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 Functional obsolescence can be indicated by timeworn plumbing, obsolete boilers, outdated lighting fixtures and electrical work, unreasonably high ceilings, bad decorating, and dated architecture (Ratterman).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.

Photos are taken from:
http://www.retailnewsblog.com/wp-content/uploads/2009/03/cost-approach-summation-table.jpg
http://photos.igougo.com/images/p144985-Tennessee-Graceland.jpg
https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEil9NeCp00LGsvV32f2VL-ltQVRv0SBvMrlvJzbKBe4zVpgM4n6ldtV1kpFeqPyW8kIoxJ1cM5QxVJW0IXieHb_VX4jAqAWB15K3vzL4PbVy0L7pMGOgFgqZrohQJgBMhf-OtFSuCcLtdI/

Adjustable Rate Mortgages

There are many forms of loans available in the marketplace today, including mortgages and
other real estate secured loans. Of the mortgages that are available to consumers, the adjustable rate
mortgage, also known as an “ARM,” and may also be referred to as “sub-prime,” is one of the choices
homeowners may have when purchasing or refinancing a loan on real property if the loan's
specifications meet the need of the borrower. The ARM is not limited to owner occupied properties,
but is also available to landlords who rent their properties to tenants. Adjustable rate mortgages can be
a major benefit to a borrower, or if mishandled or misunderstood, can end up being a huge financial
burden to the borrower.

The adjustable rate mortgage was designed for the short term borrower, who requires a below
market interest rate which fluctuates according to the terms of the loan, for a specified period of time.
This below market interest rate results in an initial lower monthly payment on the loan for the first few
years of the loan. Typically the loan is amortized for 15 or 30 years, with the first few years requiring a
lower payment, and when those few years have passed, the interest rate then adjusts closer to what the
current market rate is at that time, while possibly even growing the loan rate higher than the market rate.

The benefits of an adjustable rate mortgage can vary between borrowers. For example, a person
that wants to purchase a home and currently does not earn enough income to qualify to make the
payments on a fixed rate mortgage, may qualify for the payment on an adjustable rate mortgage for the
same loan amount, based on what the payments will be for the first few years. Another example is a
person who knows for sure that they will be selling a piece of property or knows they will be
refinancing the adjustable rate mortgage before the initial low payment period expires. This process
prevents them from having to pay higher payments. Each of these examples may even have an option
of “interest only” during the initial period, in which the required monthly payment for the first few
years may only include the interest, and not any principle to help pay down the mortgage balance.

It is possible that the benefits of an adjustable rate mortgage can be reversed and end up being a
financial nightmare, if the borrower does not know exactly what the loan terms contain or even what
they mean. The examples above appear to be good for the buyers, but if they fail to make a higher
income, or sell or refinance the property, then the borrowers might end up having to pay a mortgage
payment that they will be unable to afford. After the lower payment period has expired, the monthly
payments can immediately (depending on the loan terms) increase to reflect the new interest rate that
the loan defaults to. And, it could be worse if the borrower was paying interest only; not only will the
new payment include the new interest rate, but will also include principle and interest, which could be
too much for some people to handle. It's quite possible for the loan to eventually go into foreclosure if
the payments aren't made, the loan refinanced, or the property sold.

If the borrower is responsible and educated when taking out an adjustable rate mortgage, this
type of mortgage can be very beneficial. Unfortunately, there are many people who have
fallen “victim” to the ARM, and have been unable to recover. When signing mortgage papers, those
few initial years with low payments can seem a long way ahead, when in reality it arrives very fast.
This type of mortgage must be monitored so as to prepare financially for the near future, unlike
traditional fixed rate mortgages, which have the same payment for the life of the loan.

Factors of Value

There are four factors that a piece of property must have to create value. Since there are different markets all over, there are different ways people look at what is valuable to them and what is not. Appraisers have to look at that to determine how valuable a property is. Demand is what creates value (Rattermann).

The first quality that is needed to create value is utility. An item will have value only if it has use to it (Rattermann). If land for agricultural use is too hard to be used to plant corn, then it has no value in that situation. On the other hand, the land can be useful to someone else with a different reason of need. Basically, if the property can be utilized by your needs, then there is value.

Scarcity is the next quality that is needed to create value. Something that is abundant like air has no value because there is no demand for it. With something less plentiful like water to farmers in certain markets where there is no abundant amount of water, has value. Since different markets have different items that are scarce, it depends on what is valuable to that market (Rattermann).

Having desire for the item is needed as well to create value. If there is only one house in a neighborhood with a swimming pool and that’s one of the main items that a family wants when they are looking to purchase a house, then that creates value (Rattermann). Also, it brings in utility and scarcity factors as well. The last quality is effective purchasing power for the buyer. If a $1.5 million house is for sale in a community where the highest household income is $75,000/year, there isn’t enough demand for that house since no one will be able to afford it. The property must appeal to those in a market that can afford it to give it value (Rattermann).

Overall, having these four factors establishes value for the property or item. Another example is that there is only one house that has a guesthouse in a neighborhood that you would like to rent out to a college student to gain some extra income and you can afford it. The guesthouse would be utility because you wanted to obtain some income, the reason being that it’s the only one in the neighborhood is scarcity, your desire is for there being a guesthouse and the property’s price appeals to you. Without value to someone, a property is nothing.

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

Market Segementation

Market segmentation is the dividing of an overall market into key customer subsets, or segments, who are share similar characteristics and needs. According to Mark R. Rattermann, the defining characteristics of a submarket are property type, property features and market area. Market segmentation is used for price prediction, formulation of appropriate marketing strategy, defining geographical boundaries and for understanding housing market structure.

By delineating housing markets an agent or broker can determine much wasier on properties in particular areas. According to Rattermann, many appraisers define neighborhoods by the price of homes, but that probably isnt the best way since it's because neighborhoods share similar land uses. The area in which homes are located will determine the price; also features on the house will strengthen or weaken the price. Features that can add value to homes can be shopping centers close by, schools and universities, sporting venues and many others. These are features buyers are looking for when buying a home and can make a home more expensive or more attractable to a buyer or investor.

By creating market segmentation it's defining different market areas that will pertain to needs contingent on ones desires. Formulating the proper marketing strategy can be applied after delineating housing markets, becasue you can determine what neighborhoods to target for customers. For example, if a client is looking for a large home with many bedrooms to fit his family, then you will know which areas to show him.

"A neighborhood should be defined geographically," says Rattermann. Market segmentation is a conceptual approach that commercial real estate developers can use to identify unmet needs. By developing properties for which there is an unmet need instead of those that are already supplied, the developer attains a huge advantage over developers. This is why setting geographical boundaries can be very beneficial to someone trying to understand the market and where they should apply their focus.

When market segmentation is implied, it gives better understanding of housing market structure. By outling boundaries to create market areas, it gives a salesperson a greater advantage to catering to potential buyer. Knowing which neighborhoods would best suit the client is something that an agent has to have to be successful. Understanding the unique needs of clients and being able to apply them is crucial.

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

Capital Market

     In contrast to the money market with a short- term maturity, which is less than one year, the capital market gives investors the possibility to buy and sell intermediate-term and long- term securities with maturities over one year. It conduces to investors, which could be companies, governments and households, to finance investments and other transactions.
     In the capital market the investors can borrow money for market transaction, e.g. for buying real estate, because in these transactions larger sums of money are required.
The investors can invest in stocks, bonds, mutual funds, exchange traded funds, mortgage loans, deed trusts, options, and futures.
In real estate transactions they invest usually in bonds, stocks, mortgage loans and deed trusts.
     Bonds e.g. are, as mentioned above, long- term debt instruments from which the investors get periodic interest payments and stocks represent an ownership in a company and are an equity investment, which has a fixed dividend rate.
     The capital market can be divided in two parts, the primary and the secondary market. In the primary market new securities are issued from companies and are sold to the investors. In the secondary market you can sell to and buy the securities from other investors, which are already in the market.
     There exists a capital market risk, because of the long-term investment the investors could suffer from there investments, if there occurs another better investment and they cannot get out (fast enough) of their investment they are involved.

Rattermann, M. R. (2009). The Student Handbook to The Appraisal of Real Estate. Chicago, IL: Appraisal Institute, 13^th edition

Lawrence J. Gitman, Michael D. Joehnk, Scott B. Smart (2010), Fundamentals of investing, Boston, MA, 11^th edition,

Robert Parrino, David Kidwell (2009), Fundamentals of Corporate Finance, Danvers, MA

Market Value

The market value of a piece of property is “the highest estimated price that a buyer would pay and a seller would accept for an item in an open and competitive market” (Textbook). Therefore, for market value to exist there must be a viable market. “In a market value appraisal, an appraiser should apply the definition of market value to every comparable sale to see if the sale price in that transaction represents the market value of that property”(Textbook). There are many conditions an appraiser must consider to determine the market value of a property. “These conditions generally fall into three categories: The relationship, knowledge and motivation of the parties, the terms of the sale, and the condition of the sale” (Market Value Definitions).

Are the buyer and seller related? Is the buyer well-informed of the assets worth? Does the seller have underlying motivations to sell? These are questions appraisers must answer in determining a properties fair market value because these conditions affect the sale price of the property. To determine fair market value it is important “neither buyer or seller are under pressure to act (such as career relocation, death of a family member, divorce, etc.)” (Market Value).

Fair market value is also determined by the terms of the sale and the financial arrangements agreed upon. Some buyers may choose to purchase the property with cash, while other buyers may need financing. Some buyers may choose to obtain money through a lender and others may obtain financing from the seller. The seller may then hold a note on the property. The purchase price may be higher in this situation and lower when cash is offered. Appraisers need to be informed of the financing terms in order to evaluate the market value.

“The condition of sale is the exposure in a competitive market for a reasonable time prior to sale” (Market Value Definitions). The length of time it takes to sell a property, the properties location, the type of real estate market (i.e. buyers/sellers market), and the current condition of the property all assist in determining the condition of the sale. An appraiser must assess these items while determining the true market value.

As you can see there are many factors and conditions that help determine market value. Because real estate markets are fairly imperfect, appraisers as experts are particularly important in reporting their opinion of the fair market value.

References

Market Value. http://www.orps.state.ny.us/pamphlet/mv_estimates.htm

Market Value Definitions In The U.S. http://www.sdaao.org/website/permanent%20info/What%20is%20a%20Real%20Estate%20Appraisal%20and%20how%20is%20it%20Done.pdf

Textbook. The Student Handbook to The Appraisal of Real Estate, 13^th Edition.

Keyword: Sales Comparison Approach

The sales comparison approach is an approach that is almost used in all appraisals. It is one of the three major groupings of valuation methods. The definition that Rattermann gives on page 93 is, “this approach is based on the idea that if you paid a certain amount for a property that is similar to the subject property, you would pay it again for the subject property”. In addition, this approach deals with buying an existing property.

One view of the market value, for one’s subject site, can be supported by the analysis of past sales with similar site features plus or minus any adjustments for differences. The example in the book states, “If the sellers of that property were able to achieve a sale price of $X, then this property ought to be worth $X plus/minus the applicable adjustments.” One example I came up with to compare a homes value to another one that just sold is:

Home X – 3 bedrooms, 2 baths, no garage.

Home Y was sold for $200,000. It has 3 bedrooms, 2 baths, 2-car garage. Garage value is $5,000.

For the sales comparison approach, you would have to subtract the garage value of $5,000, to get the comparable value of $195,000 for Home Y.

This is a simple example but makes the sales comparison model easy to understand the basics.

According to Rattermann, there is a procedure to finding the sales comparison approach. In the first step, you want to gather and data on current listings, pending sales, and recent sales that relate well to your property. Next, you should verify any of the information you gathered. Accurate data and accurate market considerations of similar subjects are a key to comparing sales. The third step considers selecting the most relevant units of comparison in the market and developing an analysis for each unit. Some examples of units of comparison are prices per acre, square foot, and front foot. The next step is adjusting the sales price for each of the comparable properties. This step is used to reproduce hoe each of the comparable properties differentiate from your subject property. In the fifth and final step you want to bring together the various value indications produced from the analysis of comparable sales to a value bracket or single value indication. The comparable sales will give you an indication of sales, but comparable listings will show what the competition is and what the subject can and cannot sell for.

The sales comparison approach is the best understood of the three approaches to value. This approach is best suited for residential and investment type properties that sell often on the open market and where there are sufficient sales to use this approach.

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

income capitalization approach

Whether you’re an investor, broker, or just looking to rent, buy, or sell a house, real estate is a unique industry that affects just about everyone at one point or another in their lifetime. In almost any case, from residential to commercial, an appraisal is needed in order to accurately determine the value of property. With every appraisal comes a standard seven-step process known as the Normative Evaluation Model. The fifth step of this model requires the appraiser to estimate the value using three methods; Cost Approach, Sales Comparison Approach, and Income Capitalization Approach.

The Income Capitalization Approach is one of three valuation methods used by appraisers and investors to estimate the value of a real property. This particular approach is based on the premise of anticipation, or the expectation of future benefits (cash flows). It values property by the amount of income that it can potentially generate, so it’s most heavily relied on by investors looking for income producing property, such as apartments, office buildings, malls, and any other property that generates a regular income.

To ultimately find the property’s value using the income capitalization approach, you must first find, in this order, 1) the annual gross income, 2) effective gross income, 3) net operating income, and 4) capitalization rate.

The annual gross income is found by doing market studies to determine what the property could potentially earn. The effective gross income is then found by subtracting the vacancy rate and rent loss from the gross income. Next, the net operating income (NOI) is found by subtracting the annual operating expenses from the effective gross income. Then the capitalization rate is found by finding the rate of return, or yield, that other property investors are getting in the local market. You may also find it by dividing the net operating income by the property value.

Ex)  Annual Gross Income=100,000   Vacancy Rate =9,000   Rent Loss=1,000 

        Operating Expenses=5,000     Property Value=400,000

1)      Effective Gross Income= 100,000-9,000-1,000

    = 90,000

2)      Net Operating Income  = 90,000-5,000

                                                 = 85,000

3)      Capitalization Rate       =85,000/400,000

                                      =.2125 or 21.25%

 Also, the property value could be determined by dividing the net operating income by the cap rate (if the cap rate is already known).

The capitalization rate is the rate of return on the investment, so ultimately, the higher the cap rate, the more money an investor is likely to make on the initial investment.

Sources

·         Rattermann, Mark. The Student handbook of Appraisals, 12^th Edition. 550 West Van Buren, Chicago, IL 60607

·         http://www.propex.com/C_g_inc.htm

·         http://thismatter.com/money/real-estate/real-estate-appraisal.htm

Highest and Best Use

Highest and Best Use

Sometimes when a buyer is interested in purchasing real estate property, they would want to know if that property suits their needs such as location, profitability, and etc. “Highest and best use” is a term that is use frequently in real estate appraisals to help analyze and determine the market value of the property. It states that the value of the land, building or any real estate property is directly related to the use of that real estate property. It is the appraiser’s job to help the buyer and find the highest and best use.

Highest and best use is sometimes hard to determine or sometimes may change over time and because of this reason appraisers will evaluate the subject property from several alternative of usages including the buyer’s most and probable use. When the appraiser is analyzing the highest and best use for the subject property they use a two step procedure. The first step is to determine what the highest and best use is while the subject property is vacant and the second step is when the property is improved such as changes and/or modifications that may add or decrease the value of the property.

In order to even be considered as a possible choice for the highest and best use the selection must pass four tests:

1-Due to zoning, government interventions, building codes and other laws the first test asks if the selection is legally permissible.
2-The second test asks if the selection is even physically possible, for example the site may be too large or too small for the proposed idea.
3-The third test is a financial feasibility of the proposed use. The selection must justify the cost through profits.
4-The final test is maximally productive use. This means the selected use must create the highest profit to the buyer.

Most cases in real estate property that has existing usage that usage is probably the highest and best use, but in some cases it may not be. When existing usage shuns and lowers the value of the property, another option may be to demolish and redevelop the property. An appraiser must analyze the cost of this option.

Part of the appraiser’s job is to help a potential buyer to determine if the proposed idea would be profitable to the buyer in the subject property. In order to accomplish this, the appraiser will use several selective alternatives that has pass the four test to find the highest and best use for the subject property.

Federal Reserve System

Federal Reserve System: Monetary Policy

The Federal Reserve System is the central banking system of the United States. The Federal Reserve was created in 1913, as part of the Federal Reserve Act. Although its duties has changed and evolved since its creation, the Federal Reserve has a clear and important role in the economy of the United States. The Federal Reserve’s official responsibilities are to conduct the monetary policy, regulate banking institutions, and maintain the stability of the financial system. The Federal Open Market Committee controls the monetary policy, in an attempt to control the money supply and affect the interest rates. To understand how this committee implements policy, the remainder of this paper will discuss tools they use to control the money supply and how it can affect interest rates.

The first major tool the FOMC has is making adjustments to the reserve requirement. The reserve requirement is the ratio of deposits to the total amount of money loaned out. When the FOMC increases the reserve requirement it will decrease the amount of loanable money financial institutions have. This will put upward pressure on interest rates and discourages borrowing. This scenario could take place in order to lessen spending in a time of increased inflation. If the FOMC decreases the reserve requirement they are essentially trying to put more money into the economy by increasing loanable funds. A decrease in the requirement would lower interest rates and encourage spending in a slow economy.

Another tool the FOMC can utilize involves open-market operations. The FOMC can buy or sell government securities through the Fed Trading Desk. When the FOMC sells securities it pulls money out of financial institutions and into the Federal Reserve, where it is out of circulation. This act will decrease an institution’s ability to loan funds. Once again, less loanable funds will tighten lending practices and drive up interest rates. If the FOMC buys securities, they are injecting additional funds into the institution. The amount of loanable funds will then increase. Due to the loosening of lending practices interest rates will decrease to encourage borrowing.

The third and final tool that I will discuss is the discount rate. The discount rate is the interest rate banks and other financial institutions are charged when they borrow money from their regional Federal Reserve Bank. Institutions that are eligible for the primary credit program are usually loaned funds on a short term basis, usually overnight. For those who do not qualify, secondary credit is also available. During times of inflation, the discount rate may be increased to reduce the availability of money. The opposite is also true. When the discount rate is decreased, there is downward pressure on interest rates. Banks will have more funds to loan, which encourages investors to borrow.

When all three tools are simultaneously used it is clear how the Fed can control the money supply and implement its monetary policy. Any change in either of these tools will have an effect on financial institutions as well as the borrowers who go to them seeking loans. Our book mentions these three tools briefly, but never explains in much detail how they affect the real estate industry. When the money supply is tight loans become harder to obtain. Thus, many people will be unable to finance the sale of a home. This will cause the effective demand to decrease, which in turn drives home prices down. Of course, many other factors need to be considered to get a broader understanding of real estate prices and the appraisal process. However, having knowledge of the Federal Reserve System’s monetary policy is a valuable tool for any real estate appraiser.

Madura, Jeff. Financial Markets and Institutions. Mason, OH: South-Western Centage Learning, 2010. Print.

McKenzie, Dennis J., and Richard M. Betts. Essentials of Real Estate Economics. Mason, OH: Thomson/South-Western, 2006. Print.

Rattermann, Mark. The Student Handbook to the Appraisal of Real Estate. Chicago, IL: Appraisal Institute, 2009. Print.

Final Keyword: Market Area

In appraising a piece of real property, analyzing the location’s market area is a vital component in determining the property’s market value. First of all, a market area is defined as “the surface over which a demand or supply offered at a specific location is expressed” (Rodrigue). Moreover, this surface may also encompass many districts and neighborhoods; it is “an area where people live and work” (Ratterman). Market area analysis is important and beneficial for potential buyers because it enables a broader range of options in terms of supply and demand in the area.

For commercial property investors and purchasers, in particular, market area analysis helps decide which location is best for their business to operate at. Factors that control this analysis include income level, demographics, sites surrounded by necessary resources, as well as transportation. Having proper accessibility is important because it impacts a property’s ability to attract residents and cliental (Rodrigue).

A widespread trend in some market areas may be to change one original use of property into a completely different one. This is done for many reasons, particularly in areas that serve no further purpose remaining the way they’ve been. This may be due to buildings being too old or too costly to continue to repair; thus, the building is torn down and reconstructed into something far more feasible to the owner. An area may be in a revitalization stage in efforts to improve economic growth or to fulfill the supply of homes in potentially high demand (Ratterman).

Competition is another large factor in market area analysis. Price is the basic, number one source of competition, but attributes involving space and distance are also key foundations. Businesses selling the same good or service may be spread accordingly to the area’s range of population density, location of their competitors, and the cost of transportation. This is referred to as market coverage, and plays a big role in establishing an appraised value of real property in that area (Rodrigue).

Whether a buyer is looking to invest his or her money in a residential purchase or a commercial property, market area analysis is one of the best tools in appraising the value of that property. Because a market area includes not just a single neighborhood or district, market area analysis gives the buyer knowledge of the property’s deeper, outside environment. Incorporating the market area when determining the property’s market value allows the purchaser to make a much more informed decision regarding whether or not that property is exactly what they are looking for.

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

Rodrigue, Dr. Jean-Paul. Market Areas Anaysis. Hoftsra University.

New keyword

Agents of Production

Keyword - capital market

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Keyword is market segmentation

Keyword

Market Value

Keyword for Blog paper: DEPRECIATION

Keyword

The Life Cycle of a Market Area

Keyword

Federal Reserve System-Monetary Policy

Keyword

Adjustable rate mortgage

ETS Criterion

ETS Criterion is ready to go.  See our course website for sign-in instructions.  When you login, look for our class, FIN 181 #71940 and the Blog Post 1 assignment.

Blog 1 Keyword: Sales Comparison Approach

Salvage Value

Salvage Value: When reading those two words what are the first ideas that come to your mind in regards of the definition? Depreciation, throwing away an expired television or maybe a value your beat up old vehicle is worth? Those all being good thoughts, but the correct definition is “The estimated value that an asset will realize upon its sale at the end of its useful life.” (INVESTOPEDIA.COM) You are probably asking, how does one estimate the price of an asset that is at the end of its useful life? Or also thinking of the best use or economic value. Determining the value of an asset is very easy and may spark up memories of your Managerial Accounting class as we use accounting principles along with depreciation. With that being said lets first investigate how to determine Salvage Value of a building that has been determined to have a better use.

Let’s say you would like to determine the salvage value of the building you conduct business in as it ages and has an opportunity to become of better use. First we know that when you built the building in 1990, it cost you $500,000 and it's now the year 2010. Next we would need to know the salvage value; the salvage value of the building is estimated at $80,000. How we get the estimated salvage value is by looking into what the comparables are worth in the current market. This is also known as market value, the price that the building could be sold at as of today. Now the accounting principles come into place. We would like to determine how much the building has depreciated in the past 20 years. In doing so we can guarantee that this is a reliable estimate and that the building will actually sell for what it’s worth or make more sense to demolish and rebuild for the best use.

Many businesses use this method to determine the salvage value of an asset, especially in businesses that have machinery, delivery trucks, and other expensive highly depreciating assets. If you’re not familiar with the term salvage value businesses also refer salvage value to residual value or scrap value. For our example we are using a business building that one owns as a personal investment, but we could also say it’s his or her interest in the building is no longer there since it's not being used for the best use. The building owner would like to determine if demolishing the building is more profitable than building on as he or she decides to change the use of the building into an apartment complex.

In our example we are using a straight line basis. The formula looks like this: Asset cost in 1990 = $500,000 and the salvage value as of 2010 are estimated at $80,000. Taking the cost of your asset in 1990, which was $500,000 and subtracting the salvage value $80,000 we get the amount below:

$500,000 - $80,000 = $420,000
Now take the years that have expired, which are 20 years and divide $420,000 by 20:

$420,000 ÷ 20 = $21,000

The $21,000 is your yearly depreciation, which goes to show you that buildings can depreciate at a large amount or what's around the building can cut the life of that building short. In this case we will say that more apartment complexes are being built instead of what it once was, commercial usage.

You can determine any asset’s salvage value by using this formula if you would like to estimate the value before you decide to sell the asset or do whatever you please to do with it. Say you determine the value to be so little that you demolish the asset, in our case the building. In order to gain some kind of profit and it to make sense you would want to determine this Salvage Value so you can have a clear picture on what your return might be. The owner of this building decides to demolish the building and actually receives more than the $80,000 that he or she would have got if they were to sell the building. Many companies saw the opportunity to use the reusable materials for their own construction use. Therefore in this case it was very valuable to determine the Salvage Value.

In the key words section of our text Salvage Value is present, but the text shows no interest in saying what it means. That made me curious as to what the text means when they use the term Salvage Value as one of the keys terms. Does it relate to trade fixtures which are assets or to much more? It’s much more than just trade fixtures. Like our example shows it can be materials recycled after a demolition and so much more. Salvage Value assets are mostly used for major divisions of your business. In the Real Estate field our Salvage Value assets will range from computers to vehicles and the best use of an asset, such as a building. I have learned that this is almost an exact estimation of what your asset is worth, especially since the market can back up the value estimated.

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

INVESTOPEDIA.COM (2010). Salvage Value Definition. Retrieved from http://www.investopedia.com/terms/s/salvagevalue.asp

Income Capitalization Approach

Blog Post 1: Appraisal Keyword

To get started with a blog post, please make a post and indicate the appraisal term that you have selected for your first blog post.