Depreciation

Depreciation is a term that has several different definitions depending on whom you are conversing with. An individual with a financial or accounting background would describe depreciation as the means of allocating the cost of an asset over its estimated useful life. For an appraiser in the real estate field using the cost approach, depreciation is considered a loss in value caused by physical deterioration, functional obsolescence, or external obsolescence. The difference between the cost of building an improvement new and its value at the time of an appraisal is equal to the full dollar amount of depreciation (Williams).
Physical deterioration of an improvement is the loss of value to improvement due to age, deferred maintenance, disintegration or decay, wear and tear, cracks, structural defects, settling of foundations, weather, vandalism, termite damage, or any loss of physical soundness (Williams). Deterioration of an improvement usually occurs at different rates, so the improvement’s components are often analyzed separately.

Functional obsolescence is the loss in value due to discordancy with present-day market wants and needs. Functional obsolescence can be indicated by timeworn plumbing, obsolete boilers, outdated lighting fixtures and electrical work, unreasonably high ceilings, bad decorating, and dated architecture (Ratterman). A swimming pool that contributes less to the property value than cost is known as a superadequacy, and may also be considered functional obsolescence.

External obsolescence is the loss of value of the improvement due to an undesirable factor outside the said improvement. Examples of external obsolescence can be shown by inappropriate uses of property, population decreases, construction of landfills or subsidized apartment complexes next to neighborhoods, legislative action, and airport and highway proximity (Williams). Obsolescence that affects the total area of improvement is said to comprise a change in the market.

Depreciation can either be curable or incurable. Curable depreciation is a loss of value that can be amended at a cost less than the increase in improvement value that would result if it were corrected (Ratterman). Incurable depreciation either cannot be rectified or would cost more than any appreciation of improvement value. Depreciation is normally estimated using three different methods which are known as the breakdown method, economic age-life method, and the market extraction method (Ratterman). The most common depreciation calculation method used by appraiser is the economic age-life method, also known as the straight line method. Using the economic age-life method an appraiser would multiply the ratio of effective life to the total economic life by the new replacement cost of the subject. An appraiser’s ability to calculate depreciation is most important when performing the cost approach valuation technique.

Ratterman, M.R. (2009). The Student Handbook to the Appraisal of Real Estate. Chicago, IL: Appraisal Institute.

Williams, Martha R. (1998) Fundamentals of Real Estate Appraisal. Chicago, IL: Real Estate Education Co.

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