Property Depreciation: Definition, Importance & Types

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

This lesson defines depreciation as it applies to real estate property valuation. We will cover the different types of obsolescence that are factors in depreciation.

Depreciation General Definition

Buildings wear out, technology improves, and general consumer tastes change. Neighborhoods and communities change. All of these are an unavoidable fact of real estate. Real estate investors who understand depreciation have the knowledge to make competent decisions in the face of these changes.

In the most general sense, depreciation refers to the diminished value of an asset as time passes. The effects of time cause a building to gradually become obsolescent (or out of date, aged). This can occur in different ways, including:

  • Physical
  • Functional
  • External
  • Economic

Let's take a deeper look at these forms of obsolescence and then learn a bit about curable or incurable obsolescence.

Physical Obsolescence

Eventually, everything gets old and wears out. Paint fades, roofs start leaking, and carpets become threadbare. A house that looks old and falling apart, on the inside or outside, also hurts property values. Wear and tear is a constant consideration and creates physical obsolescence or depreciation if left unrepaired.

Functional Obsolescence

If something about a house just seems too old fashioned and doesn't mesh with modern tastes, it's a form of functional obsolescence. As technology improves, sometimes the infrastructure of the house just isn't up to par anymore. More electronic items in a house increases the power demands, necessitating more wiring and larger circuit breaker boxes. A home with lower available amperage will require upgrades to accommodate most families' computers, TV's, stereos, tools, and other electronics. More families today demand at least two bathrooms in a home, and older homes may only have one. These factors will further depreciate the value of a house.

External Obsolescence

External obsolescence are those depreciating factors that occur outside the property. What if an interstate or high voltage power line runs right next to a house? Most people don't want to live in that house if they can avoid it. Those factors will devalue a home compared to a similar home that isn't subject to noise or eyesores. A neighboring house with broken windows, a cracked driveway, and roof that is falling in diminishes the value of surrounding homes.

Economic Obsolescence

A subset of external obsolescence is depreciation attributable to changing economic conditions. If the neighborhood is full of vacant homes due to foreclosure, the property value of the whole neighborhood will diminish. Zoning changes, regional loss of jobs, or the new development of dense, low income housing may negatively impact property values.

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