is a loss in basic utility that may cause a loss in value. Physical problems are relatively straightforward. Conversely, functional problems can be more nebulous and harder to detect. Functional obsolescence, like beauty, is in the eye of the beholder. A 40-year-old Formica kitchen with dark brown cabinets and yellow countertops may be an anathema to one person, but may be perfectly acceptable to someone else. To try to measure functional obsolescence, we need to get inside the heads of typical purchasers and read their reactions to a particular item. That 40-year-old kitchen may be acceptable in a lower price range but not in a higher price range. Another problem with identifying functional obsolescence lies in the fact that it is subject to change over time. In the definition of replacement cost, it referred to the cost to replace a structure "using modern materials and current standards, design and layout." So we are shooting at a moving target. The tastes and standards of the buying public are subject to change. In 1950 the typical new house had two bedrooms. In 1970, three bedrooms were the norm. In the 1990s, most new home buyers were looking for four bedrooms, or more. Now, three-bedroom houses are making a comeback. In 1930, a bathtub on legs was new and modern. In the 1960s and 1970s, people were dragging those ugly things off to the dump. Today they are desirable and fashionable again. The formal dining room was an important component of housing in the 1950s. By the 1970s, formal dining rooms were being replaced by family rooms. Today, some new houses are being built without living rooms and the "great room" concept is in vogue. Preferences cycle in and out and trends change, 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.

Atypical or Unusual

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 out 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.

Cost Approach Using Age- Life Method

Here is a more lengthy and detailed example of how the age-life method can be used to estimate depreciation in the cost approach. The cost new of the improvements is $245,200, the site value is $60,000, and the effective age is 17. The total economic life expectancy judged by comparable sales is 55 years. 17 / 55 = .309 or 30.9% $245,200 x .309 = $ 75,767 Total cost of the improvements $245,200 Less total depreciation - 75,767 Depreciated cost $169,433 Plus site value + 60,000 Indicated value by the cost approach $229,433 The indicated value should be appropriately rounded. In this case, we would probably round to $230,000.

Short - Lived Items Ages

I imagine you might be thinking, "Well, that's all well and good, but how do I know the expected life of an air conditioning compressor?" A lot of that comes with experience. You may have lived in a house for your entire life (even if you didn't own it), and you know how frequently a built-in dishwasher or a water heater or a furnace needs to be replaced. Also, you can contact people in the trades. Talk with a plumber and ask about the typical lives of water heaters or fixtures. Talk with a roofer or a contractor about the expected lives of different types of roofing materials. You can call an appliance store and ask how long dishwashers or ranges usually last before they need replacing. When applying these age-life ratios we should be utilizing the useful lives of those components‚ not the economic life. In other words, how long can that dishwasher be expected to perform the function for which it was designed (i.e., cleaning dishes)? Another good source is illustrated on the next page. Marshall & Swift has four pages in their Residential Cost Handbook entitled Life Expectancy Guidelines. These pages are located in the Depreciation section of the Handbook. These guidelines are based on years of study of typical items. A sample page appears next.

External Obsolescence - Land and Building

In some cases, external obsolescence can be attributed entirely to the land. In other cases, the loss in value will accrue primarily or entirely in the building improvements. In most cases, the loss of value will be shared by both land and building components. As we shall see later, it is important to separate this diminution in value and allocate it between the two components. When completing a cost approach, we separately estimate the site value. If there are negative influences, or external obsolescence, it will serve to reduce the value of the site. Then after the cost new of the improvements is calculated, we subtract any depreciation from the cost new of those building improvements. We may identify a loss in value from external causes, but we need to use care in applying only that portion of the total loss in value to the cost of the building improvements. Otherwise, we will "double-dip" or apply an incorrect amount of obsolescence by counting again the depreciation already taken off the site value.

In some cases, external obsolescence may be more local or site specific

In some cases, external obsolescence may be more local or site specific. For example, a subject property might be suffering from external obsolescence caused by a single property next door or across the street which has severe physical or environmental problems, such as environmental contamination that has not been remediated. Or perhaps the subject property is the only one that has a particular zoning that prevents it from attaining its potential highest and best use. Or perhaps your subject property is in an area with no zoning or land-use controls, and it now suffers external obsolescence because of a recently constructed industrial property nearby. Your property may be the only one suffering the noise pollution, air pollution, or water pollution. External obsolescence can also be created by inadequate access, unusually heavy traffic, or a remote location too far away from supporting services. There are myriad possibilities.

Age-Life Method

In the age-life method, total depreciation is estimated by calculating the ratio of the effective age of a property to its economic life. This gives a percentage of the life that has been used up. It is perhaps less accurate than other methods, because of the judgments involved, but is easy to apply. Effective age ————————— X total cost = depreciation Total economic life Here's a quick example. Let's assume a 20 year old building that would cost $220,000 to build new today. It is in good condition, and you estimate the effective age to be 15 years. Your estimate of total economic life is 60 years, based on analysis of similar properties. 15 — X $220,000 = $55,000 depreciation 60

Summary of Breakdown Method

In the breakdown method of estimating depreciation we look to identify and quantify all sources of depreciation. We break down the elements into physical, functional, and external causes of loss in value. Physical and functional causes of depreciation may be either curable or incurable. External obsolescence is almost always incurable. We perform mathematical operations to identify precise amounts of depreciation predicated on ages, expected lives, costs to cure and expected additions to value. Then we add them all together. The resulting estimates are only as good as the supporting data on which these estimates are based. Sometimes the necessary data are scarce. It is a detailed and time-consuming operation. The degree of difficulty and resulting amount of accuracy should be balanced by the procedures employed in estimating the reproduction or replacement costs. If the costs are estimated on the simplest method of cost estimation (the comparative unit method), then the depreciation should be measured by the simplest method of estimating depreciation (the age-life method). Conversely, if the costs are calculated in a more detailed fashion, such as unit-in-place or quantity survey, then the breakdown method of estimating depreciation would be more appropriate for use.

Layout

Inadequacies in the layout are often easy to spot. This would include such items as a peculiar 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 scarcity of closet or storage space. Or, perhaps there are six bedrooms but only one bathroom! Layout problems can sometimes be corrected, but often at considerable expense. When a project involves moving or removing walls, raising ceilings, or adding a bedroom or bathroom, the costs may become prohibitive.

Depreciation

Let us begin with the basic definition of depreciation (which we briefly encountered in the previous chapter): "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." So, simply, depreciation is a loss in value. If a property is not worth as much now as it was when it was new, the difference is depreciation. A similar, but more detailed, definition of depreciation is found in the IVS (International Valution Standards) Glossary of The Dictionary of Real Estate Appraisal, Fifth Edition (Appraisal Institute, 2010). This definition is: "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." There are three different kinds of depreciation: Physical deterioration Functional obsolescence External obsolescence

example of short-lived depreciation

Let's look at another example of short-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.

Physical Deterioration examples

Let's start with physical deterioration. Remember these items are real. They are part of the physical structure. It can be divided into three categories: Deferred maintenance Short-lived items Long-lived items Deferred maintenance is considered to be curable. Conversely, depreciation charged to the short-lived and long-lived items is incurable.

Long-Lived Items

Long-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.

Economic Life

Most buildings have an economic life that is shorter than their physical life. Economic factors are always changing and the tastes and standards of the buying public change. This may make a building obsolete and valueless even though it still may be physically sound. The neighborhood around a building may deteriorate and cause it to lose value as a consequence. More buildings are torn down than fall down! This is more apparent in commercial buildings than in residential properties. The typical economic life of a fast-food building might be only 10 or 15 years. Fast food franchises come and go as the public's tastes change. What is hot today can grow very cold tomorrow. Traffic patterns change or the fortunes of a mall wane and ebb. The economic life of motels and gas stations might be measured in terms of 20 or 25 years. Have you stayed lately in a 30-year-old motel? They become outdated rather quickly, even though the building may be physically sound. Sometimes such structures are extensively renovated, and the cost of such renovations are often only slightly less than the cost to build a new structure.

Inadequacies

Sometimes, elements of a structure are simply inadequate. 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 physical 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.

Breakdown Method

The breakdown method is the most detailed and comprehensive way to measure depreciation. It breaks down depreciation into its component parts of physical deterioration, functional obsolescence and external obsolescence and measures each individually. Given enough time, money, and expertise, it might be physically possible to correct any deficiency. But it might not make financial sense to do so. I might have an old, outmoded kitchen in a $60,000 house in a declining neighborhood. I could put in a complete new kitchen for $30,000, but it might add only $5,000 to the property's value. Physically, it could be curable, but economically it would be a disaster. So that is how we judge any kind of depreciation. It might be from physical causes such as a worn-out roof, or from functional causes such as not enough closets or storage. However, the ultimate test is whether it is curable or incurable. It becomes a test of economic feasibility. Would a prudent person make such an investment, or not? If a repair or improvement will add more than its cost - let's do it! If I spend the money and then wind up losing value - who needs it!

deterioration in short-lived items is measured by

The deterioration in short-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

Short-Lived Items

The formal definition of short-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-lived items may still have some life at the time of the appraisal and would not need to be replaced immediately. Examples would include: Roof covering Water heaters Carpeting Furnaces For example, let's say a house is 15 years old and it has its original 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.)

Long-Lived Items Exercise

The house you are appraising has a total cost of $182,844. It is 22 years old and has an estimated remaining economic life of 28 years. The cost to cure deferred maintenance items is $1,290 and they are 100% depreciated. Short lived items of depreciation have been identified; the depreciation is $3,530 and the cost of these items is $12,300. What is the amount of long-lived depreciation attributable to the building? What is the total depreciation? Total Cost $182,844 Minus Deferred maintenance cost - 1,290 Minus Short-lived items cost - 12,300 Cost of Long-lived items $169,254 Total life = 22 + 28 = 50 years Depreciation = 22 / 50 = .44 or 44% Long-lived depreciation = $169,254 x .44 = $74,472 Long-lived Depreciation $74,472 Deferred maintenance cost to cure + 1,290 Short-lived Depreciation + 3,530 Total Depreciation $79,292

Outmoded Items

These are the type of things that readily come to mind when discussing functional obsolescence. This would include the old-fashioned kitchen, old-fashioned bathroom, 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 typical purchasers want the latest and greatest. I'm sure you could make a list of things that are "in" and trendy in construction now. Depending on where you live, it could include such things as: Ten-foot ceilings Media rooms Granite or quartz countertops Bamboo flooring Composite decking Fiber-cement siding Three-car garages Gas fireplaces The problem is knowing where to draw the line, because over-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.

Building Lives

Useful life and physical life are somewhat nebulous and hard to gauge. They are used infrequently by appraisers. Economic life is a key indicator. It implies that building improvements are a wasting asset. Over time, building improvements lose value, and will eventually reach a point where the improvement contributes no value to the land. Land is deemed capable of retaining its intrinsic value. That's not to say that land will never depreciate and lose value. It may, due to specific circumstances in a market or that land may suffer physical damages such as washing away in a storm. However, land will not lose value simply because it is older, whereas buildings will lose value as they age.

Functional Obsolescence definition

We have addressed physical depreciation in the breakdown method of estimating depreciation; now we are going to address functional depreciation. First let's look at the definition of functional utility. That is defined as: "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." That is the desired situation. You have a property that is functioning well and in harmony with its parts and its surroundings. If that is hampered, it results in functional obsolescence. That is defined as: "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. There are five 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

Capitalization of Income Loss

When a property is income-producing, the external obsolescence may be estimated by capitalizing the loss in income attributed to that factor. Here's an example: assume a house that would rent for $1,200 per month in a normal market. In this market that has experienced overbuilding, it can only bring $1,150 per month. The appropriate GRM is 120. $50 (rent loss) x 120 = $6,000 (external obsolescence) We haven't yet covered the income approach in any detail in this course, so don't worry if these numbers seem a little bit confusing (e.g., if you are wondering where do these numbers come from and what do they mean?). We will cover the procedures for developing the income approach later in this course.

Physical Depreciation Procedure

When totaling up the physical depreciation in a structure utilizing the breakdown 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 short-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. For example, 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.