Depreciation

1. Depreciation Loss in value from any cause Dis-utility Difference between contribution to market value and cost as though new of the improvements Wayne Foss, MBA, MAI, CRE Foss Consulting Group Email: wfoss@fossconsult.com

2. Depreciation Cost As If New as of the date of appraisal Less Depreciation (from all causes) Equals Contribution of Improvements to the Site

3. Three Types 1. Physical Deterioration - Curable and Incurable 2. Functional Obsolescence - Curable and Incurable 3. External Obsolescence - always incurable • Curable means you can do something about it - and it makes economic sense to do it • It’s curable when the cost-to-cure is exceeded by value added. • Whether something is curable is an economic test, not physical.

4. Underlying Concepts Effective age and Economic life rather than Actual Age and Physical Life are important standards • Depreciation is a market phenomenon not a physical or accounting concept. • The market decides these amounts; we interpret what it is saying.

5. Underlying Concepts Physical Age = Chronological Age Effective Age is the age indicated by the condition and utility of the structure. If well-maintained, with good long-lasting appealing design, effective age often is less than actual age. depends on market standards, quality of care and maintenance.

6. Underlying Concepts Economic Life is the period of time over which improvements contribute to property value. This is usually shorter than useful life. • Economic life is influenced by Physical, Functional and External considerations.

7. Underlying Concepts • Accrued Depreciation is an economic phenomenon applied to the total sum invested in improvements. • It is not the same as accountants book depreciation - the prescribed systematic write-off of the cost of an asset over time. • Depreciation in appraising is market related with no relationship to the assets original cost or book depreciation.

8. Underlying Concepts • Depreciation ultimately comes from the market is the difference between cost as if new and worth or value. • Depreciation applies only to the improvements. • Depreciation is relative to market standards. It is not a mechanical process imposed on the property.

9. Depreciation:Basic methods of estimating depreciation • Market Extraction • Age-Life Method • Modified Age-Life Method • Breakdown or Engineering Method

10. DepreciationMarket Extraction, overall depreciation 1. For a comparable sale observation: First, find the contribution of the main improvements for example: Sale Price: $250,000 Less Site Value: - 100,000 Less Minor site Improvements:- 5,000 Equals: Contribution of Main Improvements: $145,000

11. DepreciationMarket Extraction, overall depreciation 2. Compare the contribution of improvements to cost as if new $ Cost as if new, improvements: $200,000 Less Contribution of improvements: - 145,000 Equals: Depreciation Overall: $ 55,000

12. DepreciationMarket Extraction, overall depreciation $ Depreciation  Cost As Though New = Depreciation % $ 55,000  $200,000 = 27.5% Divide by effective age: 27.5%  15 yrs To get Depreciation per year: 1.83% Also, you can divide into 1.0 (reciprocal) to get market indication of total economic life expected by the market. 1.0  1.83% = 55 years

13. DepreciationMarket Extraction, overall depreciation Do this for a number of similar properties: Sale Eff. Age Deprec.%/yr. Life Exp.. 1 10 2.0% 50 yrs 2 12 1.5% 67 yrs 3 8 1.7% 59 yrs 4 15 2.2% 45 yrs Conclusion: depreciation for this type of property is about 2% per year; and the market’s expected economic life is about 55 years.

14. DepreciationAge-Life method; overall depreciation Concept: Effective Age divided by Total Economic Life equals Depreciation Percentage. Example: consider this building: Actual Age: 18 years; Effective Age: 12 years Remaining Economic Life is 48 years, so ….. Effective Age = 12 Remaining Economic Life = 48 Total Economic Life = 60 years Overall Depreciation = 12 / 60 = 20% Improvements have 12 years used up out of 60 , or 20%

15. DepreciationModified Age-Life method; overall depreciation In the modified method, the physical curable items, or repairs needed, are deducted first. Then the effective age and remaining economic life are considered, as though after the repairs completed, as before. For example …….

16. Building: 100,000 @ $60 = $ 6,000,000 Other Improvements: 100,000 Total Cost as though new: $6,100,000 Less Physical Curable - Repairs: - 50,000 Subtotal: $6,050,000 Effective age after repairs: 10 years; Total Economic Life of 50 years; Physical Incurable then: 10/50 = 20% or $1,210,000 Depreciated Cost of Improvements: $4,840,000 Add Site Value: 1,500,000 Indicated Value by Cost Approach: $6,340,000

17. DepreciationBreakdown method Each type of depreciation is handled in sequence • Physical Deterioration, Curable & Incurable • Functional Obsolescence, Curable & Incurable • External Obsolescence (always incurable; allocate total to Improvements)

18. Depreciation 1. Physical Deterioration Wear and tear, action of the elements, loss in value from aging, wearing out, being used-up. Curable - to cost of replacing or fixing the item less than the value added to the property. Incurable - makes no economic sense to fix or replace the item. Can be short or long lived items, difference is life of the component.

19. DepreciationBreakdown method; overall depreciation In the breakdown method, the physical curable items, or repairs needed, are deducted first. Then the short-lived components are analyzed and depreciation deducted. Then the residual remaining to be analyzed is the long lived components. The effective age and remaining economic life are considered, as though after the repairs completed, as before. For example …….

20. Building: 100,000 @ $60 = $ 6,000,000 Other Improvements: 100,000 Total Cost as though new: $6,100,000 Less Physical Curable - Repairs: - 50,000 Subtotal: $6,050,000 Less Short Lived Components: Component Cost Age Life % Deprec Total Roof: $30,000 8 20 40% $ 12,000 Less Long-Lived Components: Total Cost as though new: $6,100,000 Less Curable Items: - 50,000 Less Short-Lived Components: - 30,000 Residual: Long Lived Components: $6,020,000 Effective age after repairs: 10 years; Total Economic Life of 50 years; Physical Incurable then: 10/50 = 20% or $1,204,000 Depreciated Cost of Improvements: $4,834,000 Add Site Value: 1,500,000 Indicated Value by Cost Approach: $6,334,000

21. Depreciation 2. Functional Obsolescence From inadequacy or super-adequacy (too much or too little) of building materials, design, floor plan layout, etc. May be curable or incurable The test of curability is to see if it is economically sensible to fix the problem. It is curable if the value added exceeds the cost-to-cure.

22. Procedure for Estimating all forms of Functional Obsolescence Step 1: Cost of existing item: $xxx,xxx Step 2: Less depreciation previously charged -$xxx,xxx Step 3: Plus Cost to cure (all costs) or $xxx,xxx Value of the loss Step 4: Less cost if installed new -$xxx,xxx Step 5: Equals depreciation for functional obsolescence $xxx,xxx

23. Example: Functional Obsolescence - Curable Example of deficiency requiring an addition: Office building without air conditioning in a market where that feature is standard. Current Cost to install: $15,000 Cost to install if part of the original construction: $12,000 Contributory value of the air conditioning: $25,000

24. Example: Functional Obsolescence - Curable Step 1: Cost of existing item: $ 00 Step 2: Less depreciation previously charged -$ 00 Step 3: Plus Cost to cure (all costs) or $15,000 Value of the loss Step 4: Less cost if installed new -$12,000 Step 5: Equals depreciation for functional obsolescence $ 3,000

25. Example: Functional Obsolescence - Incurable Office building with exterior and interior walls partially constructed with concrete block and wood frame and stucco. Market does not recognize superior construction of concrete block with increased rents, hence the excess cost is superadequate. Total Square Feet in Building: 5,000 Cost of Concrete Block over Wood frame&stucco: $ 5.00 sf Total Excess Cost: $25,000

26. Example: Functional Obsolescence - Incurable Step 1: Cost of existing item: $25,000 Step 2: Less depreciation previously charged -$ 5,000 Considered in Physical Deterioration, long-lived components: 20% Step 3: Plus Cost to cure (all costs) or $ 00 Value of the loss Step 4: Less cost if installed new -$ 00 Step 5: Equals depreciation for functional obsolescence $20,000

27. Depreciation 3. External Obsolescence Loss in value of improvements (only) due to factors outside property boundaries. Almost always incurable because of being beyond the owners control. Causes: Physical Externality - example: near adverse influence Economic - example: currently in economic downturn, building costs above values.

28. External Obsolescence Estimate loss to property overall; then allocate to the building part (land part was considered in site value estimate). For example: a capitalization rent loss method: Income loss due to bad influence: $10,000 per year for a property with 20% of its value in the site. Capitalization Rate from the Income Approach is 10%. $10,000 / 10% = $100,000 total Allocation to the Building: $100,000 x 80% = $80,000 External Obsolescence

29. So that’s an overview of Depreciation Remember: • Its market driven, comes from the market • Its not like accounting depreciation • Its applied to cost as though new as of the date of appraisal - not original cost Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA Phone: (714) 871-3585 Fax: (714) 871-8123 Email: wfoss@fossconsult.com