Deconstructing Depreciation Part II

Last week we discussed physical depreciation. This week we will focus on the other components of depreciation: functional and external.

Functional depreciation, sometimes called functional obsolescence, addresses inadequacies or superadequacies within the property.

Here’s an easy example. Compare a house built in 1914 to a house built in 2014. Here are some of the differences you would see:

  • The 2014 house is bigger
  • The 2014 house is better insulated
  • The 2014 house has more closets
  • The 2014 house has more bathrooms
  • The 2014 house has a master suite
  • The 2014 house probably has a basement with a eight foot ceiling
  • The 2014 house has at least two garages, neither of which is used to store an automobile

In addition to physical deterioration, changing tastes and technology can make a property obsolete over time.

Functional obsolescence can also be a superadequacy, which simply means, “more than the market will bear.” Like it or not, every neighborhood has a value ceiling – the top price a buyer is willing pay to live in the area. And every neighborhood has a house that is just too much: too big, to much finish and too many amenities that no one will pay for. The replacement cost exceeds the market value, so an adjustment for functional depreciation is needed.

External obsolescence comes from sources outside the property lines. Sources of  external obsolescence can include a nearby railroad track, odors or noise from an industrial or commercial use, or proximity to any Kardashian or Jersey Shore cast member. Deteriorating market conditions (i.e, the real estate market between 2008 and 2012) or a generally declining neighborhood can also result in external obsolescence.

We know that all of these types of depreciation exist, but they are very difficult to estimate individually. Often the best we can do is  estimate accrued depreciation, which is the sum total of all depreciation.

You may ask, “who needs that?” Insurance companies. Some policies cover the Actual Cash Value of a building, which in appraisal terms is the Depreciated Value of the Improvements.

You may ask, “how do you measure accrued depreciation?” It is not easy, but it is doable. Here are the steps:

  1. Estimate the market value the property including the improvements. A house, for example.
  2. Then estimate the market value of the lot the house sits on. The difference is the depreciated value of the improvements. This number is (sometimes) important to insurance companies.
  3. Then estimate the replacement cost of the improvements using a cost service such as Marshall & Swift or an architect’s estimate. The difference between replacement cost and the depreciated value of the improvements is (ta da!) the accrued depreciation. This number is important to no one.

– Bob Gagliano

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