Depreciation of real estate is often a confusing and misunderstood process. Calculating the depreciation factor(s) of an improved piece of real estate is a key component of a value estimate. It begins by estimating the replacement or reproduction cost of a structure or component. If the building is new there may be no physical depreciation; however, after several years of use, there will be certain items that need to be replaced. This is where depreciation comes in. Who determines the amount of depreciation? What source of data are they using? What qualifies them to be the expert on depreciation? Good questions!
Fundamentally speaking, depreciation is a loss in value due to any cause. It’s the difference between the market value of a structural improvement or piece of equipment, and it’s reproduction or replacement cost as of the date of the valuation. Depreciation is divided into three main groups.
- Physical Depreciation – The loss in value based on physical deterioration.
- Functional Depreciation – A loss in value due to lack of utility or desirability.
- External Depreciation – A loss in value due to forces outside the physical structure including locational or economic obsolesce.
The improvement may experience multiple types of depreciation depending on what is observed during inspection or due to various economic factors. Using the depreciation tables in the Marshall & Swift Valuation Service a simple deprecation example can be calculated in the following manner. Time for math!
Let’s start with a new home purchased in the year 2000 for $500,000 with a land value at that time of $250,000. This means that the home and its improvements were around $250,000. (Land @ $250,000 + home/ improvements @ $250,000 = $500,000).
Let’s say we purchase that home today in 2018, for $800,000. The price has obviously increased by $300,000; however, the home is no longer new. How much of this increase is land value vs cost to build?
According to the Marshall & Swift Valuation Service, construction costs have trended up an average of 3-4% a year over the decades. Let’s say we trend our original cost of $250,000 to build in the year 2000 to today (2018) by 0.04% a year, that would equal a 72% increase between 2000 to 2018 (0.04 x 18 years = 1.72 as a multiplier), this means our cost to build today (2018), is around $430,000.
$800,000 – $430,000 = land value of around $370,000.
$430,000 in 2018 is the cost new to build, however, the home has been used for 18 years. This is where depreciation comes in. Depending on the type of value sought, several depreciation methodologies exist. There are two primary methods of depreciation used in real estate appraisal, straight-line (age/life) and extended life. To gain a better understanding of the methodologies we must look at how each methodology approaches the math.
Straight-line (age/life): Is a widely used accounting-type concept of depreciation, particularly with individual short-lived components. A life expectancy is estimated and a constant annual percentage (equal wear or serviceability each year) is taken for depreciation so that at the end of that life the depreciation equals 100% of the initial cost.
Let’s look at the roof cover of our home as a short-lived item. The original roof cover cost was $10,000 dollars when the home was built in the year 2000 with a life expectancy of 16 years, according to the depreciation charts found in the Marshall & Swift Valuation Service. By taking $10,000 and dividing by 16 years we get $625.00 (the annual dollar amount of depreciation). By taking $625.00 divided by $10,000 we get 0.0625 (the annual percentage of depreciation). At the end of the sixteenth year, the roof is completely depreciated. The downside to this methodology is that it fails to recognize any value in use. Now that we are 18 years into the home, the roof should technically be worth 0% or have $0.00 value, but what if it is still in good shape with no issues? This is where the extended life methodology can be a better option.
Extended Life: (commonly used in residential appraising) Is the process of depreciating a building using an effective age approach. This considers value in use which allows older structures to compete with younger structures based on remodeling, upgrades, maintenance and physical condition.
Let’s look at our 18-year-old home which contains many short and long-lived items. By using the Extended Life method, we can conclude that the entire home has a 60-year life. 60 years with an effective age of 18 equals 16% depreciation from the cost new. Replacing the roof and remodeling the kitchen and baths may lower our overall effective age down to 9-10 years giving us less depreciation. Our 18-year-old home may now be valued as a 9-10-year-old home overall.
The easy way to determine effective age is to determine the remaining life; and then, deduct that from the total life expectancy. For example, if the home looks like it has a remaining life of 50 years, then your effective age is 10 years.
60-year total life
– a 50-year remaining life
= a 10-year effective age.
Determining the purpose and scope of the appraisal assignment will help decide which approach is needed. Knowledge, experience and benchmarking all play a critical role in determining the proper amount of depreciation. Keeping these two methods in mind will help determine which approach works best for the value being sought.
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