Depreciation

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Depreciation

• Loss in value from any cause
• Dis-utility
• Difference between contribution to market value
  and cost as though new of the improvements

Wayne Foss, MBA, MAI, CRE Foss Consulting
Group Email wfoss_at_fossconsult.com
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Depreciation

• Cost As If New as of the date of appraisal
• Less Depreciation (from all causes)
• Equals Contribution of Improvements to the Site

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Three Types

• 1. Physical Deterioration - Curable and
  Incurable
• 2. Functional Obsolescence - Curable and
  Incurable
• 3. External Obsolescence - always incurable
• Curable means you can do something about it - and
  it makes economic sense to do it
• Its curable when the cost-to-cure is exceeded by
  value added.
• Whether something is curable is an economic test,
  not physical.

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Underlying Concepts

• Effective age and Economic life rather than
  Actual
• Age and Physical Life are important standards
• Depreciation is a market phenomenon not a
  physical or accounting concept.
• The market decides these amounts we interpret
  what it is saying.

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Underlying Concepts

• Physical Age Chronological Age
• Effective Age is the age indicated by the
  condition and utility of the structure. If
  well-maintained, with good long-lasting appealing
  design, effective age often is less than actual
  age. depends on market standards, quality of care
  and maintenance.

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Underlying Concepts

• Economic Life is the period of time over which
  improvements contribute to property value. This
  is usually shorter than useful life.
• Economic life is influenced by Physical,
  Functional and External considerations.

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Underlying Concepts

• Accrued Depreciation is an economic phenomenon
  applied to the total sum invested in
  improvements.
• It is not the same as accountants book
  depreciation - the prescribed systematic
  write-off of the cost of an asset over time.
• Depreciation in appraising is market related with
  no relationship to the assets original cost or
  book depreciation.

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Underlying Concepts

• Depreciation ultimately comes from the market is
  the difference between cost as if new and worth
  or value.
• Depreciation applies only to the improvements.
• Depreciation is relative to market standards. It
  is not a mechanical process imposed on the
  property.

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DepreciationBasic methods of estimating
depreciation

• Market Extraction
• Age-Life Method
• Modified Age-Life Method
• Breakdown or Engineering Method

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DepreciationMarket Extraction, overall
depreciation
1. For a comparable sale observation First,
find the contribution of the main
improvements for example Sale Price 250,00
0 Less Site Value - 100,000 Less Minor site
Improvements - 5,000 Equals Contribution
of Main Improvements 145,000
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DepreciationMarket Extraction, overall
depreciation
2. Compare the contribution of improvements to
cost as if new Cost as if new,
improvements 200,000 Less Contribution of
improvements - 145,000 Equals Depreciation
Overall 55,000
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DepreciationMarket Extraction, overall
depreciation
Depreciation ? Cost As Though New
Depreciation 55,000 ? 200,000
27.5 Divide by effective age 27.5 ? 15
yrs To get Depreciation per year 1.83 Also,
you can divide into 1.0 (reciprocal) to get
market indication of total economic life expected
by the market. 1.0 ? 1.83 55 years
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DepreciationMarket Extraction, overall
depreciation
Do this for a number of similar
properties Sale Eff. Age Deprec./yr. Life
Exp.. 1 10 2.0 50 yrs 2
12 1.5 67 yrs 3 8 1.7
59 yrs 4 15 2.2 45
yrs Conclusion depreciation for this type of
property is about 2 per year and the markets
expected economic life is about 55 years.
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DepreciationAge-Life method overall depreciation
Concept Effective Age divided by Total Economic
Life equals Depreciation Percentage. Example
consider this building Actual Age 18 years
Effective Age 12 years Remaining Economic Life
is 48 years, so .. Effective Age 12 Remaining
Economic Life 48 Total Economic Life 60
years Overall Depreciation 12 / 60
20 Improvements have 12 years used up out of 60
, or 20
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DepreciationModified Age-Life method overall
depreciation

In the modified method, the physical curable
items, or repairs needed, are deducted
first. Then the effective age and remaining
economic life are considered, as though after the
repairs completed, as before. For example .
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Building 100,000 _at_ 60
6,000,000 Other Improvements 100,000 Total
Cost as though new 6,100,000 Less Physical
Curable - Repairs - 50,000 Subtotal 6
,050,000 Effective age after repairs 10
years Total Economic Life of 50 years Physical
Incurable then 10/50 20
or 1,210,000 Depreciated Cost of
Improvements 4,840,000 Add Site Value
1,500,000 Indicated Value by Cost
Approach 6,340,000
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DepreciationBreakdown method

• Each type of depreciation is handled in sequence
• Physical Deterioration, Curable Incurable
• Functional Obsolescence, Curable Incurable
• External Obsolescence (always incurable allocate
  total to Improvements)

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Depreciation

• 1. Physical Deterioration
• Wear and tear, action of the elements, loss in
  value from aging, wearing out, being used-up.
• Curable - to cost of replacing or fixing the item
  less than the value added to the property.
• Incurable - makes no economic sense to fix or
  replace the item. Can be short or long lived
  items, difference is life of the component.

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DepreciationBreakdown method overall
depreciation

In the breakdown method, the physical curable
items, or repairs needed, are deducted
first. Then the short-lived components are
analyzed and depreciation deducted. Then the
residual remaining to be analyzed is the long
lived components. The effective age and
remaining economic life are considered, as though
after the repairs completed, as before. For
example .
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Building 100,000 _at_ 60
6,000,000 Other Improvements 100,000 Total
Cost as though new 6,100,000 Less Physical
Curable - Repairs - 50,000 Subtotal 6
,050,000 Less Short Lived Components
Component Cost Age Life
Deprec Total Roof 30,000
8 20 40
12,000 Less Long-Lived Components Total Cost
as though new 6,100,000 Less Curable
Items - 50,000 Less Short-Lived
Components - 30,000 Residual
Long Lived Components 6,020,000 Effective age
after repairs 10 years Total Economic Life of
50 years Physical Incurable then 10/50 20
or 1,204,000 Depreciated Cost of
Improvements 4,834,000 Add Site Value
1,500,000 Indicated Value by Cost
Approach 6,334,000
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Depreciation

• 2. Functional Obsolescence
• From inadequacy or super-adequacy (too much or
  too little) of building materials, design, floor
  plan layout, etc.
• May be curable or incurable
• The test of curability is to see if it is
  economically sensible to fix the problem. It is
  curable if the value added exceeds the
  cost-to-cure.

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Procedure for Estimating all forms of Functional
Obsolescence
Step 1 Cost of existing item
xxx,xxx Step 2 Less depreciation previously
charged -xxx,xxx Step 3 Plus Cost to
cure (all costs) or xxx,xxx Value of
the loss Step 4 Less cost if installed new
-xxx,xxx Step 5 Equals depreciation for
functional obsolescence xxx,xxx
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Example Functional Obsolescence - Curable
Example of deficiency requiring an
addition Office building without air
conditioning in a market where that feature is
standard. Current Cost to install
15,000 Cost to install if part of the original
construction 12,000 Contributory value of the
air conditioning 25,000
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Example Functional Obsolescence - Curable
Step 1 Cost of existing item
00 Step 2 Less depreciation previously charged
- 00 Step 3 Plus Cost to cure (all
costs) or 15,000 Value of the
loss Step 4 Less cost if installed new
-12,000 Step 5 Equals depreciation for
functional obsolescence 3,000
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Example Functional Obsolescence - Incurable
Office building with exterior and interior walls
partially constructed with concrete block and
wood frame and stucco. Market does not recognize
superior construction of concrete block with
increased rents, hence the excess cost is
superadequate. Total Square Feet in Building
5,000 Cost of Concrete Block over Wood
framestucco 5.00 sf Total Excess
Cost 25,000
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Example Functional Obsolescence - Incurable
Step 1 Cost of existing item
25,000 Step 2 Less depreciation previously
charged - 5,000 Considered in
Physical Deterioration, long-lived components
20 Step 3 Plus Cost to cure (all costs) or
00 Value of the loss Step 4 Less
cost if installed new - 00 Step 5
Equals depreciation for functional obsolescence
20,000
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Depreciation

• 3. External Obsolescence
• Loss in value of improvements (only) due to
  factors outside property boundaries. Almost
  always incurable because of being beyond the
  owners control.
• Causes
• Physical Externality - example near adverse
  influence
• Economic - example currently in economic
  downturn, building costs above values.

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External Obsolescence
Estimate loss to property overall then allocate
to the building part (land part was considered in
site value estimate). For example a
capitalization rent loss method Income loss due
to bad influence 10,000 per year for a property
with 20 of its value in the site. Capitalization
Rate from the Income Approach is 10. 10,000 /
10 100,000 total Allocation to the
Building 100,000 x 80 80,000
External Obsolescence
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So thats an overview of Depreciation

• Remember
• Its market driven, comes from the market
• Its not like accounting depreciation
• Its applied to cost as though new as of the date
  of appraisal - not original cost

Wayne Foss, MBA, MAI, CRE, Fullerton, CA
USA Phone [phone] Fax [phone]
Email wfoss_at_fossconsult.com