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@fossconsult.com

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

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.

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.

Depreciation:
Basic methods of estimating depreciation

Market Extraction

Age-Life Method

Modified Age-Life Method

Breakdown or Engineering Method

Depreciation
Market Extraction, overall depreciation
1. For a comparable sale observation:
First, find the contribution of the main improvements

for example:
Sale Price:

$250,000

Less Site Value:

- 100,000

Less Minor site Improvements:

Equals: Contribution of Main Improvements:

$145,000

5,000

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Depreciation
Market 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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Depreciation
Market Extraction, overall depreciation
$ Depreciation Cost As Though New = Depreciation %
$ 55,000 $200,000 = 27.5%

Divide by effective age:

To get Depreciation per year:

27.5% 15 yrs
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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Depreciation
Market Extraction, overall depreciation
Do this for a number of similar properties:
Sale
1
2
3
4

Eff. Age
10
12
8
15

Deprec.%/yr.
2.0%
1.5%
1.7%
2.2%

Life Exp..
50 yrs
67 yrs
59 yrs
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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Depreciation
Age-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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Depreciation
Modified 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 @ $60 = $ 6,000,000

Other Improvements:

100,000

Total Cost as though new:

$6,100,000

Less Physical Curable - Repairs:

Subtotal:

$6,050,000

50,000

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:
Add Site Value:
Indicated Value by Cost Approach:

$4,840,000
1,500,000
$6,340,000
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Depreciation
Breakdown 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 usedup.
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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Depreciation
Breakdown 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 @ $60 = $ 6,000,000

Other Improvements:

100,000

Total Cost as though new:

Less Physical Curable - Repairs:
Subtotal:

$6,100,000
50,000
$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:

Indicated Value by Cost Approach:

1,500,000
$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 frame&stucco: $ 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

-$

00

Value of the loss

Step 4: Less cost if installed new

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: (714) 871-3585 Fax: (714) 871-8123
Email: wfoss@fossconsult.com

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