# Calculate Depreciation - PowerPoint by wzw10454

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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
• 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
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
– Incurable
• Deficiencies
• Defects

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
– 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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