Chapter 6: Cost Approach- Depreciation

Short-Lived Maintenance

"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 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.

Physical 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."

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." Simply, depreciation is a loss in value. There are 3 different types of depreciation -Physical deterioration -Functional obsolescence -External obsolescence

Long-Lived Maintenance

"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.

External Obsolescence

"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." IVS Definition: 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. 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.

Market Data Analysis

"Breaking the market down statistically to assess the types of product, consumer and competitor" External obsolescence can be measured by market data analysis. This involves analysis of comparable sales. Example: 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).

Superadequacies

"Caused by a structural component that is too large or of a higher quality than that needed for the highest and best use of the property." 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.

Deferred Maintenance

"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 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 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 ..."

Functional Utility

"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."

Effective Age

"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

"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."

Functional Obsolescence

"The impairment of functional capacity of improvements according to market tastes and standards." IVS Definition: 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." 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.

Actual Age

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

Useful Life

"The period of time over which a structure or a component of a property may reasonably be expected to perform the function for which it was designed."

Economic Life

"The period over which improvements to real estate contribute to property value." 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. -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. -The economic life of motels and gas stations might be measured in terms of 20 or 25 years.

Physical Deterioration

"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.

Ages:

-Actual Age -Effective Age 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.

3 Main Methods of Estimating Depreciation

-Age-life method -Modified age-life -Breakdown method or observed condition

5 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

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

Most Common Cause of Functional Obsolescence

-Layout problems -Outmoded items -Inadequacies, -Superadequacies -Atypical or unusual items.

Different Kinds of Depreciation

1. Physical deterioration 2. Functional obsolescence 3. External obsolescence

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. Subtract immediate expenditures for repairs from cost new estimate, then apply age-life method on remainder

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

Calculation of External Obsolescence

External obsolescence may be estimated by: -Analysis of market data -Capitalization of income loss The 1st method is the most commonly employed in residential appraising. It looks at comparable sales. The 2nd method is most commonly used in the appraisal of income-producing properties.

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. 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

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. 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.

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 / Total Economic Life x Total Costs= Depreciation

Layout Problems

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.

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." 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.

Breakdown Method

Most detailed and comprehensive way to measure depreciation. It breaks down depreciation into its component parts of: -Physical deterioration -Functional obsolescence -External obsolescence Measures each individually

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.

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.

Physical Deterioration

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.

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. 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)