DEPRECIATION

DEPRECIATION

In connection with the appraisal of real property, depreciation is defined as “loss in value from any cause.” It is
customarily measured by estimating the difference between the current replacement or reproduction cost new
and the estimated value of the property as of the date the property was appraised.

Contrasting with depreciation is appreciation of value from inflation or special supply and demand forces
relating to the specific property. Appreciation may reduce or offset entirely a normally anticipated decrease of
value due to depreciation.

Depreciation includes all of the influences that reduce the value of a property below its cost new. The principal
influences are often grouped under three general headings and subdivided as follows:

1. Physical deterioration resulting from:

a. Wear and tear from use;

b. Negligent care (sometimes termed “deferred maintenance”);

c. Damage by dry rot, termites, etc.; or

d. Severe changes in temperature.

2. Functional obsolescence resulting from:

a. Poor architectural design and style;

b. Lack of modern facilities;

c. Out-of-date equipment;

d. Changes in styles of construction;

e. Construction methods and materials obsolete by current standards;

f. Changes in utility demand such as desire for master bath or more garage space; or

g. Superadequacies in improvements, such as pools or excessive room additions, where the actual cost is
more than the market is willing to pay for those improvements.

3. External obsolescence resulting from adverse environmental and economic influences outside the property
itself, such as:

a. Misplacement of improvement (not typical for neighborhood);

b. Zoning and/or legislative restrictions;

c. Detrimental influence of supply and demand;

d. Change of locational demand; or

e. Proximity to undesirable influences such as highly trafficked streets, freeways, airport flight patterns,
toxic waste sites, or high tension power lines.

The first two categories of accrued depreciation are considered to be inherent within the property and may be
curable or incurable. The third category is caused by factors external to the property and is almost always
incurable.

Appraisal and Income Tax Views - “Book” vs. Actual Depreciation

It is important to understand that “depreciation” is a word with two meanings: one for the appraiser and another
for the owner concerned with tax position.

Book depreciation. Depreciation, for the owner’s income tax position, is “book” depreciation, a mathematical
calculation of steady depreciation from owner’s original purchase price or cost basis. This “book” depreciation
allows the owner to recover the cost of the investment over the “useful life” of the improvement. It accrues
annually and is an income tax deduction. In this sense, the owner’s accountant sees depreciation as a deduction
from gross income.

Frequently, “book” depreciation results in negative gross income, at least on paper. The building seems to be
losing value faster than the income replaces it. This gives the owner a “paper loss” that can be offset against
other income. This “paper loss” or “tax shelter” is a motivating factor for purchase or exchange of many income
properties.

“Book” depreciation is:

1. an allowable deduction from cost for accounting or income tax purposes;

2. determined by owner’s policy and to meet IRS requirements; and

3. deducted from owner’s original (historic) cost.

“Book value” is the current value for accounting purposes of an asset expressed as original cost plus capital
additions minus accumulated depreciation, based on the method used for the computation of depreciation over
the useful life of the asset for income tax purposes. Depreciation is allowed on improvements only, not land.

The book value of the property may be ascertained at any given time by adding the depreciated value of the
improvement to the allocated value of the land.

Actual depreciation. The “book” depreciation from owner’s original cost is not the depreciation normally
considered by the appraiser. The appraiser looks not to owner’s original cost, but cost new on date of value.
From this current cost new, the appraiser deducts the estimate of accrued actual (not book) depreciation.
Depreciation (loss in value) is estimated only for improvements.

Actual depreciation used by appraisers is:

1. loss in value;

2. determined by market data, observed condition, etc.; and

3. deducted from current reconstruction cost new.

Because accountants and appraisers select rates of depreciation for different purposes, accruals for book and
actual depreciation vary considerably. While both estimators may use the same period as to the remaining
economic life of the property and may also use the same method, additional considerations may affect the
resultant rate. Whereas the accountant may be restricted because of accounting conventions, the appraiser is
under no such restrictions.

The real estate agent who is determining values should understand the necessity for following proper appraisal
procedures and should not rely on book values either to estimate accrued depreciation or for future depreciation
accruals.

Methods of Calculating Accrued Depreciation

Accrued depreciation is depreciation which has already occurred up to the date of value. Remainder
depreciation is depreciation which will occur in the future. Accrued depreciation may be classified either as
curable or incurable. The measure between curable and incurable is economic feasibility. It is possible to
physically restore or cure most depreciation such as by expensive restoration of old homes. However, in most
circumstances, cure of deficiencies is measured by the economic gain (increased rents) compared with the cost
of the cure. Three methods of estimating accrued depreciation are discussed next.

Straight line or age-life method is depreciation which occurs annually, proportional to the improvement’s total
estimated life.

For example, an improvement with an estimated total life of 50 years would be said to depreciate at an equal
rate of 2 percent per year. (2 percent x 50 years equals 100 percent depreciation.)

The effective age of the building is generally used instead of the actual age. Effective age is the age of a similar
and typical improvement of equal usefulness, condition and future life expectancy. For example, if a building is
actually 25 years of age but is as well maintained and would sell for as much as adjoining 20-year-old
properties, it would be said to have an effective age of 20 years.

The straight line method is: easy to calculate; used by the Internal Revenue Service; and easily understood by
the lay person.

However, in actuality, buildings do not depreciate in a straight line at a stated percentage each year, but will
vary according to maintenance and demand for the type of structure.

The cost-to-cure or observed condition method (breakdown method) involves:

1. Observing deficiencies within and without the structure and calculating their costs to cure. The cost to cure
is the amount of accrued depreciation which has taken place.

2. Computing an amount for physical deterioration or deferred maintenance for needed repairs and
replacements.

3. Determining and assigning a dollar value to functional obsolescence due to outmoded plumbing fixtures,
lighting fixtures, kitchen equipment, etc.

4. Measuring functional obsolescence which cannot economically be cured (e.g., poor room arrangements and
outdated construction materials) and calculating the loss in rental value due to this condition.

5. Calculating external obsolescence (i.e., caused by conditions outside the property) and determining the loss
of rental value of the property as compared with a similar property in an economically stable neighborhood.
The capitalized rental loss is distributed between the land and the building.

This is the most refined method of examining complex causes and cures of depreciation. However, it can be
difficult to calculate minor or obscure depreciation accurately. Also, measurement by rental loss is sometimes
difficult to substantiate.

A combination of the straight line and cost-to-cure methods may be used to:

• determine the normal depreciation as if the property is not suffering from undue depreciation; and,

• add any excess deterioration and obsolescence.

Reproduction or replacement cost method. The subject property is improved with a duplex, two detached
garages, a covered porch for each unit and common driveway and walk.

Measurements and current cost replacement figures for the improvements are as follows:

Each unit of duplex is 25’ x 35’ @ $55.00 per sq. ft.

Each detached garage is 21’ x 25’ @ $20.00 per sq. ft.

Each covered porch is 6’ x 10’ @ $14.00 per sq. ft.

Driveway is 20’ x 100’ @ $2.40 per sq. ft.

Walk is 3’ x 40’ @ $2.40 per sq. ft.

The improvements are now 12 years old and it is determined that such improvements have a remaining
economic life of 38 years. The current lot value, by comparison, is $45,000.00. Depreciation computations are
based on the use of the straight line method.

What is the replacement cost new and the present value of this property?

Each duplex unit (25’ x 35’ x $55.00) x 2 ................... $96,250.00

Each detached garage (21’ x 25’ x $20.00) x 2 ................ 21,000.00

Each covered porch (6’ x 10’ x $14.00) x 2 .................... 1,680.00

Driveway (20’ x 100’ x $2.40) ................................. 4,800.00

Walk 3’ x 40’ x $2.40 ........................................... 288.00

Improvements – Total Replacement Cost New............... 124,018.00

Depreciation:

12 yrs. + 38 yrs. = 50 yrs. life of improvements when new

100 ÷ 50 = 2 percent annual depreciation rate, or recapture rate.

12 yrs. x 2 percent = 24 percent total depreciation to date.

124,018 x 24 percent = Total depreciation in value to date..... 29,764.00

Total value of improvements less depreciation ................ $94,254.00

Plus site value................................................ 45,000.00

Total Current Value by Replacement Cost Approach ....... $139,254.00

Market data method (more commonly known to appraisers as “abstraction.”). A comparative method is
sometimes used in residential appraisals where the property being appraised can be compared with market data
of buildings of similar type and condition.

1. From the sales price of a comparable residential property, deduct an estimate of land value.

2. From the resulting total comparable improvement value, deduct the estimated contributory value of
secondary improvements and landscaping.

3. The result is the value of the comparable main residence at its total depreciated value in place.

4. Divide this main residence value by the residence square footage. This yields depreciated unit value.

5. By multiplying the appraised building square footage by the unit value of the comparable residence, the
total indicated depreciated value is found for the appraised residence.

Sales price of comparable property .................... $180,000

Less estimated land value .......................... - 55,000

Improvement Value ...................................... 125,000

Less estimated value of secondary improvements
and landscaping ................................... - 23,000

Value of comparable residence .......................... 102,000

Divide by area of comparable residence ............. ÷ 2,900 sq.ft.

Depreciated unit value of comparable residence ... $35.17/sq.ft.

Multiply by size of appraised residence ............ x 2,850 sq.ft.

Indicated depreciated value in place of appraised
residence ............................................. $100,234

Advantage of the Market Data Method: This method can be an accurate measure of depreciation from the
market.

Disadvantage of the method: It is difficult to obtain truly comparable market data and difficult to accurately
estimate land value and secondary improvement value for deductions for main residence value indication.

Age-life method using effective age. A house has an actual physical age of 25 years with an overall useful life
of 50 years, thus depreciating at the rate of 2 percent a year. It is the opinion of the appraiser that the subject

house is of the same condition and utility as similar houses that are only 20 years of age. Therefore, the house
has been assigned an effective age of 20 years.

The accrued depreciation would thus be 20 years times 2 percent or 40 percent.

Calculated cost new ............................................... $120,000

Accrued depreciation (40 percent x $120,000) ........................ 48,000

Depreciated value of improvement..................................... 72,000

Plus land value ..................................................... 50,000

Indicated value by cost approach................................... $122,000

Measuring physical deterioration. A store building has a remaining useful life of 30 years and an effective
age of 20 years. Present reproduction cost for the structure is $230,000. The roof is 75% deteriorated. A new
roof will cost $10,000. The air conditioning and heating systems are 40% depreciated. Their installed cost new
is $8,000. What is the total amount of physical deterioration?

The building, under the straight-line or age-life method, is 40% depreciated (100% ÷ 50 = 2% x 20 years
effective age = 40%). This 40% depreciation to the building is to be applied to the amount of the building’s
reproduction cost less the depreciation already taken on the other components.

Depreciation to roof (.75 x $10,000) ................................ $7,500

Depreciation to air conditioning and heater (.40 x $8,000)........... $3,200

Depreciation to rest of building (.40 x $212,000) .................. $84,800

Total physical deterioration ....................................... $95,500

Income approach - future depreciation. Future depreciation is loss in value which has not yet occurred but
will come in the future and is of significance in the capitalization of income method, which will be discussed
next. In the income approach to valuation, depreciation is based on the remaining economic or useful life,
during which time provision is made for the recapture of the value of improvements. It is the return “of” the
investment, as differentiated from the return (interest and profits) “on” the invested capital. Under the income
approach, this depreciation is usually measured by one of two methods: straight-line or sinking fund.

In straight-line depreciation, a definite sum is deducted from the income each year during the total estimated
economic life of a building to replace the capital investment. If the appraiser estimates that a building will have
a remaining life of 25 years, this method provides that 1/25 or 4 percent of the building’s value be returned
annually as a deduction from net income.

The sinking fund method also includes a fixed annual depreciation deduction from income, but with yearly
reserves from such funds deposited into a sinking fund which, with possible compound interest, may offset the
depreciated value of the structure and be collectible at the end of the building’s useful life. Accruals for future
depreciation to replace the capital investment are in addition to and essentially different from both maintenance
charges and reserves for periodic replacement of curable depreciation.

Should there be any estimated salvage value to the improvement at the end of its economic life, this amount
need not be returned through the annual depreciation charge under either the straight-line or the sinking-fund
method.

INCOME (CAPITALIZATION) APPROACH

The Income Approach is concerned with the present worth of future benefits (the income stream) which may be
derived from a property. This method is important in the valuation of income-producing property. An important
consideration in this approach is the net income which a fully informed person using competent management
can expect to receive. An alternative, using gross income and gross income multipliers is explained later in this
chapter.

The process of calculating the present worth of a property on the basis of its capacity to produce an income
stream is called capitalization. The Income Approach is based primarily on the appraisal principle of
anticipation.

Appraiser’s and Owner’s Viewpoints

A real estate professional will understand that there are several differences in the owner’s and appraiser’s
viewpoints on income property.

An owner purchases income property as an investment, based on personal desires and tax position. The owner
frequently views the investment as equity in a financed property. “Equity” is the owner’s down payment or the
difference between the loan amount and the value or price of the property. The owner calculates the payments
on the loan as an expense of owning the property, and deducts from income tax the interest paid on the loan and
the “book” depreciation from the purchase price or cost basis. The owner can deduct only actual expenses, not
reserves for future expenses, and can compute gross income only from income actually collected (or owed), not
just projected. The owner looks for a profitable resale or exchange at a higher price or favorable tax position.

The appraiser reconstructs expense and income into amounts the well-informed investor would anticipate,
without specific regard for personal equity, spendable income, or tax consequences. Using methods outlined
below, an appraiser analyzes an income property to ascertain its value to the market generally, i.e., the Market
Value.

Capitalization

Capitalization converts the future income stream into an indication of present worth of property. The two
income capitalization methods used in appraisal are Direct capitalization and Yield capitalization. In Direct
capitalization, such as Overall Rate and GRM analysis, the income from a single annual period is converted to
an opinion of value. Yield capitalization measures the present worth of a series of income payments occurring
over the multi-year life of the investment.

Income property investors expect a return of the capital invested, plus a return on that capital. The return of
capital (recapture) may occur through income payments received, the net proceeds of the sale of the property at
the end of the holding period (reversion), or through a combination of the two. Property characteristics and the
income stream pattern impact investor behavior and, therefore, the applicability of the various capitalization
methods for a specific property.

One of the most common Direct income capitalization methods uses an Overall (capitalization) Rate. The
preferred method of Overall Rate derivation is from an analysis of comparable sales and their relationship
between net income and sales price. The appraiser analyzes each comparison property’s sales price, rents,
expenses, net income and Overall Rate, makes needed adjustments and selects an appropriate indicated Overall
Rate for the property being appraised. This rate represents both the return on and the return of the investment.
To ensure reliability of the selected rate, the appraiser uses judgment and experience to make certain the
comparables and the subject property have similar age, physical, location, income, expense and risk
characteristics.

The Overall Rate Formula

To find the indicated value of income property, divide the net annual income by the Overall Rate:

Net Annual Income ÷ Overall Rate = Property Value

or

I ÷ R = V

If any two factors in this formula are known, the third can be obtained.

I = R x V

and

R = I ÷ V