Deconstructing Depreciation Part I

Depreciation is a widely misunderstood concept. Most people don’t know, for example, that there are three kinds of depreciation: physical, functional and external. Today we will focus on physical depreciation.

The concept of physical depreciation is pretty simple: things break down and wear out. As a gentlemen on the back nine of life (in fairness, I just teed off on the 10th hole) I can assure you, everything wears out.

There are a couple of terms associated with physical depreciation that are key. The first is expected life, which simply answers the question, “How long will this thing last? The next is actual age. This is just math, counting candles on a cake or rings in a tree. The last term is the biggest problem for most people: effective age.

Here is a little thought experiment to illustrate how this all works. Let’s say you build your dream house in 2014 that has an expected life of 50 years, which is typical for most American homes. After about 20 years you replace the roof and the HVAC system and renovate the kitchens and bathrooms. What you just did is reduce the actual age of 20 years to an effective age of 10 years. With proper maintenance, a well built house can last a hundred years or more, because every repair and renovation sets the clock back.

Accountants often use a technique to calculate depreciation called the age/life method. It is pretty simple: a 20 year old thing expected to last 50 years is 40% depreciated. The reality is that physical depreciation tends to work on an exponential curve.

Go back to the dream house you built in 2014. After 20 years not much changes. However, if you don’t replace the roof, water may start to infiltrate. Not much at first. Maybe the roof sheathing gets a bit damp and expands. Then the leak gets bigger. The the rafters get wet and start to warp. The leak gets bigger. Then the water starts to seep into the walls. The drywall starts to crumble. The floor gets wet and the subfloor and joists start to expand.

At this point the depreciation is accelerating as the bad things tend pile up on one another. After about 50 years the place is uninhabitable or maybe (blessedly) falls in on itself.

I was once in a house once where this actually happened. And the woman was a hoader. The clean up crew found a cat skeleton. I get the willies just thinking about it.

– Bob Gagliano

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Rotting House

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