11 The Cost Approach—Part II: Depreciation Depreciation is a loss in value from any cause Accrued depreciation is total depreciation due to all causes from time of construction to the effective date of the appraisal

Categories of Depreciation Physical deterioration Caused by wear-and-tear and action of the elements, and usually the most obvious form of depreciation Curable when repairs result in equal or greater increase in overall property value Incurable when repairs are not economical

Categories of Depreciation Functional obsolescence Caused by presence of currently undesirable layout, design, or other features, or absence of currently desirable features Curable if alteration is economical Incurable if alteration is not practical

Categories of Depreciation External obsolescence is also called environmental obsolescence, economic obsolescence, or locational obsolescence It is any loss of value from causes outside the property and is always considered incurable. Examples: Change in land use or natural conditions Change in business environment, such as loss of jobs due to layoffs or closures

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Methods of Computing Depreciation Age-Life Method Also called straight-line method or economic age-life method Based on assumption that depreciation occurs at an even rate throughout the projected life of a structure Normally based on effective age of structure rather than actual age in years

Methods of Computing Depreciation (cont.) Formula for age-life method Total Economic Life Effective Age Accrued Depreciation ÷ =

Methods of Computing Depreciation (cont.) Observed condition method Also known as breakdown method Appraiser estimates loss in value from curable and incurable items: Physical deterioration—curable Physical deterioration—incurable Functional obsolescence—curable Functional obsolescence—incurable External obsolescence—incurable only

Methods of Computing Depreciation (cont.) Capitalized value method Also called rent loss method Appraiser determines loss of income due to depreciation by comparing the income produced by similar properties, and then applying capitalization rate to the loss of income to determine effect on property value

Methods of Computing Depreciation (cont.) Market extraction method Also called market comparison method and sales comparison method Appraiser analyzes comparable sales from which value of depreciated feature can be isolated

Market Extraction Method Land value of comp is subtracted from comp’s sales price to find depreciated value of improvements Depreciated value is subtracted from reproduction cost of improvements to find dollar amount of depreciation Dollar amount of depreciation is divided by age of improvements to find depreciation rate If rate is consistent for comps, appraiser applies that percent of depreciation to reproduction cost of improvements to find dollar amount of depreciation for subject property

Itemizing Accrued Depreciation Part 1 Compute amount of depreciation for items below, then compute loss due to depreciation from home if estimated reproduction cost is $247,000 Item Reproduction Cost Percent Depreciation Amount of Bath fixtures $1,800 75% Carpeting 4,200 50% Furnace 2,800 25% Roof 5,500 90%

Itemizing Accrued Depreciation Part 2 Depreciated value of home is $237,900 ($247,000 - $9,100 accrued depreciation) Item Reproduction Cost Percent Depreciation Amount of Bath fixtures $1,800 75% $1,350 Carpeting 4,200 50% 2,100 Furnace 2,800 25% 700 Roof 5,500 90% 4,950

Usefulness of Cost Approach Reproduction cost tends to set upper limit of a building’s value There can be a significant difference between reproduction cost and market value Estimating current construction cost of an older structure may be difficult Cost approach most useful when valuing buildings for which other approaches are impractical