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									                The Cost Approach

                   Real Estate 614
                 Real Estate Appraisal
                    Dr. Longhofer

Dr. Longhofer         Real Estate Appraisal   1
                The Cost Approach
• Begin by estimating the cost of any improvements
  on the land
     – Reproduction cost is the cost to construct the building
       today, replicating it in exact detail
     – Replacement cost is the cost required to construct a
       building of equal utility, using modern construction
       techniques, materials, and design
• Subtract from this the cost of any accrued
  physical, functional, or external depreciation
• Add in the value of the site as raw land to get the
  indicated value using the cost approach
Dr. Longhofer             Real Estate Appraisal                  2
   Estimating Construction Costs
• Comparative-unit Method – For relatively standardized
  structures, the size of the building is multiplied by the per-
  square foot cost of that type of construction
• Segregated-cost Method – The costs of the individual
  components in the building are used to estimate the overall
  replacement cost
• Quantity-survey Method – Identifies the exact materials
  required to reproduce the structure to estimate the cost
• Index Method – Assumes that the replacement cost is
  simply the original construction cost times a cost index


Dr. Longhofer            Real Estate Appraisal                 3
Categories of Accrued Depreciation
• Physical deterioration is the result of wear and
  tear, weathering from the elements, vandalism and
  neglect
• Functional obsolescence refers to features, design,
  and other elements of the building that are not up
  to modern standards; it also includes features in
  excess of what the market can support
  (superadequacies)
• External (economic) obsolescence refers to loss of
  value due to influences outside the property
Dr. Longhofer        Real Estate Appraisal          4
   Estimating Accrued Depreciation
• Lump-sum age/life method
     – Easy to apply
     – Does not explicitly account for each particular
       type of depreciation (esp. econ. obsolescence)
• Breakdown method
     – Complex and time consuming to apply
     – Explicitly considers each type of depreciation
     – Helps to avoid “double counting”

Dr. Longhofer          Real Estate Appraisal             5
                Age/Life Method
• This method estimates depreciation as a lump sum
  based on assumed straight-line depreciation
                                Effective age
       Accrued depreciati on                  Cost new
                               Economic Life
• Economic life is estimated using rules of thumb
  based on past experience or published sources
• Effective age is usually used in place of actual
  age, but this varies

Dr. Longhofer             Real Estate Appraisal            6
         Age/Life Method Example
Reproduction cost new                         $245,000
 Total economic life     55 years
 Effective age           20 years
 % accrued depreciation = 20/55 = 36.4%
Accrued depreciation                            89,180
Depreciated value of improvements              155,820
Land value                                      39,000
Estimated market value                        $194,820



Dr. Longhofer         Real Estate Appraisal          7
         Modified Age/Life Method
• Sometimes the age/life method is modified
  by subtracting out curable physical and
  functional depreciation before calculating
  the lump sum depreciation of the rest
     – The idea is that the owner will cure these
       problems because it adds more value than it
       costs


Dr. Longhofer         Real Estate Appraisal          8
Modified Age/Life Method Example
Reproduction cost new                           $245,000
Physical and functional depreciation, curable     12,500
Adjusted cost                                   $232,500
 Total economic life      55 years
 Effective age            17 years
 % accrued depreciation = 17/55 = 30.9%
Accrued depreciation                              71,843
Depreciated value of improvements                160,657
Land value                                        39,000
Estimated market value                          $199,657
Dr. Longhofer           Real Estate Appraisal          9
  Comments on Age/Life Method
• The general relationship between age and
  depreciation varies from market to market
     – Use local patterns, not national ones
• Although this method assumes straight line
  depreciation, this is not typically accurate
     – The amount of depreciation changes from year to year
• Location of a property within a given market area
  does not appear to affect depreciation rates

Dr. Longhofer             Real Estate Appraisal               10
  Comments on Age/Life Method
• Effective age (based on subjective appraiser
  judgment) appears to be more accurate than
  physical age
• Depreciation rates of between 0.70 and 1.25
  percent per year seems to be a useful benchmark
  for properties that are not too old
• Depreciation rates can be estimated from
  comparable sales (market extraction)

Dr. Longhofer       Real Estate Appraisal           11
       Market Extraction Example
Sale price of property                           $1,520,000
 Less: Land value                                   300,000
 Less: Contributing value of site improvements      150,000
Depreciated value of improvements                $1,070,000
Reproduction cost of improvements                $1,500,000
 Less: Depreciated value of improvements          1,070,000
Accrued depreciation                               $430,000
Depreciation = 430,000 / 1,500,000 = 28.67%
Annual depreciation rate (20 years old)              1.43%

Dr. Longhofer          Real Estate Appraisal             12
                Breakdown Method
• In the breakdown method, the physical,
  functional and external factors contributing
  to the loss in value of the improvements are
  isolated and estimated separately
     – This is particularly important for external
       obsolescence, which may vary for a property
       over time


Dr. Longhofer         Real Estate Appraisal          13
         Categories of Depreciation
• Physical deterioration
     – Curable (deferred maintenance)
     – Incurable
           • Short-lived
           • Long-lived




Dr. Longhofer              Real Estate Appraisal   14
         Categories of Depreciation
• Functional obsolescence
     – Curable
           • Deficiencies
           • Defects
           • Superadequacies
     – Incurable
           • Deficiencies
           • Defects
           • Superadequacies

Dr. Longhofer             Real Estate Appraisal   15
         Categories of Depreciation
• External obsolescence
     – Locational
     – Economic




Dr. Longhofer       Real Estate Appraisal   16
      Steps in Breakdown Method
1. Identify each component cost and total
   cost new; classify as short- or long-lived
2. Estimate cost of deferred maintenance
   (curable physical deterioration)
3. Estimate cost of curable functional
   obsolescence
4. Estimate impact of incurable physical
   deterioration on short-lived items
Dr. Longhofer     Real Estate Appraisal         17
      Steps in Breakdown Method
5. Estimate the impact of long-lived
   incurable physical deterioration
6. Estimate cost of incurable functional
   obsolescence
7. Estimate the impact of external
   obsolescence
8. Add up total depreciation and estimate
   property value
Dr. Longhofer    Real Estate Appraisal      18
  Curable Physical Deterioration
• The depreciation associated with deferred
  maintenance is simply the cost of curing the
  item
     – Generally, deferred maintenance will apply to
       short-lived components
     – In some cases, long-lived components may
       have deferred maintenance as well; treat these
       the same way

Dr. Longhofer         Real Estate Appraisal             19
Incurable Physical Deterioration of
     Short-lived Components
• For each component, depreciation is
  calculated using the age/life method based
  on the effective age and useful life of the
  component
     – Make sure you subtract off the cost of deferred
       maintenance from each component before you
       calculate depreciation (avoid double counting)


Dr. Longhofer          Real Estate Appraisal         20
       Incurable Long-lived Physical
              Deterioration
• Use the age/life method to estimate the
  depreciation due to physical deterioration of the
  long-lived components
     – Begin with the total reproduction cost of the
       improvements
     – Subtract off the cost of curing deferred maintenance
     – Subtract off the adjusted cost (after curing deferred
       maintenance) of short-lived components


Dr. Longhofer             Real Estate Appraisal                21
   Curable Functional Obsolescence

• Deficiencies are items or features that are
  missing and would be required by the
  market
     – The loss from a deficiency is the difference
       between the cost of installing the item today
       and what it would have cost to include the item
       when the building was constructed


Dr. Longhofer         Real Estate Appraisal          22
   Curable Functional Obsolescence

• Defects are items that are present but do not
  meet modern standards
     – The loss in value due to a defect is the cost of
       the item new less the undepreciated cost of the
       existing item (the part of the cost that has not
       yet been depreciated)



Dr. Longhofer          Real Estate Appraisal              23
   Curable Functional Obsolescence
• Superadequacies are features or
  components that exceed modern standards
     – Excess cost adjustment method – Loss equals
       the added cost associated with the item less the
       depreciation already taken
     – Rent loss method – Loss equals the capitalized
       difference in NOI between what it would take
       to support the item compared to market rent,
       less depreciation already taken

Dr. Longhofer          Real Estate Appraisal          24
Incurable Functional Obsolescence

• The loss associated with incurable
  functional obsolescence is calculated using
  the rent loss method




Dr. Longhofer     Real Estate Appraisal         25
   Incurable External Obsolescence
• This, too, is calculated using the rent loss
  method, with some modifications
     – Use the difference between the building’s rent
       and market rent for comparable properties
     – No need to subtract off depreciation already
       taken because external obsolescence relates to
       factors outside the property
     – The loss is generally allocated between land
       and building
Dr. Longhofer         Real Estate Appraisal             26
      Add Up Total Depreciation and
         Calculate Market Value

  Physical deterioration
+ Incurable short-lived components
+ Incurable long-lived components
+ Functional obsolescence
+ External obsolescence
  Total depreciation

Dr. Longhofer    Real Estate Appraisal   27
      Add Up Total Depreciation and
         Calculate Market Value

  Reproduction cost new
– Total depreciation
  Depreciated value of improvements
+ Contributing value of site improvements
+ Land value
  Value indication from cost approach

Dr. Longhofer    Real Estate Appraisal      28

								
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