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Depreciation & Cost Approach for Real Estate Valuation

Instructor: Eileen Cappelloni

Eileen worked for the Orange County Asssociation of Realtors for 31 years. She has written real estate courses and exams for other publishing companies

This lesson will discuss how to calculate depreciation in the cost approach to real estate valuation. Physical curable, physical incurable, both short-lived and long-lived, and functional and external obsolescence will also be discussed.

Types of Deterioration

Physical Deterioration is the normal wear and tear and lessening of a building's value as it ages. The amount and degree of physical deterioration often depend on the quality of the original construction and the degree of adequate maintenance of its components. There are two categories of physical deterioration:

  • curable, which is economically practical to repair, meaning that the cost of correcting the deterioration is less than that the increase in value
  • incurable, which occurs when the cost of repairing exceeds the value it adds

Short-Lived and Long-Lived Deterioration

Since two identical structures can and probably will depreciate in value differently, appraisers will type them as either short-lived or long lived. Building items or appliances that are short-lived include air-conditioning units, windows, doors, hot water heaters, carpeting, roofing, trash compactors, garbage disposals, kitchen appliances, and bathroom and kitchen cabinets, washers and dryers and countertops. In other words, during the lifetime of a structure, these items will probably need to be replaced several times.

Long-lived items are those which are anticipated to last as long as the structure, such as the walls and the foundation. If a long-lived component needs to be repaired or replaced, it is generally going to be considered incurable, as it probably would make more sense economically to raze the building rather than attempt to repair it.

However, short-lived components can either be repaired or replaced. If the hot water heater has a leak, it may be more economical to repair it, and it could still be considered functional. When it needs to be replaced, then it would be beneficial to put in a newer, more modern hot water heater. This is what's considered to be short-lived incurable physical deterioration. There is still some debate by appraisers as to whether short-lived deterioration can still be considered curable.

Obsolescence

There are two types of obsolescence: functional obsolescence and external obsolescence. Some functional obsolescence can be deemed curable or incurable. Generally, since external obsolescence occurs outside the boundaries of the property's land borders, it is considered incurable.

Functional obsolescence - If an older home has four bedrooms and one small bathroom, that feature can be considered functionally obsolescent and incurable because the cost of adding another bathroom would probably exceed any increase it might add to the value of the home. If a home had outdated appliances, and there's no dishwasher, the cost of updating the kitchen and adding a dishwasher might very well 'cure' the obsolescence of the home, and therefore, would probably be considered curable.

External obsolescence - This is caused by factors outside of the boundaries of the land where a structure exists. External obsolescence is always incurable because the structure cannot be removed from the land. For example, a residential home may exist in an area that has since become primarily a commercial area, and consequently, the value of that property may have gone down dramatically.

Methods of Estimating Physical Depreciation

There are three separate methods of estimating physical depreciation: market extraction method, the age-life method and the breakdown method.

The market extraction method requires that you search comparable improved sales similar to the subject property. Adjust for any sales concessions, or conditions of sale, then subtract the land value at the time of its sale and any site improvements. This would determine the depreciated value of the improvements.

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