Chapter 6: Cost Approach- Depreciation Flashcards

Chapter 6: Cost Approach- Depreciation Flashcards

Physical Deterioration"The wear and tear that begins when a building is completed and placed into service."Physical deterioration is real and tangible. It is something that you can touch and see. It goes on every day.From the moment a building is constructed to its very end, things wear out physically.Every time someone walks on the floor or runs their hand along the wall, it wears away some of the finish.Every time rain or snow hits a roof or sand blows against siding, it causes some physical wear and tear. As a building settles over time, nails pop, beams twist as they dry out, and joists sag.It is a never-ending process that is occasioned by forces of nature and human habitation. Some wear and tear is normal and expected in every structure. Some elements of a structure may also encounter abnormal amounts or types of physical deterioration. This may come from defective materials, improper installation, or unexpected occurrences in the physical atmosphere around the property.Short-Lived Maintenance"1. A building component with an expected remaining economic life that is shorter than the remaining economic life of the entire structure.2. An item that will probably be replaced one or more times during the life of the improvements, such as painting or flooring."Short-lived items may still have some life at the time of the appraisal and would not need to be replaced immediately. Examples

would include:-Roof covering-Water

heaters-Carpeting-FurnacesExample: Let's say a house is

15 years old and it has its original furnace, which has been maintained properly and is currently working. The useful life of a furnace might be 20 years. The existing furnace is not completely worn out, but it will likely need to be replaced within the next several years. At this time, it is 75% depreciated (15/20) however it would not make economic sense to replace it right now and throw away the 5 years or so that remain of its life. This is an example of an item of short-lived physical depreciation.Useful Life"The period of time over which a structure or a component of a property may reasonably be expected to perform the function for which it was designed." External Obsolescence"A type of depreciation; a diminution in value caused by negative external influences and generally incurable on the

part of the owner, landlord, or tenant. The external influence may be either temporary or permanent."IVS

Definition: A loss in value due to factors outside the subject

asset. External obsolescence is also called economic, environmental, or locational obsolescence. Examples of external obsolescence are changes in competition or in surrounding land uses like an industrial plant near a residential area. It is deemed incurable as the expense to cure the problem is impractical.Physical deterioration and functional obsolescence both occur within a property.External obsolescence, however, occurs off the site.It is a type of depreciation, or loss in value. It happens because of some negative influence up the street, around the corner, or somewhere in the neighborhood or market area. It may not even be directly visible from the subject property. It may take some research on your part.External obsolescence is often market-wide and may impact all properties in a market area equally. An example of this might be a loss in value created by adverse economic influences in an area.There may be high unemployment or recent factory closings that will exacerbate the situation and make it even worse. There may be an oversupply situation due to job losses or net population migration out of an area.External obsolescence may even be caused by state-wide or national influences. Perhaps people are leaving a state because of unreasonably high taxes. If the national economy is in recession or if interest rates are unusually high, this could also create a loss of value on a broad scale.

Remaining Economic Life"The estimated period over which existing improvements are expected to contribute economically to a property; an estimate of the number of years remaining in the economic life of a structure or structural components as of the effective date of the appraisal; used in the economic age-life method of estimating depreciation." Market Data Analysis"Breaking the market down statistically to assess the types of product, consumer and competitor"External obsolescence can be measured by market data analysis.

This involves analysis of comparable sales.Example: The

subject property is a house adjoining a busy interstate highway. A vacant lot next door recently sold for $60,000 and a similar lot with the same zoning, in a quiet location, recently sold for $65,000. These two sales indicate there is a premium of $5,000 for less traffic noise.-A house along the interstate in the next block recently sold for $340,000, and a similar house away from the interstate sold for $360,000. Thus, the property located along the interstate suffered a $20,000 loss for the location.-The external obsolescence attributable to the whole property is $20,000 ($360,000 - $340,000).-Pairing the two land sales indicates a loss of $5,000 for the land portion. Therefore, the external obsolescence attributable to the building is $15,000

($20,000 - $5,000).

• Types of Functional Obsolescence-Curable caused by a deficiency requiring an

addition-Curable caused by a deficiency requiring substitution or modernization-Curable caused by a superadequacy-Incurable caused by a deficiency-Incurable caused by a superadequacy Breakdown MethodMost detailed and comprehensive way to measure depreciation. It breaks down depreciation into its

component parts of:-Physical deterioration-Functional

obsolescence-External obsolescenceMeasures each individually Age-life MethodIn the age-life method, total depreciation is estimated by calculating the ratio of the effective age of a property to its economic life. This gives a percentage of the life that has been used up. It is perhaps less accurate than other methods, because of the judgments involved, but is easy to apply.Effective Age / Total Economic Life x Total Costs= Depreciation Actual Age"The number of years that have elapsed since construction of an improvement was completed; also called historical or chronological age."

Capitalization of Income LossWhen a property is income-producing, the external obsolescence may be estimated by capitalizing the loss in

income attributed to that factor.Example: Assume a house

that would rent for $1,200 per month in a normal market. In this market that has experienced overbuilding, it can only bring $1,150 per month. The appropriate GRM is 120.-$50 (rent loss) x 120 = $6,000 (external obsolescence)

• Main Methods of Estimating Depreciation -Age-life method-Modified age-life-Breakdown method or

observed condition InadequaciesSometimes, elements of a structure are simply inadequate.For example, the heating system is not large enough or the insulation is inadequate.Some of these things were installed that way right from the beginning. Perhaps a certain structure should have a furnace with an output of 100,000 BTUs but it was built with a 60,000 BTU unit.Sometimes inadequacies occur when standards change. A house that was built in the 1950s was insulated minimally but met the standards that were in effect at the time. After the oil crisis of 1973, insulation standards increased sharply. The 20-year-old house, at that point, was woefully inadequate in terms of insulation and energy efficiency.Think of the changes that have occurred in window design and construction in northern climates over the last 30 years. Single-pane glass became functionally obsolete and dual-pane glass was expected. Then we had the advent of triple-pane glass, Argon-filled glass and low-E glass with insulated framework.Inadequacies are really based in the physical components of the structure, but the measure is whether or not that component is lacking in functional utility according to today's tastes and standards of the buying public.External obsolescence can be caused by a number of

factors, including:

-High unemployment-Building moratoriums-Recessions-Traffic noise-Road-Rail line or airport-Location near hazardous influences-Air or water pollution, smog or odor-Toxic wastes-Abandoned landfills-High tension power lines-Above or below ground high pressure gas lines-Unsightly views-Abandoned or boarded up buildings nearby-High crime rate or unsafe living conditions-Poor access Effective Age"The age of property that is based on the amount of observed deterioration and obsolescence it has sustained, which may be different from its chronological age." Functional Utility"The ability of a property or building to be useful and to perform the function for which it is intended according to current market tastes and standards; the efficiency of a