Estimating Depreciation

For valuation purposes, depreciation is de-fined as a loss in value from any cause. Appraisers estimate depreciation in terms of physical depreciation and functional and economic obsolescence. In this sense, depreciation represents the difference in value between the building under appraisal and a new, substitute building.

Depreciation, in the sense used here, refers only to the value estimate. The depreciation allowable for income tax purposes is unrelated to depreciation for- valuation purposes. The depreciation used in the accounting sense or in income tax accounting follows specific legal rules and financial practices unrelated to the market value. For the present purpose, remember that the estimate of cost is not necessarily equal to market value; usually an allowance must be made to reduce the building cost estimate to market value. Hence the depreciation for appraisal purposes rests on a highly subjective opinion and not on mathematical, legal, or financial rules permissible for non appraisal purposes.

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Physical Depreciation. Buildings lose value because of normal wear and tear, the action of the elements, and catastrophic events, such as earthquakes, hurricanes, and. fires. The loss in value from these sources represents physical depreciation. Virtually every building shows some evidence of physical depreciation. Consequently, in valuing a building under the cost approach, the cost is reduced by the estimated amount required to correct the physical deficiency (for example, new exterior painting) or by an allowance to account for the aging of the structure at some average rate of decline per year. The latter is highly subjective: a building with an estimated economic life of 50 years would be depreciated by 20 percent at the end of 10 years (2 percent per year).

Functional Obsolescence. The loss in value from a decrease in functional utility illustrates functional obsolescence. Building utility decreases because of technological improvements, changes in architecture, new materials, and other innovations that make existing buildings obsolete for their original purpose. Although a house may be physically intact and in excellent condition, functional depreciation may be evident in such forms as a poor floor plan, unusually small rooms, an outmoded heating system, lack of insulation, and limited storage space. The appraiser’s familiarity with market preferences and his or her technical knowledge of building features lead to the estimate of functional obsolescence.

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Economic-Obsolescence. A new service station would generally decrease the value of a single-family dwelling on an adjoining lot. The owner of the dwelling cannot modify the house or land to minimize the loss in value from this cause. The example illustrates economic obsolescence: the loss in value from forces external to the property appraised. The point is that not all depreciation is explained by physical and functional causes. A change in the neighborhood, the unavailability of parking, and the encroachment of such nuisances as noise or smells are factors which lower market value, yet cannot be traced to the property under valuation in a condo in manila.

Therefore, after revising the cost estimate and accounting for physical and functional depreciation, experienced appraisers examine the property for losses arising from surrounding environmental factors. For it is quite possible that an undesirable environment will substantially lower the value of a building. In short, economic obsolescence results from factors physically unrelated to the building under appraisal.

To illustrate these concepts refer to the following table which provides examples of depreciation on single-family dwellings. This figure identifies value deficiencies of single-family dwellings. Even if the cost approach is not used, the recognition of depreciation helps in evaluating real estate sales and gross rent multipliers. If the cost technique is used, these deficiencies would lead to depreciation deductions.

Note that physical depreciation is classified into curable forms that may be estimated from the cost required to remedy the deficiency. Such items as the cost of exterior painting and the cost of replacing wall-to-wall carpets or roofing provide a means of estimating the loss in value from new conditions. Physical incurable depreciation concerns losses that are not economically feasible to remedy; yet the examples given indicate that some allowance must be subtracted from replacement or reproduction cost to account for incurable physical depreciation.

Depreciation Illustrated for Single-Family Dwellings

Types of Depreciation Illustrative Examples
Physical
Curable Required exterior painting Wall-to-wall carpets in poor condition

Deteriorated asphalt shake roofing Hardwood floors in need of refinishing

Incurable Normal wear and tear on wood frame

Gradual loss in value due to an aging plumbing system

Normal wear and tear to foundation, walls, and support columns

Functional
Curable Linoleum, kitchen drain board

Old-style bathroom plumbing

Wood hot air stove

Incurable Bedrooms smaller than 10 feet by 10 feet

Awkward floor plan

Obsolete architecture

Economic Encroachment by adjoining incompatible land use

Obnoxious smells, air pollution

Traffic noise

Noise generated by low-flying aircraft

Similarly, the functional depreciation examples listed in the table before suggest that this type of depreciation is commonly encountered among single-family dwellings. Numerous other examples could be used to supplement this brief list. Like incurable physical depreciation, incurable functional depreciation relates to items that would not be subject to cost analysis. It is much easier to capitalize the rental loss resulting from curable functional depreciation. For example, a poor floor plan would lead to an estimated annual rental loss of P500, which capitalized at 10 percent would indicate a P5,000 loss due to incurable functional depreciation. If the cost technique is to be used, such a procedure, though highly subjective, helps refine that approach.

Note also that economic depreciation is not curable. The examples of the table refer to environmental or neighborhood factors that reduce a dwelling’s value. Economic depreciation is not curable since it is difficult to remove these deficiencies by modernization or rehabilitation of the property appraised.

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