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LESSON 9 The Cost Approach Part III – Depreciation Estimates

Assigned Reading 1.

Appraisal Institute of Canada & Appraisal Institute (US). 2010. The Appraisal of Real Estate, Third Canadian Edition. Vancouver: UBC Real Estate Division. Chapter 19: Depreciation Estimates

Note: Selected readings can be found under "Online Readings" on your Course Resources website. Recommended readings are provided only for your information, should you wish to learn more about these topics. Recommended readings are NOT tested on the final examination.

Recommended Reading 1.

Derbes, M.J., Jr. 1998. "Accrued Depreciation Redefined and Reordered". Appraisal Journal. 66(2). pp. 131-143. Changes and refinements are suggested in the measurement of accrued depreciation using the breakdown method in the cost approach.

2.

Derbes, M J. Jr. 1987. "Economic Life Concepts". Appraisal Journal. 55(2). pp. 216-224. Although this article is dated, it provides both a glimpse into the evolution of depreciation concepts as well as a good discussion of the economic life concepts that are still an essential part of depreciation analysis.

3.

Galleshaw, M. 1991. "Market-wide External Obsolescence". Appraisal Journal. 59(4). pp. 519-525. A good discussion of external obsolescence and the link between feasibility and a market-extracted period of obsolescence.

4.

Laronge, J.A. 2000. "Solving the Functional Obsolescence Calculation Question? Part I" Appraisal Journal. 68(3). pp. 327-339. This article discusses the correct methodology to calculate functional obsolescence.

5.

Laronge, J.A., Vandell, K.D. 2001. "Solving the Functional Obsolescence Calculation Question? Part II" Appraisal Journal. 69(2). pp. 152-159. Continuation of Part I.

6.

Ramsett, D. 1998. "The Cost Approach: An Alternate View". Appraisal Journal. 66(2). pp. 172-180. The cost approach is not highly regarded by appraisers as an accurate and efficient method of estimating the market value of single-family homes. This article is intended to improve the usefulness and acceptance of the cost approach by offering an alternative method, which integrates land and improvements, offers an innovative view of depreciation, and encourages more reliance on market-based information.

7.

Wilson, D.C. 1998. "Principle of Production: A Logical Premise for the Cost Approach". Appraisal Journal. 66(1). pp. 25-40. This article proposes a principle of production as an adequate premise for the cost approach. The principle of production helps clarify many aspects of the cost approach, as well as the issues surrounding why and when this approach should be used.

9.1

Lesson 9

Recommended Reading – Environmental Depreciation and Stigma These are just a sampling of the numerous articles on the specialized subject of environmental and stigma impacts on real property values. 1.

Bond, S.G. 2007. "The Effect of Distance to Cell Phone Towers on House Prices in Florida". Appraisal Journal. 75(40). pp. 362-370. This article outlines the results of a study carried out in Florida in 2004 regarding the effect that cell phone tower proximity has on residential property prices.

2.

Hollander, J., Greenberg, M. 2006. "Neighbourhood Stigma Twenty Years Later: Revisiting Superfund Sites in Suburban New Jersey". Appraisal Journal. 74(2). pp. 161-173. Six superfund hazardous waste sites in suburban New Jersey were examined for evidence of long-term stigma.

3.

Jackson, T.O. 2005. "Evaluating Environmental Stigma with Multiple Regression Analysis [Environment and the Appraiser]". Appraisal Journal. 73(40). pp. 363-369. Regression models for evaluating environmental stigma.

4.

Jackson, T.O. 2009. "When Good Things Happen to Bad Properties [Environment and the Appraiser]" Appraisal Journal. 77(2). pp. 112-116. Article on environmental stigma and the remediation lifecycle – empirical evidence of recovering property values presented in a case study.

5.

Mertz, C.K., Flynn, J., Hunsperger, W., Johnson, S.M., MacGregor, D.G. 2004. "A Survey Approach for Demonstrating Stigma Effects in Property Value Litigation". Appraisal Journal. 72(1). pp. 35-44. This article presents an approach for designing a survey to address stigma issues.

6.

Sanders, M.V. 2005. "Mold: What Appraisers Should Know". Appraisal Insights & Perspectives. 10(3). pp. 42-43.

7.

Williams, T.P. 1996. "Categorizing External Obsolescence". Appraisal Journal. 64(20. pp. 148-154. This article describes three basic categories of external obsolescence: location, environment and economic. The author presents various scenarios in which obsolescence exists, and develops examples for estimating the loss in value for residential and non-residential property types.

Learning Objectives After completing this lesson, the student should be able to: 1.

define depreciation and related terms;

2.

explain the methods which may be used to estimate accrued depreciation;

3.

distinguish between physical deterioration, functional, and external obsolescence as they apply to the breakdown (observed condition) method of estimating accrued depreciation;

4.

explain the difference between repair, short-lived, and long-lived physical deterioration;

5.

explain the difference between curable and incurable functional obsolescence;

6.

identify and explain the types of external obsolescence;

7.

estimate the accrued depreciation for a subject property, using the appropriate method; and

8.

estimate the value of a subject property using the cost approach to value.

9.2

The Cost Approach Part III – Depreciation Estimates

Instructor's Comments This lesson introduces the concept of depreciation as it applies to real estate, outlining the various forms of depreciation and methods for measuring it. Some of the concepts of depreciation are straight-forward and easy to quantify, particularly in the physical categories. Functional and external obsolescence are more involved and complicated to analyze. Several recommended reading references have been listed to give different perspectives on these concepts, to help facilitate a solid understanding of them. Some of the articles are dated, but the theory and approach(es) they suggest provide both insight into the evolution of current theory, and alternate views. Appraisers must be very diligent when inspecting a property to note all forms of deterioration and obsolescence. The owner/tenant should be questioned about any problems that are not evident or any reports on the building's condition or foundations. For impaired properties, such as leaky condos in Vancouver, appraisers have to be very careful to gather all the facts before any valuation is undertaken. A thorough inspection will also enable the appraiser to estimate the effective age of the building and its remaining economic life, both of which are essential when calculating depreciation. The different methods of measuring depreciation each have advantages and disadvantages, in terms of applicability and limitations. Extracting data from the market to estimate depreciation and age-life methods are very simple ways of measuring depreciation and are often found in form reports when applying the cost approach. The most comprehensive approach to depreciation is the breakdown method. This approach is useful in that it gives the appraiser and the client a detailed breakdown of all forms of deterioration and obsolescence with their related costs. It will also help the appraiser understand the theory of depreciation and why some properties are worth more or less than similar ones on the market. The breakdown method can assist the appraiser in estimating value when reviewing plans for new homes or plans for renovations of existing homes as they will be able to identify any form of depreciation or obsolescence such as a poor floor plan, lack of some major component, or inappropriate building materials or piece of equipment. A case study will be provided in this lesson to illustrate the breakdown method. Some appraisers argue against the use of the breakdown method as it provides much more detail than many clients require, and does not represent a good use of appraisers' time in appraisals where the cost approach is not particularly applicable. However, because this is the most comprehensive depreciation method, it illustrates all of the possible forms of depreciation and techniques for measuring them, so we will use the breakdown method in this lesson as an educational tool.

Depreciation Lesson 8 provided the theory and demonstration how to estimate the cost new of a building. But, as soon as a building is finished, like everything else, it begins to depreciate or lose value. Depreciation is defined as: "In appraising, a loss in property value from any cause."1 The type of depreciation analyzed in an appraisal report is referred to as accrued depreciation. Accrued depreciation is defined as "The difference between the reproduction or replacement cost [new] of the improvements on the effective date of the appraisal and the market value of the improvements on the same date."2

1

The Dictionary of Real Estate Appraisal, 4th Edition, Appraisal Institute.

2

Ibid.

9.3

Lesson 9

Definitions

Before examining depreciation in detail, we will first explain some definitions relating to depreciation. Physical life and chronological (actual) age are factual and easy to determine.

The physical life of a building is the total period of time that the building can remain standing. It can be well over 60 years depending upon the type of construction. Through proper maintenance and replacement of components as or before they wear out, the physical life of a building can be extended for considerable lengths of time. In some parts of Canada, many buildings are hundreds of years old.

Chronological (actual) age is the actual age of the building; the number of years since it was originally built. Economic life refers to the period of time over which the improvements will contribute to the overall property value. Economic life is normally shorter than the physical life. Useful life is the period of time over which a structure may be reasonably expected to perform the function for which it was designed. Economic life is determined from both internal characteristics of the property (condition, maintenance) and external (to the property) market characteristics, trends and evolution (zoning changes, supply and demand, changes in density of development, etc.). Economic life is an estimate and a difficult concept to understand. As its name suggests, while it does give consideration to some physical factors of the subject property, it is largely based on economic factors in the market place. Considerations in estimating economic life can include:     

physical age, quality and condition of subject dependent upon economic cycles when similar buildings undergo major renovation or rehabilitation when similar lands have been rezoned to more intensive uses when demolition permits are issued for similar buildings

Effective age is based on the property's condition and general overall maintenance. Effective age can be the same as, or lesser or greater than its actual age at the date of the appraisal. It is the responsibility of the appraiser, based on their inspection of the building, to estimate the effective age of the subject property. Effective age is an estimate and has to be justified by the appraiser. It takes into account the building's actual age, quality of construction, any updates and overall condition. It examines the market to estimate the age of buildings against which it is competitive. For example, a 30-year old quality built home that is very well maintained may be competitive with 20-year old homes in the market. If its construction was average, and it is in need of significant maintenance, it may be competitive with 40-year old homes in the market. The greater the difference between actual age (fact) and effective age (opinion), the more explanation is required of the appraiser.

Remaining Economic Life (REL) is the difference between economic life and effective age. The REL is the remaining expected (future) economically productive life span of the structure. It changes due to market conditions and the building's overall maintenance. This may be important for mortgage lenders when determining the amortization of a loan. Short-lived items are usually building components or equipment such as furnaces, hot water tanks, carpets, roof cover, kitchen cupboards, electrical fixtures, and windows and doors; i.e., those items whose remaining life expectancy is less than that of the entire structure. For instance, a hot water tank will usually last for 5-10 years. During the lifetime of a home it will probably be replaced 5 or 6 times. Therefore, the tank is depreciated over

9.4

The Cost Approach Part III – Depreciation Estimates

a 10 year period, while the house may be depreciated over a 50 year period. The same is true for other building components as each will have their own unique lifespan. Long-lived items are those building components with an expected remaining economic life that is the same as the remaining economic life of the entire structure. Examples would include the foundation and structural framing of floors, walls and roof structure. Figure 9.1 provides a timeline to illustrate these terms. Figure 9.1: Age-Life Chart for a Building YEARS Physical Life

60

Econo mic Life or Useful L ife

50

R ema ining Econ om ic Life is 4 0 years. Econo mic life m inus Effe ctive Age

Actu al Age

15

Effective Age

10

Date of Appraisal

SHORT-LIVED ITEMS Age N ew

0

Short-lived ite ms will have a life expectan cy typically u p to 25 yea rs, d ep end ing up on the i te m’s o rigin al co st an d overall qua lity of man ufacture. D urin g the life of a ho me the se ite ms will b e re placed a nu mbe r of time s. Such items are carp ets, furnace , ho t w ater tan k, ro of cove r, an d an y othe r item tha t we ars o ut w ith u se.

9.5

Lesson 9

Depreciation Methods There are three principal methods for estimating depreciation: market extraction method, economic and modified age-life method and observed condition, also known as breakdown method. Principal Methods of Estimating Depreciation    

Market Extraction Age-life Modified age-life Observed Condition (Breakdown)

Most appraisers apply the market extraction or age-life method. These are applied to the whole property, and are easier to understand and apply. With no detailed depreciation examination, the elements of depreciation are implicit. Both methods assume a lump-sum depreciation from all causes can be expressed in an overall estimate. They rely primarily on the appraiser's estimates of effective age and remaining economic life, and typically reflect a straight-line pattern of depreciation. The market extraction method is the better of the two to demonstrate depreciation patterns over time.

Market Extraction Method

Applying the principle of contribution, the appraiser analyzes the contributory value of an improvement (the house) to the sale price of a property. Then, the improvement's value in contribution is compared to its cost to construct as brand new. The ratio of the value in contribution, with its inherent depreciation, to the cost new provides an indication of the rate of depreciation appropriate to the subject building. Let's look at an example to clarify this. Comparable 1 sold for $350,000. The land value appropriate to this comparable was estimated at $100,000. Therefore, the indicated value of the house alone was $250,000. The cost to build the house new today is estimated at $300,000. The house is 10 years old, so its indicated $250,000 value is 83.3% of its estimated cost new. This indicates an annual rate of depreciation of 16.7%/10 = 1.67% per year. By applying this market extraction technique to several properties, the appraiser can estimate a market-supported annual depreciation rate for the subject house. To conclude our example, if there are several sales supporting a depreciation rate of 1.67% per year, and if the subject is 15 years old at the date of appraisal, then it is reasonable to conclude that it has depreciated: 1.67%/year × 15 years = 25.1% This is a relevant market-based approach to estimate depreciation. However, it is rarely seen in practice due to the research effort required and the difficulties in accurately estimating value in contribution and cost new for a number of comparable properties. This approach requires the development of an accurate estimate of the contributory value of the site to the property value, and a defensible estimate of cost new for each sale. Also, the comparables should have physical, functional and external characteristics that are similar to the subject property, and they should have incurred similar amounts and types of depreciation. Care must be taken to ensure that differences in value are not attributable to differences in design, quality or construction. This method requires sufficient sales data to meet the above criteria. Steps in the Application of the Market Extraction Method of Estimating Depreciation

1. Find and verify sales of improved comparable properties that are similar in terms of age and utility to the subject property. 2. Make adjustments to the sale prices of the comparable properties to adjust for property rights conveyed, financing and conditions of sale. 3. Estimate and subtract the value of the land at the time of sale from the sale price of each comparable. This gives the contributory value of the improvements.

9.6

The Cost Approach Part III – Depreciation Estimates

4. Estimate the cost new of the improvements for each comparable, as the time of its sale. 5. Subtract the contributory value of the improvements from the cost new of the improvements. This gives the total dollar amount of depreciation of the improvements at the date of sale. 6. Convert the dollar estimate of depreciation into a percentage by dividing the estimate of total depreciation by the cost new of the improvements. If the ages of the comparables are the same as the subject, reconcile their indications into a single estimate and apply this rate to the cost new of the subject's improvements.

Market Extraction Method Procedure: 1.

Find comparables with the same depreciation losses in value as the subject. Make adjustments to the sale prices for:  property rights included  seller financing concessions  conditions of sale Subtract the value of the land. Estimate the reproduction or replacement cost. Subtract the calculated value of the building(s) from the adjusted sale price to show depreciation.

2.

3. 4. 5.

7. If the ages of the comparables differ from the subject, then develop an annual depreciation rate for each comparable by dividing the total percentage rate by the age of the comparable. Reconcile the indications of percent depreciation per year from the comparables into a single indication for the subject. Economic Age-Life Method

The economic age-life method is a quick and easy method to apply and is often used in form reports to give an estimate of the building's depreciated value. It is based on the building's effective age divided by its economic life. However, this method does not consider individual short-term items like the furnace, hot water tank, etc. The appraiser can account for newer short lived items by adjusting the effective age, thereby reducing the amount of the depreciation charged against the property.

Economic Age-Life Method  

effective age divided by economic life = percentage depreciation for example, a 10 year-old roof with a 20-year life is 50% depreciated (10/20)

For example:      

Replacement cost new of subject house: $150,000 Effective age of 10 years Economic life of 50 years Depreciation is estimated at 10/50 or 20% Age-life depreciation estimate: $150,000 × 20% = $30,000 Depreciated replacement cost is: $150,000 - $30,000 = $120,000

The age estimates may be modified to reflect the condition of building components that would normally be replaced before the end of the structure's useful life: roof cover, floor cover, painting, windows, etc. The age estimates may be further adjusted to account for any repairs immediately required as of the effective date of appraisal. In residential form reports, the age-life method is usually applied due to its simplicity and ease of application. The age-life method is simple and easy to apply and understand. It allows the appraiser to estimate total depreciation. Inherent in this method is the assumption that every building depreciates on a straight-line basis (equal percentage of depreciation every year). All forms of depreciation are inherent in the one estimate, and depreciation is not divided into its various categories. It does not differentiate short-lived from long-lived items. 9.7

Lesson 9

Modified Age-Life Method

There are situations where the impact of certain items of depreciation are readily known. These items are typically those that are reflected in the direct comparison approach as the ones relating to the costs incurred by the buyer upon purchase of the property. They normally relate to correcting problems that are readily apparent, when the cost to cure or correct the problem are easily quantifiable. Examples would include replacing worn out shingles on a roof, repairing leaks in a bathroom, replacing worn out carpet. The "breakdown method", discussed next, will categorize such elements as curable physical deterioration. In the modified age-life method, these "immediate repair or replacement" components are costed first, then the age-life method is applied to the balance of the cost new of the structure. Consider the following example, taken from the textbook. The subject building has a cost new estimate of $892,000. It is 20 years old, but after the items requiring immediate attention are repaired, it is estimated to have an effective age of 15 years. The economic life estimate is 50 years. The cost to refurbish the interior has been estimated at $82,500 – this investment essentially equates the interior to new condition. The $82,500 repair cost addresses this same amount reflected in the cost new estimate for the interior. The depreciation estimate is calculated by applying the modified age-life method as follows: Cost New Estimate Less cost to refurbish interior Remaining cost

$892,000 – 82,500 $809,500

Depreciation on remaining cost via age-life method = $809,500  15/50 – $242,850 Depreciated cost

$566,650

Stated another way, the total depreciation according to the age-life method is: Cost to refurbish interior Depreciation on balance of the building Total depreciation

$ 82,500 + $242,850 $325,350

Other examples of how the age-life method may be modified are described and illustrated in the textbook. Exercise: Age-Life Terminology You are appraising a house and want to apply the age-life method to estimate depreciation. Each of the following numbered points illustrates one or more of the various definitions of building age or economic life. For each point, indicate which definition of age, life, or remaining life is illustrated, and discuss how this might influence the subject's valuation. 1. 2.

3.

4. 5.

9.8

The subject house was built 20 years ago. The ruins of an old, dilapidated house still exist in the subject neighbourhood. It was vacated when the roof caved in last winter. The house suffered from poor maintenance over the years, and it was 60 years old when it became uninhabitable. The age and condition of the surviving partial structure is such that the building cannot be saved. A 65 year old house, in habitable condition, in the same municipality as the subject property was recently torn down. It was built in an area originally zoned residential, but 5 years ago, the block in which it was located was rezoned to commercial and that block is now undergoing change to commercial uses. The owner plans to redevelop this site, along with adjacent lots, into a neighbourhood shopping centre. Demolition permits indicate that houses comparable in style and construction to the subject are normally torn down, and the site redeveloped, when the houses are 70 years old. The subject house was recently upgraded with a new roof, renovated kitchen, and bathroom. It is now competitive on the market with 10 year old houses.

The Cost Approach Part III – Depreciation Estimates

Answers: Actual or chronological age – 20 years. This house may be in competition with houses that are 20 years old. The actual age is a consideration in estimating effective age, which is used in the age-life calculation (depreciation = effective age/economic life). 2. Physical life – 60 years as this is when the house became uninhabitable due to the caving in of the roof. One could also argue that this is also the economic life of the building, since it was habitable to the point of the roof caving in. However, normally economic life can be extended through normal maintenance, replacements, and modernization. This apparently wasn't the case for this building as it is stated that it suffered from poor maintenance over the years. Therefore, the 60 year age is more indicative of physical life expectancy than economic life. 3. Economic life – 65 years. The house's economic life ended at 65 years when it was demolished in favour of redevelopment for commercial uses. This provides an indication that the economic life of the subject house is at least 65 years. 4. Economic life – 70 years. The age of houses when demolition permits are approved is a good indicator of the economic life expectancy of these homes. Renovation and rehabilitation are no longer practical to extend the utility and remaining economic life of the buildings due to the costs required, and redevelopment is justified when the buildings have reached the end of their economic lives. 5. Effective age – 10 years. The subject's physical life is still 20 years, but the recent modernization has improved it such that it is competitive with houses on the market built only 10 years ago. Now that we have an indication of the effective age of the subject, we can calculate its remaining economic life. We have two indicators of economic life: 65 years based on the redevelopment of one property, and 70 years based on the issuance of demolition permits for houses comparable to the subject. Since the 70 year indication is based on more than one house, it is reasonable to conclude an economic life expectancy of 70 years for the subject. The remaining economic life is 60 years (economic life minus effective age, or 70 minus 10). Age-life depreciation would be measured as 10/70 = 14%. 1.

Breakdown Method

The breakdown method is the most detailed and comprehensive way to measure depreciation. It breaks down total depreciation into three categories, physical, functional, and external, and then breaks down each of these further into subheadings: physical deterioration  curable  incurable – short-lived  incurable – long-lived functional obsolescence  curable – deficiency  curable – modernization  curable – superadequacy  incurable – deficiency  incurable – superadequacy external obsolescence  locational  economic First, it is necessary to differentiate between physical and functional depreciation, and within these, curable and incurable. Figure 9.2 provides a chart that illustrates four sub-categories.

9.9

Lesson 9

Breakdown Method Categories  

physical deterioration – caused by wear and tear or the passage of time functional obsolescence – usually the result of the property no longer conforming to a market requirement or not in compliance with highest and best use external obsolescence – caused by factors outside the property

A deficiency is a missing component that would normally be found in the subject property type. For example, the subject property may have only one full bathroom, where comparable and competing properties also have a ½ bathroom off the master bedroom. The absence of the ½ bathroom would be an example of a deficiency. Whether or not it is curable would depend on whether it is economical to add the ½ bathroom to the house, at the date of appraisal.

A superadequacy refers to a component of the building that exceeds the standard normally expected in the market place. Examples could include an excessively ornate and expensive finish in a house of average quality of construction, or foundation walls built to a thickness of 12" where 8" is the standard in the market. 

Components can be corrected economically if their cost is greater than or equal to the resulting increase in market value, or offsets a loss in market value if the expenditure is not made. Breakdown Method – Methods of Calculating Depreciation   

estimation of the cost to cure the problem application of functional obsolescence procedure capitalization of lost income

 

application of the age-life ratio analysis of market data to obtain physical, functional, or external losses

Figure 9.2: Categories of Depreciation

CURABLE

INCURABLE

9.10

PHYSICAL

FUNCTIONAL

Physical Curable:

Functional Curable:

physical wear and tear that would be corrected economically and immediately, such as repainting worn-out painted areas, or replacing worn-out kitchen flooring.

an outdated feature, deficiency or superadequacy that can be corrected economically, such as outdated bathroom fixtures

Physical Incurable:

Functional Incurable:

short-lived – physical wear and tear that would not be immediately corrected as there still is remaining utility. For example, roof shingles that are half-worn out, but would have to be replaced before the end of the economic life of the house. long-lived – physical wear and tear that would not be immediately corrected for building components that have the same remaining economic life as the structure. For example, foundation or structural walls, trusses or joists that still adequately perform their function.

a deficiency or superadequacy that cannot be corrected economically, such as a poor floor plan that would require a significant redesign and remodeling of the building that would not have any benefit to market value that would offset the cost.

The Cost Approach Part III – Depreciation Estimates

Physical depreciation represents the accumulated loss in market value caused by physical wear and tear since the date the building was completed. Functional depreciation is the loss in value caused by an outmoded or inadequate design, or over-improvement beyond what the market demands. The key difference between these is:   

Deferred maintenance (curable items) typically require a lump-sum adjustment in the direct comparison and income approaches because these problems are specific to the subject property and would not be reflected in the values provided by comparable sale or rental properties.

physical depreciation is tangible, such as items that are worn, broken, or no longer fulfilling their function; functional depreciation results from perception of market participants, referring to items that may still be fulfilling their function, but the market does not demand them in their current form; for example, a worn carpet is physical depreciation, while an orange shag carpet in perfect condition would be functional depreciation (with apologies to those still living in the 1970s).

Physical or functional depreciation can be curable or incurable. The distinction here is whether something is economically repairable B keeping in mind that anything can be fixed if you are willing to pay the price, but at some point items are no longer economically worth fixing. Consider a car example: your 1974 Ford Pinto has a broken transmission and a repair quote for $3,000. While you could spend the money and get it fixed, it is more likely this repair would outweigh the car's value, and it is not economically worth repairing. Therefore, this is incurable physical depreciation. Figure 9.3 lists the various subcategories of functional depreciation, and provides an example how each may arise in a house. Figure 9.3: Examples of Functional Depreciation Category of Functional Depreciation

Example

Curable – deficiency Curable – superadequacy (overbuilt) Curable – modernization

No air conditioning Excessively ornate dining room finish Outdated bathroom fixtures

Incurable – deficiency

Poor floor plan, outdated architectural style

Incurable – superadequacy

Foundation wall 12" thick when 8" is the norm

For curable items, the depreciation is easily estimated as the cost to cure. For example, if windows are broken (physical curable) or the bathroom fixtures are outdated (functional curable), the depreciation is simply the cost to replace or repair them, less any salvage value that may exist. For incurable items, the depreciation is more difficult to estimate. You have already identified that the items are not worth fixing, so what loss in value should be attributed to them? Take for example an old house that has sloped floors due to foundation settlement, but the house remains habitable and the foundation is stable. You estimate the house has 10-15 years of remaining economic life, given the local trend of demolishing and rebuilding old houses. It does not appear worthwhile to spend $100,000 to raise the house and repair the foundation, so instead the owner will likely choose to live with the problem until the house is eventually torn down. If the repair is not going to be completed, then you can be fairly certain this physical incurable depreciation is less than $100,000, but determining the appropriate loss in market value is a challenging appraisal problem. For want of a more precise or accurate method, the age-life method is typically applied.

9.11

Lesson 9

External Depreciation is a third depreciation category, referring to items outside the property itself that impact its value. The following figure presents two categories of external depreciation for a house, locational and economic. These factors should have already been considered in the land value estimate, but their impact on improvements must also be addressed. Figure 9.4: Examples of External Depreciation Category of External Depreciation

Example

Locational

Adjacent to a 24 hour convenience store

Economic

Major industry shut down in the community, a period of excessively high mortgage rates

Environmental Depreciation

A new category of depreciation is already impacting appraisal analyses, and may more formally make its way into appraisal theory as a new depreciation category in the near future. That category is environmental depreciation. This can refer to negative or positive, environmental property characteristics either on the subject property or external to the subject property, but having an impact on it. Current depreciation theory addresses the negative impact of environmental issues under the heading of external depreciation, locational. An example could be the negative impact on residential property values resulting from being located near an airport where the residential neighbourhood suffers from noise pollution from the aircraft taking off and landing. Or, residential property located downwind from a sulphur plant that generates rotten gas odours. Or, a residential area which abuts a railroad line, where there had been a train derailment and chemical spill resulting in stigma being attached to the residential area. Stigma is an adverse public perception regarding a property, the identification of a property with some type of opprobrium (environmental contamination, a grisly crime) which exacts a penalty on the marketability of the property, and hence its value.3 However, former industrial properties are being redeveloped. There are potential issues of environmental contamination, and the degree of cleanup required. Leakage of older underground gasoline and diesel tanks is not uncommon with service station properties. Older air conditioners could have leaked environmental contaminants into the ground of residential yards. Residential or park properties may have had the weeds treated with chemicals now considered dangerous and unsafe. There are issues with asbestos and mould. All of these may be grouped under the heading of environmental depreciation, whether they actually exist or are perceived to exist. This introductory course focuses on the basic techniques of measuring depreciation. Most causes of environmental depreciation are treated in much more depth in more advanced courses. What could be considered as environmental depreciation and stigma, whether internal to the property or external, can all be analyzed under the existing observed condition (breakdown) methods of measuring depreciation. For the student who wishes to read more on this subject, the recommended reading includes articles on environmental depreciation and stigma.

3

The Dictionary of Real Estate Appraisal, 4th Edition, The Appraisal Institute.

9.12

The Cost Approach Part III – Depreciation Estimates

Measurement of Each Category of Depreciation in the Observed Condition Method

The following provides a summary of the calculations to measure each category of depreciation analyzed in the observed condition method. The textbook and the following case studies in this Lesson provide additional detailed information and examples of the analysis of each category. Observed Condition Method Category of Depreciation

Method of Calculation

Physical Deterioration, Curable

Depreciation is measured by the cost to cure.

Physical Deterioration, Incurable, Short-Lived

Depreciation is measured by applying the age-life method (appropriate to the component) to the cost new of each, individual component that would be replaced before the end of the building's remaining economic life.

Note that it is also necessary for the appraiser to estimate the cost new of the building's component(s) being cured, that is, what that component would cost new, if the building were under construction as of the effective date of appraisal. This figure will be needed for the long-lived calculation. Normally, the cost to cure exceeds the cost new of the component, due to extra costs of preparation that are not incurred during new construction.

As was the case for physical deterioration curable, the cost new of the incurable, short-lived items will be brought forward to be used in the long-lived calculation. Note that if a short-lived item has an effective age that equals or exceeds its expected life, then, by definition, it is a curable item that would be repaired or replaced immediately. Physical Deterioration, Incurable, Long-Lived

Depreciation is measured by applying the age-life method (appropriate to the building) to the balance of the cost new of the building not addressed by the curable or short-lived calculations. Deducting the cost new associated with the curable and short-lived items avoids double depreciation of these components.

Functional Obsolescence, Curable, Deficiency

Depreciation is measured by the excess cost to cure the deficiency. The difference between the cost to add the missing component to the existing, constructed building minus the cost to include the missing component if the building were under construction as of the effective date of appraisal equals the depreciation charged. Cost to add now – cost to add if the building were under construction = depreciation from functional obsolescence, curable, deficiency.

9.13

Lesson 9

Functional Obsolescence, Curable, Superadequacy

Depreciation is measured by the formula: (1) (2) (3) (4) (5) (6)

Cost new of existing (superadequate) component - physical depreciation previously charged + all costs to now add a standard component (removal costs and cost to add new component) - salvage value - cost to install if under construction

= depreciation from functional obsolescence, curable, superadequacy. Functional Obsolescence, Curable, Modernization

Depreciation is measured exactly the same as for functional obsolescence curable, superadequacy. Instead of replacing a superadequate component, an outdated component is replaced.

Functional Obsolescence, Incurable, Deficiency

Depreciation is measured by deducting the cost to include the missing component if the building were under construction, from the value of the loss incurred by the property by not having that component. The cost to add the component now, after the building has been constructed, is exceeded by the increase in market value. Since the component is incurable, it will not be added to the building. So, the depreciation equates to the impact on market value of this omission. The impact on market value of the missing component may be measured via a paired sales analysis as described in the direct comparison approach; or by applying elements of the income approach through an analysis of the resultant net income loss attributable to the deficiency, and then capitalize that loss into an indication of market value.

Functional Obsolescence, Incurable, Superadequacy

Depreciation is measured by the formula: Cost new of existing (superadequate) component - physical depreciation previously charged + present value of additional costs of ownership resulting from the superadequate component If there were an increased cost of, say, heating and cooling resulting from the superadequacy, then this annual increased cost would be capitalized into an indication of the value impact; and this amount would be added to the above figure to give the total depreciation. The textbook provides an example.

9.14

The Cost Approach Part III – Depreciation Estimates

External Obsolescence, Locational and Economic

There are 3 methods of measuring external obsolescence: 1. Allocation of market-extracted depreciation. 2. Paired sales analysis. 3. Capitalization of gross income loss via application of a gross rent multiplier or net income loss via application of a capitalization rate. The textbook demonstrates the first method, which is rarely seen due to the number of estimates (building's contributory value, building's cost new, depreciation from all causes other than external obsolescence) that must be made. For the paired sales analysis, adjustments must be made first for any differences that exist between the sales being paired, to isolate on the external obsolescence being the only remaining difference. Care must be taken to ensure that no double depreciation occurs by allocating the correct proportion of the calculated loss to the building only. Any impact to the land value caused by external obsolescence may have already been taken into account. Typically, only the loss in value to the building is applied as external depreciation, using an allocation approach based on the building's percentage of property value. However, for apartment buildings subject to rent control, the loss is generally attributable 100% to the improvements only, because the site if vacant could be developed for other residential use, such as condominium, congregate care, group home, etc. Theoretically, there might be an exception if the highest and best use were for residential rental; however, the developer of a Greenfield site would be able to set initial rents at market. One method of estimating the loss due to external obsolescence for income properties requires the use of the building residual technique. This requires the application of an income residual analysis that estimates the income produced only by the building. This income than then be capitalized by applying the building composite capitalization rate to indicate the value loss. This approach is beyond the scope of this course, and is only included for the sake of completeness of the theory on methods of calculating the loss.

The textbook provides a standard formula for calculating all forms of functional obsolescence (which is also reflected in the above summary: Step 1 Step 2 Step 3 Step 4 Step 4

Cost of existing item Deduct (physical) depreciation already charged Add cost to cure (cost of new component, net of removal costs and salvage value) Or, Add value of the loss Deduct cost if installed new (if under construction) Equals depreciation from functional obsolescence

$ –$ +$ -$ $

An alternative technique for estimating functional and external depreciation would be based on the paired sales analysis technique, from the direct comparison approach, if it is possible to isolate on the reason for the functional or external depreciation. In many cases, this may be impractical due to the lack of sufficient detail that can be obtained and result in a conclusion without a high degree of reliability. Additionally, this may be criticized as simply modifying the standard cost approach with too many elements of the direct comparison approach, and thereby weaken the potential use of the cost approach as an independent check on value for the direct comparison approach. 9.15

Lesson 9

Cost Manuals and Services – Estimates of Depreciation

Cost manuals and computerized costing services, such as Marshall & Swift/Boeckh, also contain estimates of depreciation. These services should only be used by an appraiser to estimate depreciation if their formula is clearly understood by the appraiser, who is then prepared to justify its application as representing the local market appropriate to the subject property. Such depreciation estimates are typically not based on a straight-line depreciation calculation, but reflect a curve whereby the annual rate of depreciation is lower in the early years, and greater as the building Cost manuals and services provide ages, and never reaching 100%. life span estimates for the various buildings they model. These relate more to physical life expectancy than to economic life, and should not be relied upon at face value as indicators of economic life.

The Marshall & Swift/Boeckh costing used in the Frobisher report was re-run, using an effective age of 20 years. As seen below, the service automatically calculated physical and functional depreciation at 21.0%, or $26,244. This reflects the cost service's estimate of life span, which may or may not equate to economic life, and formula to calculate the percentage of depreciation.

As will be seen in the excerpt from the Frobisher report at the end of this lesson, the depreciation applied based upon the observed condition method was $58,476 – over double of that suggested by the costing service. Site Improvements

Site improvements are normally considered on the same basis as short-lived items in the building. Depreciation on site improvements, such as paved or concrete driveways, parking lots, lot lighting, fencing, and walkways is estimated using the age-life method. Normally, this is done in a chart when each site improvement is listed and costed in the cost analysis step of the valuation process. The continuation of the Frobisher Report in this lesson will provide an example. Note that landscaping is considered not to depreciate on a short-lived, or age-life basis. However, if there were significant problems with the landscaping, such as insect infestations killing the grass, or dead or infested trees or shrubs, the cost to cure would be used to estimate the depreciation.

9.16

The Cost Approach Part III – Depreciation Estimates

Case Study – Breakdown Method The following is a case study which will be used to assist students in understanding the breakdown method. The subject property is an older, single family two-storey home of 225 square metres and contains certain features and construction techniques not common in contemporary construction practices. These include an extra large foundation and extra framing to provide for an optional third floor. The third floor was never built although a set of external stairs were constructed to access this level. Since the stairs were never used they are considered a superadequacy. Also, the original plumbing was iron pipes; by today's standards, this is considered to be outdated and should be replaced by steel or copper pipes. The house is 25 years old, but the effective age is 20 years and its remaining economic life is 40 years. Total economic life is 60 years. The cost breakdown of this house is shown in Table 9.1. Other items that require attention will be discussed in the appropriate sections. Figures 9.5 and 9.6 are included as a guide to the calculations needed for the breakdown method. Each of the various sections are summarized on these worksheets so that students can see how accrued depreciation is summarized and the final depreciated value is calculated. Figure 9.5 shows depreciation based on replacement costs and Figure 9.6 is based on the use of reproduction cost. These two figures can be downloaded as spreadsheets from the BUSI 330 webpage under "Online Readings"; the references in parentheses in the following calculations are to cells in these spreadsheets. Note: in Figures 9.5 and 9.6 "RCN" refers to replacement cost new or reproduction cost new.

9.17

Lesson 9

Table 9.1: Reproduction and Replacement Cost by the Unit-in-Place Method Subject: 2-storey residence, 225 square metres (2,422 square feet) Chronological age = 25 years; Effective age = 20 years Remaining economic life = 40 years Direct Costs Excavation and site preparation Foundation*

Reproduction Cost

Replacement Cost

$1,500

1,500

7,000

5,100

Exterior walls and insulation

24,100

24,100

Exterior windows and doors

15,800

15,800

Roof structure

8,700

8,700

Roof cover (210# asphalt shingle)

2,500

2,500

18,600

16,200

Frame* Exterior stairs

1,500

0

Floor structure

11,500

11,500

Floor cover (carpeting and tile)

10,400

10,400

Ceiling

3,400

3,400

Interior partitions

8,150

8,150

12,000

12,000

Painting (interior)

2,400

2,400

Plumbing system

5,150

5,150

Plumbing fixtures**

4,500

4,000

Electrical system

6,200

6,200

Electrical fixtures

3,150

3,150

Kitchen cupboards

Furnace

4,000

4,000

Contractor's profit

10,000

10,000

Total direct costs

160,550

154,250

$13,540

13,300

15,000

15,000

189,090

182,550

$189,100

$182,600

840

812

78

75

Indirect Costs Architect's fees, survey, legal fees, permits and licences, insurance, taxes, financing charges, selling expenses, leasing expenses, and holding expenses*** Entrepreneurial Profit Total Reproduction-Replacement Cost Rounded to Cost per square metre Cost per square foot *

The building was designed and built to accommodate two and one-half storeys, not two. The difference in the reproduction and replacement cost estimates is due to additional framing and foundation costs.

**

The original plumbing consisted of old-style iron plumbing. The standard today calls for copper fixtures.

***

A portion of the indirect costs is based on a percentage of direct costs, so the indirect costs included in the reproduction and replacement cost estimates will differ slightly.

9.18

The Cost Approach Part III – Depreciation Estimates

Figure 9.5: Replacement Cost SITE VALUE Size of site Rate per SITE VALUE TOTAL BUILDING REPLACEMENT COST NEW (RCN) Building size in sq. m. Cost per square COST OF BASIC RESIDENCE Other costs (if any) TOTAL RCN OF RESIDENCE ACCRUED DEPRECIATION PHYSICAL DETERIORATION CURABLE Deferred Maintenance Roof cover repair Painting 1 - Total repair depreciation INCURABLE SHORT LIVED ITEMS Flooring Roof cover Kitchen cupboards Plumbing fixtures Windows and doors Electrical fixtures Furnace 2 - Total short lived depreciation INCURABLE LONG LIVED ITEMS Replacement Cost New less reproduction cost of: 1. Repair depreciation 2. Total short lived Remaining cost of residence Total Physical Depreciation FUNCTIONAL OBSOLESCENCE Curable Cost to install lavatory Modernization of elec. fix Superadequacy stairway Incurable Deficiency Rent loss poor floor plan Superadequacy Foundation Framing EXTERNAL OBSOLESCENCE Next to all night drive in Total Functional & External Depreciation TOTAL ACCRUED DEPRECIATION DEPRECIATED VALUE OF THE BUILDING depreciated value of site improvements TOTAL VALUE ESTIMATED BY THE COST APPROACH

$________ $65,000

$65,000

225 $________ $ $________ $182,600

RCN $250 $2,400 $2,650 RCN $10,400 2,250 12,000 4,000 15,800 3,150 4,000 $51,600

$182,600

Cost to Repair $250 $2,600 $2,850 Age

Life

Dep. %

Dep. $

6 12 15 12 6 12 12

12 20 20 22 20 15 25

50.00% 60.00% 75.00% 54.00% 30.00% 80.00% 48.00%

$5,200 1,350 9,000 2,160 4,740 2,520 1,920 $26,890

$26,890

Dep. $ $42,355

$42,355

$2,850

$182,600 $128,350

Age 20

Life 60

Dep. % 33.00%

($72,095) Cost to cure $1,800 $3,400 $0

Annual Rent Loss $600 Excess Cost $0 $0

Cost to install when built = Salvage val. = Cost to remove stairs =

GIM 12.50

$1,500 $630 $200

Value Loss $7,500

Loss in value= Loss in value= Loss in value=

Cost if under construction - $3,000

$300 $2,770 $200 $3,270

$4,500

$0 Annual Rent Loss $600

GIM 12.50

Bld Ratio 75%

$5,625 $13,395

($13,395) ($85,490)

($85,490) $97,110 $5,000

$97,110

Say

$167,110 $167,100

9.19

Lesson 9

Figure 9.6: Reproduction Cost SITE VALUE Size of site Rate per SITE VALUE TOTAL BUILDING REPRODUCTION COST NEW (RCN) Building size in sq. m. Cost per square COST OF BASIC RESIDENCE Other costs (if any) TOTAL RCN OF RESIDENCE ACCRUED DEPRECIATION PHYSICAL DETERIORATION CURABLE Deferred Maintenance Roof cover repair Painting 1 - Total repair depreciation INCURABLE SHORT LIVED ITEMS Flooring Roof cover Kitchen cupboards Plumbing fixtures Windows and doors Electrical fixtures Furnace 2 - Total short lived depreciation INCURABLE LONG LIVED ITEMS Reproduction Cost New less reproduction cost of: 1. Repair depreciation 2. Total short lived Remaining cost of residence

$________ $65,000

225 $________ $ $________ $189,100

RCN $250 $2,400 $2,650 RCN $10,400 2,250 12,000 4,500 15,800 3,150 4,000 $52,100

$134,350

Modernization of elec. Fix

$3,400

Superadequacy stairway

$1,500

Foundation Framing

EXTERNAL OBSOLESCENCE Next to all night drive in Total Functional & External Depreciation TOTAL ACCRUED DEPRECIATION DEPRECIATED VALUE OF THE BUILDING depreciated value of site improvements TOTAL VALUE ESTIMATED BY THE COST APPROACH

Cost to Repair $250 $2,600 $2,850 Age

Life

Dep. %

6 12 15 12 6 12 12

12 20 20 22 20 15 25

50.00% 60.00% 75.00% 54.00% 30.00% 80.00% 48.00%

$2,850 Dep. $ $5,200 1,350 9,000 2,430 4,740 2,520 1 ,920 $27,160

$27,160



Cost to cure $1,800

Rent loss poor floor plan Superadequacy

$189,100

$189,100

Total Physical Depreciation FUNCTIONAL OBSOLESCENCE Curable Cost to install lavatory

Incurable Deficiency

$65,000

Age 20

Life 60

Dep. % 33.00%

Dep. $ $44,336

$44,336 ($74,346)

Annual Rent Loss $600 Excess Cost $1,900 $2,400

Annual Rent Loss $600

Cost to install when built = Salvage value = Dep charged 33% =

GIM 12.50

Dep charged 33% = Dep charged 33% =

$1,500

Loss in value=

$300

$630

Loss in value=

$2,770

$1,005+200

Loss in value=

$1,205 $4,275

Value Loss $7,500

Cost under construction -$3,000

- $630

$4,500

$1,270

- $790 $1,610 $7,380 GIM 12.50

Bld Ratio 75%

$5,625 17,280

($17,280) ($91,626)

($91,626) $97,474

$5,000

Say

9.20

$97,474

$167,474 $167,500

The Cost Approach Part III – Depreciation Estimates

Part One: Estimating Depreciation with Reproduction Cost Physical Deterioration

This method is explained and cross-referenced to the spreadsheet in Figure 9.6. The references in brackets refer to the cells in the downloaded version of the spreadsheets found on the Course Resources webpage. Deferred Maintenance

Deferred Maintenance refers to items that should be repaired immediately. The cost to repair are market costs based on quotes from contractors as to the cost to repair the item today and what it would cost for that item if the house was built new today. The subject requires the roof to be repaired at a cost of $250 for a few lost or damaged shingles. Also, the interior of the house requires repainting at a cost of $2,600, whereas if the house was painted when new it would have been $2,400. The extra $200 is for preparing the walls before repainting can take place, filling in small holes and scraping away any old flaking paint. Total reproduction cost new (RCN) is $2,650 (B25),while the cost to repair is $2,850 (C25). Short-Lived Items

Short-lived items are those items that are not ready to be replaced because they still have some useful life left. It is up to the appraiser to decide what items should be included in this category. The items listed in Figures 9.5 and 6 are some of the major ones that appraisers should examine and assess when inspecting a property. These items are depreciated using their effective age or actual age, whichever is easiest to ascertain, divided by expected life span which is based on market information. Figures 9.5 and 9.6 show the calculations for these items. The RCN is $52,100 (B36) and the total depreciation of all the individual items is $27,160 (F36). Note that if an item is 100% depreciated, then it is considered to be a repair item and is placed in that category. Long-Lived Items

Long-lived items are those that are expected to last for the rest of the building's physical life, e.g., foundations, framing, main structural members. As shown in Figures 5 and 6, to avoid double depreciation, make sure you deduct the RCN of the repair depreciation ($2,650) and the RCN of the short-lived items ($52,100) from the RCN of the home ($189,100 [H14, B39]). The remaining cost ($134,350 [B44]) represents the cost of the structural elements of the home and is depreciated by the ratio of the effective age to the property's total economic life (33%). The depreciation for these items amounts to $44,336 (F44). Total physical deprecation is $74,346. Note that the formula for calculating long-lived physical depreciation requires you to divide the property's effective age (20) by its total economic life (60), in this case it is 33% (C, D, E44). A common mistake is to divide the effective age (20) by the property's remaining economic life (40), which would incorrectly give a ratio of 50%. At this point in the process, the appraiser has accounted for all forms of physical depreciation: repair, short-lived items, and long-lived. In many instances, this is the only depreciation that has to be accounted for in an appraisal.

9.21

Lesson 9

It is important to recognize that the heading "physical deterioration" includes all of the costs necessary to construct a house, both hard and soft costs. The total of the short-lived items plus the long-lived items equals the total cost to build the house. However, because short-lived items have a different life span than long-lived items, they need to be depreciated at a different rate. A short-lived item is depreciated over its estimated economic life, while long-lived items are depreciated over the economic life of the building. This, along with other complexities in this method, can make for a very long and involved calculation to estimate depreciation.

Functional Obsolescence

Functional obsolescence is a loss in utility due to the inability of a component part to perform its proper function according to today's standards and requirements. The two types are curable and incurable. Curable Functional Obsolescence

Curable functional obsolescence refers to functionally inadequate items whose cost to cure is more than offset by the increase in utility that results from upgrading it. In other words, the market value of the change will be more than the cost of making the change, so it pays to correct the functional obsolescence. Curable Deficiency

A deficiency refers to a property which lacks a major component that the market demands. For curable deficiencies, it is cost effective to fix the deficiency. This concept is illustrated by the following example. Consider two new homes, "A" and "B". Home A has only one bathroom and home B has two bathrooms, which is the standard for this type of home. Home A cost $100,000 to build new as it had only 1 bathroom. Home B cost $105,000 to build new as it had 2 bathrooms. Therefore, the second bathroom cost $5,000 to install at the time of construction. To install the second bathroom after the home is finished will now cost $7,500. The extra $2,500 is for the work involved in ripping out walls and installing the new piping and generally preparing the home for the installation of the second bathroom. Therefore, to make home A equal to home B you will only pay $97,500 ($100,000-$2,500) for home A because it will cost $2,500 extra to make it the same value as home B. When the bathroom is eventually installed at a cost of $7,500, it will make home A worth $105,000, the same as home B. Home B, at $105,000, is the benchmark home because it is what the public expects in homes in the area, namely two bathrooms. In our example, the subject has only 2 bathrooms, while the market expects 2 1/2 bathrooms. It pays to install the half bathroom which will be $1,800 today. If it had been installed at the date of construction it would have cost $1,500. Therefore, the curable functional obsolescence is $300 (F51), the additional cost to install it today due to the extra preparation work needed to do this work. Modernization

In this section, remember you are comparing "like to like", so if all homes have been updated (e.g., with new bathroom fixtures) and the subject does not have this update, then an adjustment must be made for modernization. On the other hand, if all of the homes in this class, including the subject, still have the old bathrooms after 30 years, then no adjustment is warranted for modernization.

9.22

The Cost Approach Part III – Depreciation Estimates

In our example, the subject has older light fixtures while comparable properties of the same age have had them replaced with newer more modern ones. The cost to replace the outmoded light fixtures is $3,400 and the old ones, which are still usable, can be sold on the second-hand market for $630, so the actual net cost of the replacements is $2,770 (F52) ($3,400-$630). Superadequacy

Superadequacy applies to structures that are overbuilt, meaning that the market will not pay more for the extra costs which were involved in constructing them. An example might be the case where an owner had installed an extra large fuel storage tank in the basement, more than what the market would expect, and when selling the home finds that no one will pay for this extra cost. Given the extra value added by the finished basement space, it would be worthwhile to pay to have the tank removed and use the space for another purpose. It is curable if the cost to cure is more than offset by the increased market value (i.e., if the market would pay significantly more for the finished basement space). In our example, the subject had an exterior stairway to a third floor that was never constructed; its cost must be removed from the total cost of the house. The original cost of the stairway was $1,500 (B53). This total is already included in the long-lived portion of $134,350 (B44) which was depreciated at 33%, so the stairs have already been depreciated by $495, leaving $1,005 to be removed. To this figure is added the $200 to pay a carpenter to actually remove the stairs today. There is no salvage value for the old stairs. The total cost is $1,205 (F53). The total curable functional obsolescence is $300 + $2,770 + $1,205 = $4,275 (F54). Incurable Functional Obsolescence

Functional obsolescence is incurable when the cost to cure is not offset by an increase in utility. In other words, the market value of the change will be less than the cost to cure so it does not pay to correct the functional obsolescence. Incurable Deficiency

An incurable deficiency is property lacking a major component *Note: The GIM method applies only to which is not cost effective to fix. In estimating this depreciation single-family residential properties. For * amount, the Gross Income Multiplier (GIM) is used for single income-properties, the net rental loss family residential properties. The GIM is a factor used in the is allocated to the building, and that income method of appraisal which will be discussed in Lesson 10. loss is capitalized by applying a Basically, the GIM is calculated by dividing the sale price of a building capitalization rate. property by the annual effective gross income (EGI) or the annual gross rent (called AGR). If a purchaser knows the effective gross income of a property and the applicable GIM, then an approximate value can be found by multiplying the two figures. In the case of our subject, a poor floor plan causes it to lose a gross income of $50 per month or $600 per year (B57). The gross income multiplier is 12.5 (D57), which is based on the fact that homes in the area and similar to the subject are worth around $160,000 and the average annual rent is $12,800 per year (

$160, 000 $12,800

= 12.5).

At a rent loss of $600 per year and a gross income multiplier of 12.5, the property suffers a value loss of $7,500 (F57). A contractor has estimated that the cost to correct this deficiency if the house were under construction as of the effective date of appraisal is $3,000. This must be subtracted from the value loss. So, $7,500 - $3,000 = $4,500 is the amount of the incurable obsolescence, deficiency.

9.23

Lesson 9

Sometimes the monthly rent may be used in which case the multiplier is higher. In the above example the monthly rent loss of $50 per month, the GIM would be 12.5  12 months = 150, and the value loss is 150  $50 = $7,500. Incurable Superadequacy

Incurable superadequacy refers to unwarranted extra costs which do not add to value (and possibly detract from value), which cannot be cured economically. An example might be where an owner has constructed a home with extra large foundation walls, more than what the market would expect, and when selling the home finds no one will pay for this extra cost. The cost to cure, which is the removal of the extra large footings, is not warranted or is impossible because it would be prohibitively expensive and likely to damage the structure of the home. Therefore, the EXTRA cost of constructing the superadequate features must be removed from the reproduction cost new. In the case of our subject, it has two areas of superadequacy: (1) the extra large foundations and (2) the extra framing necessary for the third floor that has never been used. Both of these items must be removed from the reproduction cost new. The extra cost of the foundation was $1,900 (B59) and the extra cost of the framing was $2,400 (B60). These figures are already included in the long-lived portion of $134,350 which was depreciated at 33%, so the foundation has already been depreciated by $630, leaving $1,270 (F59) to be removed. The additional framing has already been depreciated by $790, leaving $1,610 (F60) to be removed. There is no added cost of ownership resulting from these two elements of superadequacy. Therefore, zero (0) is added for this reason. The total functional obsolescence incurable is $4,500 + $1,270 + $1,610 = $7,380 (F61). External Obsolescence

This type of depreciation is outside the property itself (i.e., the owner has no control over it), but it does impact on the market value. One method of estimating external depreciation is to do a market analysis of similar homes comparing a non-affected one with another that is affected by the external obsolescence. A second method of estimating external obsolescence for single family residential properties is to use the GIM mentioned above, and apply that factor to the potential annual rent loss due to the external obsolescence. An additional point to remember is that any external obsolescence applies to both the buildings and the land. Since we are only dealing with the buildings, we must apportion this loss between the land and the buildings.** This is done by using the ratio of the land-to-building which is derived from the market. If, for instance, residential properties in the neighbourhood are selling for $200,000 and the lots are worth $50,000, then the improvements are worth $150,000. The ratio of land to the building would be 1:3 or 25% for the land and 75% for the improvements. If the building represents 75% of the total property value, then 75% of the above loss is deducted from the cost new. ** Note: If the subject is a multi-family residential property, and if rent controls are the cause of the external obsolescence, then 100% of the loss is attributed to the building.

The remaining 25% which applies to the land would have been accounted for when making adjustments to the land value. In our example, if a typical lot in the area is worth $65,000, but the subject is affected by the all-night drive-in next door, then an adjustment has to be made in the land value analysis to account for this external obsolescence.

9.24

The Cost Approach Part III – Depreciation Estimates

The loss in value is calculated by estimating the rent loss due to the external nuisance; in this case, there is $50 a month loss or $600 per year. Using the GIM of 12.5 indicates a loss of $7,500 for the whole property. Since we are dealing with only the house, then 75% of this figure, $5,625 (F65) will be deducted from the cost of the home. The difference of $1,875 ($7,500-$5,625) was used as an adjustment when calculating the land value of $65,000. If there was no external nuisance, then the site would have been worth $66,875. Site Improvements

Depending upon the property being appraised, further costing analysis may have to be carried out if there are other buildings on the property. Also, the site improvements have to be costed and depreciated. In many instances, this includes landscaping such as grass, gardens, trees, walkways, and driveways. Since it is difficult to cost out average site improvements, an estimated and modest figure is used to indicate their depreciated value. In this case, an estimated value of $5,000 is used (I73). Final Value Indication

Following the above steps and using the reproduction costs in calculating depreciation indicates a value of $164,474, rounded to $164,500 (I76). When doing this type of problem, it is best to present your data using a spreadsheet so that the client can follow your calculations. In all cases, the various adjustments must be explained and documented with market evidence.

Part Two: Estimating Depreciation with Replacement Cost This method, like the reproduction cost method, is explained and cross-referenced to the spreadsheet in Figure 9.5. The final value estimate using Reproduction Cost was $167,500. If replacement cost, was used instead, the value estimate would be $167,100, a $400 difference (I76). These differences occurred in the following areas: 1. The replacement cost is $6,500 (H13) less than the reproduction cost because the extra foundation, extra framing, exterior stairs, and the older iron plumbing fixtures are not included. This affects both the short- and long-lived depreciation. Table 1 earlier in this lesson shows the differences between the reproduction and replacement cost. 2. Under functional curable depreciation, only the $200 cost to remove the stairs is included because this is a cost that will have to be incurred (D53). 3. Under functional incurable depreciation, the excess costs associated with the framing and foundation are not included and therefore do not enter into the calculation (B59, B60). In this case, the $400 difference is not significant. However, in other cases there could be a significant difference. The main difference between the two approaches is that if replacement costs are used, there will be no superadequacy, which means that this technique is easier to apply. For the purposes of this course, it is important to understand both methods and how they differ. In appraisal practice, it is more likely that appraisers will use replacement cost. 9.25

Lesson 9

Estimating Depreciation Using the Direct Comparison Method

Depreciation can also be estimated by using the direct comparison approach if good comparables can be located and analyzed. The market-extracted depreciation rate found from these comparables can then be compared to the rate found for the subject using the previous breakdown analysis, to see if the final figure is "in the ballpark". If it is not, then the appraiser must re-check the calculations to look for any possible errors or incorrect assumptions. Normally the appraiser would locate sales of similar properties and deduct the estimated land value to find the depreciated value of the improvements. Using current reproduction or replacement costs, they would estimate the cost new of the improvements. Then, dividing the depreciated value by the cost new will indicate the estimated depreciation rate. Dividing again by the age (in years) of the comparable building would give an annual rate of depreciation. Refer to page 9.7 for an example discussed under market extraction. Cost Approach Value Conclusion

Now that all steps of the cost approach have been completed, the appraiser briefly summarizes the conclusions reached, in a format similar to the following. Some summaries include all sub-categories of depreciation that existed in the subject property. The data used in this example is taken from Figure 9.6 on reproduction cost. Site Value Building Cost New Depreciation  Physical Deterioration $74,346  Functional Obsolescence $11,655  External Obsolescence $ 5,625 Total Depreciation $91,626 Depreciated value of building Depreciated value of site improvements Value Estimated by the Cost Approach

$65,000 $189,100

$ 91,626 $97,474

$97,474 $ 5,000 $167,474 Rounded to: $167,500

Note on Chapter 19 Calculations Page 19.31/.32 of the text discusses the cost savings from a lower-capacity HVAC system. The savings are $200 per month. It then states that this $200 per month represents a cost savings of $20,000, capitalized at 12%. This calculation flows from the real estate math learned in BUSI 121. This type of present value calculation is not required in BUSI 330, since BUSI 121 is only a recommended pre-requisite, not required. For your information, the calculation of this present value is as follows: the cost savings are $200 per month, or $2,400 per year. This $2,400 represents a perpetuity, an amount received for the indefinite future. At a 12% capitalization rate, the present value of this annual annuity is $2,400 / 0.12 = $20,000.

9.26

The Cost Approach Part III – Depreciation Estimates

Scope and Limitations of the Cost Approach The obvious difficulty in using the cost approach of appraisal is first deciding whether cost and market value are likely to be approximately equal in relation to the subject property. Only when this condition is satisfied may further consideration be given to the use of the cost method. In order to fulfill this condition, the property must represent the site's highest and best use. The second main difficulty is concerned with the deductions needed for depreciation, particularly incurable physical and functional depreciation. Calculation of these two items requires the considerable judgment from the appraiser since the criteria to be taken into account cannot be definitely expressed. It is difficult to objectively test the validity of the appraisal when much of the estimate relies on the appraiser's judgment (these depreciation figures cannot be tested or verified with market data). Both of these difficulties are more significant for the appraisal of older property. Therefore, the cost approach is more likely to provide a reliable answer when applied to newer developments. Given these difficulties, the cost approach has limited practical appeal. In residential appraisals, it is most commonly used to provide a rough check on the value indication from the direct comparison approach. The cost approach is most applicable to appraisal problems where data is lacking for the income or comparison approaches. Churches, public buildings, and other special use properties are often appraised using the cost method because the other approaches are inapplicable. As well, it may be useful for certain appraisal problems which require separate estimates of value for the land and improvements of a property (e.g., insurance or property tax assessment). More details were presented on the advantages and disadvantages of the cost approach in Lesson 8, which introduced the cost approach, along with Chapter 17 of the textbook. Additional issues and pitfalls to avoid in the application of the cost approach are listed below.            

Each approach must stand on its own – market-derived adjustments in the land value section of the cost approach cannot be used in the direct comparison approach, or vice versa. In a detailed depreciation analysis, ensure that double depreciation has not occurred Make sure that the theory has been correctly applied. Estimate cost and depreciation consistent with the highest and best use of the property. Exclude chattels and personal property items, unless specifically requested to include them in the appraisal instructions. Distinguish correctly between replacement and reproduction cost, both in cost estimating and in depreciation. Include all hard and soft costs, and entrepreneurial (developer's) profit in cost estimates. Clearly state the sources of all data used. Consider and apply a property rights adjustment in the cost approach, if appraising anything other than the non-encumbered fee simple interest. Apply the cost approach in accordance with the principle of consistent use, with the same use applied to the land as to the improvements. Ensure the depreciation items and details are consistent with the description of the building's quality, age, layout and condition. Ensure that the costing is consistent with the details of the building's construction.

9.27

Lesson 9

Discussion Point: Cost or Direct Comparison? Returning to the previous example of Bill Gates' luxury mansion...Mr. Gates' lawyers filed a property tax assessment appeal on his house. At the time of filing the house was only partially complete, with $53 million spent to date. The assessor relied on the cost approach in setting the assessment at $53 million and the tax bill was $620,714. Mr. Gates' lawyers argued that assessments in Washington State are based on market value and therefore he should instead be assessed on what he could get for the property should he sell it. Who is right? Pretend to be an advocate for the appellant or assessor, and prepare arguments to present to the Appeal Board. Arguments and evidence:   

 



Mr. Gates' lawyers have a point, in that Mr. Gates spending this fantastic amount of money on his house does not mean it will be worth that much in the open market. Does cost equal value? The assessor argues there is no market evidence, with no reasonably similar comparables; therefore, the cost approach is relied upon as a method of last resort. Mr. Gates' lawyers respond that the appropriate competitive set may involve luxury mansions across the United States or even internationally; what would someone in this wider market pay for Mr. Gates' mansion, high tech gadgets and all? The assessor responds that "similar" for comparables must also mean similarity in location; therefore, sales from outside this jurisdiction are irrelevant for market value. There is no clear correct answer, as all of these arguments appear valid - highlighting that two accredited appraisers can present substantially different value conclusions, and neither may be clearly wrong as long as they have relied on market value evidence and a logical approach. The adjudicator is faced with a tough decision! Endnote: the appeal was quickly withdrawn, perhaps resulting from someone in Mr. Gates' PR department realizing it is bad press for the world's richest man to be contesting his taxes! The final completed cost was $110 million and the annual tax bill $1.07 million.

Frobisher Report The Frobisher Report now examines depreciation applicable to the $165,600 replacement cost new of the house and site improvements cost estimates developed in Lesson 8. Review the Frobisher Report excerpt on depreciation and the conclusion of the cost approach, and answer the following question two-part question. Answers are found following the report excerpt. 1. If the Frobisher Report applied the age-life method, and not the breakdown method, what would the dollar value of depreciation have been? 2. a. What two elements of the depreciation analysis have the most impact on the calculation of the depreciated value of the house, yet are the most subjective? b. How could the appraiser improve the credibility of these elements?

9.28

The Cost Approach Part III – Depreciation Estimates

FROBISHER REPORT Depreciation Analysis In estimating the depreciation applicable to the subject house, James Cook Construction was the source of all of the cost estimates on the components of the building – both for the cost to cure and the cost if the building were under construction as of the effective date of appraisal. Economic lives of the short-lived components were based on contractor estimates and National Association of Homebuilders data. Effective ages of the components were based on considerations of actual age and observations by the appraiser considering comparable components in other similar properties. Physical Deterioration, Curable Item

RCN

Cost to Cure

Vinyl flooring - kitchen and dining area (243 sf @ $4 psf)

$ 972

Carpeting - 2 bedrooms (284 sf @ $4 psf)

$ 1,136

$ 1,420

TOTAL

$ 2,108

$ 2,635

$ 1,215

Physical Deterioration, Incurable, Short-Lived Item Kitchen cabinets & counter tops Furnace Central air Windows &exterior doors Shingles Interior Painting TOTAL

RCN

Eff. Age

Ec. Life

% Dep.

$ Depreciation

$11,880 $ 3,000 $ 1,500

25 yrs 15 yrs 10 yrs

50 yrs 20 yrs 20 yrs

50% 75% 50%

$ 5,940 $ 2,250 $ 750

$14,000 $ 3,500 $ 3,240 $37,120

5 yrs 10 yrs 0 yrs

30 yrs 25 yrs 15 yrs

17% 40% 0%

$ 2,380 $ 1,400 $0 $ 12,720

For the long-lived calculation, the actual age of the house is 30 years. However, because it has been very well maintained and has upgrades and replacements done as required over the years, it is competitive with 15- to 25-year old houses and therefore has an effective age of 20 years. Many homes in the municipality are 70-90 years old and still perform their original function. A review of zoning changes and demolition permits issued for single family residences indicates that these occur after 65-75 years of single-family residential use. Therefore, the economic life of the subject house is estimated at 70 years. It has an estimated remaining economic life of 50 years. continues on following two pages

9.29

Lesson 9

Physical Deterioration, Incurable, Long-Lived RCN Estimate Less ... RCN Curable RCN Short-lived RCN for Long-lived Calc.

$165,600 – 2,108 – 2,720 $150,772

Effective Age/Economic Life = 20/70 = 28.6% depreciation. Long-Lived Depreciation

$150,772 x 28.6% = $43,121

Total Physical Deterioration: Curable Short-Lived Long-Lived Total

$ 2,635 $ 12,720 $ 43,121 $ 58,476

No functional obsolescence, either curable or incurable, was evident in the subject building. Floor layout was functional and consistent with market requirements. There were no examples of components lacking or of any over-built items that would be unexpected in the market for the subject building. No elements required modernization, as evidenced by the similar styles in comparable sale properties. Total Functional Obsolescence

$ 0.

There were no factors external to the property that had any influence on market values. The subject is in a primarily single-family residential area, with no nuisances or negative impacts nearby. The economy is reasonably strong, with mortgage money readily available. Total External Obsolescence

$ 0.

Site Improvements Site improvement cost estimates were provided by James Cook Construction, and are summarized below. Item

Unit Cost New

Cost New

Age/Life

Depreciated Value

Paved driveway

583 sf @ $12

$6,996

10/20

$3,498

Concrete steps/walkways

291 sf @ $14

$4,158

30/50

$1,663

Fencing

206 linear ft @ $30

$6,180

20/20

$3,090

Metal Shed

81 sf @ $10

$810

25/30

$135

Landscaping

551 m2 @ $8

$4,408

n/a

$4,408

TOTAL

$22,552

$12,794

The depreciated replacement cost of the site improvements is estimated at $12,794.

9.30

The Cost Approach Part III – Depreciation Estimates

Summary of the Cost Approach Estimate of Value Estimate of Land Value Replacement Cost New of House Less Depreciation - Physical Deterioration - Functional Obsolescence - External Obsolescence Depreciated Cost of House Depreciated Value of Site Improvements

$ 66,000 $ 165,600

- $ 58,476 -$ 0 -$ 0 $ 107,124

$ 107,124

$ 12,794

$ 12,794

Indication of Value by the Cost Approach - rounded to ...

$ 185,918 $ 186,000

Answers to Questions

1. If the age-life method had been applied, depreciation would have been calculated as follows: $165,600 × 20/70 = $47,314. 2. a. The two elements of the depreciation analysis that have the greatest impact on the depreciation calculation, yet are the most subjective, are the estimates of effective age and economic life. b. The appraiser could improve the credibility of these two elements by providing specific data, and the rationale, in support of their quantification. The basic facts as presented are: Subject has an actual or chronological age of 30 years. The appraiser concludes an effective age of 20 years (33% less than the factual, actual age); and an economic life of 70 years. This has been supported by a brief, narrative analysis citing general information and no specifics. Consider the much more detailed analysis in support of effective age and economic life, on the next page. Although there is limited market data available upon which to base an opinion, this appraiser has done an excellent job in explaining the thinking process behind these estimates.

9.31

Lesson 9

Sample, Detailed Analysis of Effective Age and Economic Life – Limited Market Data Effective Age The chronological age of the subject refers to the actual age of the property – when the property was built. The actual age of the subject helps with the analysis of the effective age of the subject. It is important to know the actual age of the building, the actual age of the long-lived items (substructure and superstructure), and the actual age of any short-lived items so that proper depreciation analysis can be applied, and how that relates to the estimate of effective age. The effective age of the property refers to the estimate of age in relation to the overall condition of the improvements and use of the structure. The effective age of a building can be lower or higher than its actual age, depending on the degree of upgrading, refurbishing, and maintenance or lack thereof since the property was built. With just standard basic maintenance a building's effective age and actual age could be the same. The subject has received some very good improvements over the years. The shingles have been upgraded, the windows and doors replaced, the flooring upgraded, the hot water tank replaced, walls and ceilings have been well maintained, and general maintenance has been very good overall. These improvements are such that they combine to indicate an age lower than the actual age of the structure. Further, the improvements have a use and functional utility typical of new homes being constructed and homes constructed within the past five years or so, and this also contributes to a lower effective age. Similar sized homes built within the past few years have very similar exterior design and floor plans. This shows that the design and floor plan of the subject are not outdated and that the subject style and design is not losing acceptance in the market. The location of the subject property is good and there are no external factors that would be considered that might adversely affect the continued use of the subject as a single family residence. Market conditions in the City are strong and the City is growing, with reports that it will likely continue to grow for years to come. This should maintain good demand for properties such as the subject. Due to the improvements and the good overall design of the property, the continued growth in the city which will keep demand for similar properties strong, and the fact that there is no evidence of any change of use for the long range future, the subject would compete with similar homes in the 15-25 year range, thus an estimate of effective age of 20 years is a fair and reasonable estimate. Economic Life The economic life of the building refers to the estimate of total years to which the improvements will contribute to the value of the property. The subject improvements life begins when it is built, and ends when it no longer contributes value to the site. The improvements found on the subject site will continue to provide value to the site for many years to come. The overall condition of the building due to improvements, the good maintenance, and the good location will ensure a long life for the subject as a single family residence. In order to estimate how long of a life the subject might expect (economic life) an analysis of the subject neighbourhood as well as other subdivisions in the city was undertaken to try and determine life cycles – when houses reach the end of their economic life, when major renovations take place, as well as when general remodeling and rehabilitation is done. continues on following two pages

9.32

The Cost Approach Part III – Depreciation Estimates

One house that is known to be set for demolition is a property located at 860 14th Street, Saskatoon, which is located just over one mile straight east of the subject. This house was occupied right up to the summer of 2010, until the owner passed away. It is an older bungalow home that had received some upgrading 25 - 30 years ago (shingles, some flooring, furnace), with the remainder of the house basically original (windows, siding, doors trim etc). By 2010, the noted improvements had deteriorated, and the original house, due to lack of maintenance was getting worse. The property was purchased Dec. 14, 2010, for a price of $65,000, with the house slated for demolition. This lends good support to the earlier statement that a property's life ends when it no longer contributes any value to the site, as the site is worth the entire purchase price. This house had a total life of 79 years, and had received some basic maintenance some 25 – 30 years ago. However, due to a total lack of maintenance since then, and the fact that the house was always generally poorly kept (according to a long-time neighbour) the house deteriorated rapidly and is now at the end of its economic life. This is a good example of a house that received just minor maintenance through its existence, and still reached a physical age of 79 years before the end of its economic life. It would be reasonable to assume that should the property have been put up for sale a few years earlier, even though it was habitable, it still would have likely been bought for demolition and redevelopment. Therefore, an economic life of 70 total years for a marginally maintained home is reasonable. An analysis of the subject subdivision as well as a couple other subdivisions in the city has been done in order to determine the life cycle of a typical residential subdivision and what might be a reasonable economic life of a property. In viewing the immediate subject neighbourhood first, where there are many properties of similar age and quality to the subject, there are no homes that have been demolished because they had reached the end of their economic life. Many homes, like the subject, have had upgrades done, such as shingles, windows, and doors and this is typical of this age of home due mainly to the climate as harsh winters in the region lowers the economic life of these building components. This is also due to the fact that the building materials used when the house was built compared to today are inferior as today's material is better constructed and designed to handle the harsh climate. Similar aged developments in the north west end of the city have many homes of similar size and quality; many with similar evident exterior upgrades, and like the subject neighbourhood, no homes have been demolished due to end of economic life. The Qu'Appelle Subdivision is located 1 ½ miles straight north of the subject neighbourhood and features homes built in the 1950's. Like the subject area, many of these homes have good exterior improvements and have similar layouts and general house design. A few of these homes are starting to receive some major renovations. The properties in this area that are receiving major renovations are typically original owner or second owner homes that have had only the bare minimum of upgrading and require more significant upgrading to maintain value and use (likely what the property on 14th Street would have needed some years ago). This is a good residential area and will continue to be one. Homes in the area are 20-25 years older than the subject. Due to similarities of the two subdivisions in market appeal and the type of maintenance to the homes within, the subject neighbourhood will likely follow the same life cycle as the Qu'Appelle Subdivision. The best example of a subdivision under major renovation is the south central development, located approximately 1 ¾ miles north east of the subject neighbourhood. This area was developed over a relatively long time period, but mainly through the 1930's and early 1940's. Over the past few years and as of the date of this report, many of these homes have been totally refurbished, and many are under refurbishment. There are many new listings coming on the market featuring declarations of total upgrading and refurbishment. That is, not just a few upgrades and general maintenance but total gutting and refurbishing including floor plan changes and design changes. It is said that when a property reaches the end of its economic life it is either demolished, or major renovations are performed, and major renovations are being performed on many of these homes. This falls right in line with the 14th Street property, built in 1930, and which is to be demolished as it had reached the end of its life. Had major renovations taken place to this house a few years ago, it may have been able to sustain a longer economic life.

9.33

Lesson 9

The life cycle of these subdivisions shows that approximately every 20 years or so neighbourhoods get to a point where changes are required, or just happen. Starting from the beginning of the life cycle and moving forward, it appears to go from regular maintenance - to standard upgrades - to more significant upgrades then to complete refurbishment. If the Qu'Appelle Subdivision is 20 years older than the subject area; and the south central area is 20 years older than the Qu'Appelle Subdivision; and homes in the older south central area are getting major renovations performed, then a 40 year time span would be a fair and reasonable estimate before major renovations are required, or if a total lack of maintenance takes place the house may be ready for demolition (like 14th Street). In other words, the subject improvements will continue to provide value to the site for at least 40 more years. Economic Life is defined as the length of time that improvements provide value to a site. The subject has an actual age of 31 years, plus another 40 years before economic life ends, leaves a total Economic Life of 71 years, or say 70 years. This is supported by the property on 14th Street, which is also felt to have had a contributory value to the site for approximately 70 years. The Remaining Economic Life (REL) of the building is the number of years remaining to which the existing improvements will contribute value to the property. If the estimate as of the effective date of Economic Life is 70 years, and the estimate of effective age as of the effective date of this report is 20 years, then the REL of the subject is 50 years. This estimate of REL would seem to contradict the earlier statement that there is only 40 years remaining in the economic life of the subject. However, the subject is "actually" 31 years old, but "effectively" only 20 years old. REL estimate is based on effective age not actual age and thus, due to significant improvements to the building as described earlier and the good market appeal of the property, the REL of 50 years is the appropriate estimate.

Summary Understanding why and how properties lose value is important when carrying out the three approaches to value. In the cost approach, it helps the appraiser properly depreciate the improvements; in the direct comparison approach, it helps the appraiser when selecting comparables and making the adjustments; and in the income approach, it helps to explain why and how rent levels are established and why expenses can be higher or lower in relation to other similar income producing properties. The breakdown method is very detailed and time-consuming, and in practice will often not be applied. However, it can help the appraiser understand what to look for when inspecting a home, such as physical deterioration and functional and external obsolescence. If the appraiser chooses instead to use the simpler age-life method, having an understanding of the breakdown method will help to establish the effective age of the improvements in relation to their actual age.

9.34

The Cost Approach Part III – Depreciation Estimates

Review and Discussion Questions 1.

Define: total economic life remaining economic life actual age effective age Describe an example for your own residence or another you are familiar with which illustrates how they are all related.

2.

Why must depreciation be accounted for when using the cost method of appraisal? Define depreciation and describe the three basic types of depreciation. Provide your own example of each and explain whether each is curable or incurable.

3.

You have carried out an appraisal assignment using replacement cost in the cost approach to value. If this appraisal assignment had instead required you to use reproduction cost, explain how your analysis would have differed.

4.

You have been asked to appraise a very unique home on a half-acre parcel in Ottawa. Your market research has revealed that half-acre lots in this district are presently selling for $650,000. The following data is also available to you: Size of home Effective Age Remaining Economic Life Replacement Cost

6,000 sq. ft. 20 years 20 years $150/sq. ft.

You have also estimated that $80,000 would have to be spent immediately to bring the home into a reasonable state of repair. The previous owners were an elderly couple who had not maintained the property sufficiently in recent years. Using the cost method of appraisal, what is the market value of this home? 5.

Suppose you have been assigned the task of appraising the Gold Park Community Centre in Bobsville, a small town in New Brunswick with a population of 7,000. The centre is located in the middle of Maple Leaf Estates, a townhouse subdivision on the outskirts of town. The centre is built on twelve (12) 60  120 foot lots which were purchased 8 years ago at a cost of $18,000 per lot. However, by the time the centre was built one year later, similar lots (60  120 feet) were being sold for $22,000; you estimate that lot values have risen by approximately 5% per year since then. The centre, with its adjoining sports field/playground, occupies a total of 86,400 sq. ft. It was completed seven (7) years ago. Total original cost to build the centre was $326,465 which included $241,000 in construction costs (contractor's profit included), $36,150 in developer's overhead (indirect cost), and $49,315 profit to the developer (entrepreneurial profit). Construction costs were broken down into: $45 per square foot to build the 4,000 sq.ft. structure; $6 per square foot for the 3,600 square foot parking lot; and $0.50 per square foot for the remaining 78,800 sq.ft. sports field/playground. Construction costs have fluctuated wildly in Bobsville within the last 7 years, first increasing because of the housing boom and then decreasing as a result of the national recession. Costs have stabilized now at a level 10% total increase from those of 7 years ago.

9.35

Lesson 9

Developer's overhead (indirect cost) has remained at 15% of construction cost, while developer's profit is still 10% of the total of construction cost, developer's overhead, and land cost. There have been no intrusions of non-harmonious uses in the neighbourhood and the centre still represents the site's highest and best use. The centre is functionally adequate, except that it requires handicap facilities to be built (i.e. special bathrooms, wheelchair ramps) at a cost of $8,000. Two large windows facing the sports field are broken and must be replaced at a cost of $600. In addition, there is some graffiti on the parking lot wall that must be painted over, which will cost $200. The Parks Board estimates that the centre can be used for another 30 years. Even though it has been used extensively over the last 7 years, the centre has been well-maintained such that its effective age is estimated to be 5 years. While the centre is in good condition presently, the natural deterioration of an aging structure must be accounted for. You have decided to use the modified age-life method to estimate physical incurable depreciation. Given the above information, estimate the market value of the Centre using the cost approach. 6.

Complete the following case study of a 12 Unit Apartment Building, at 999 Wesbrook Boulevard, Anytown, Canada using the reproduction cost. CASE STUDY of a 12 UNIT APARTMENT BUILDING 999 Wesbrook Boulevard, Anytown, Canada Your task is to complete a cost approach to value on the property described below. The subject property consists of a 12 unit apartment building. All units are 2 bedroom and each is equipped with a fridge and stove. The Gross Floor area of this building is 10,800 sq. ft. and the estimated cost to build this 10 year old structure today would be $60. per sq. foot. This cost included all equipment, carpeting fridges and stoves. The building has been well maintained and you estimate that this typical level of maintenance has resulted in the effective age equating to the actual age. Your investigation and analysis reveals the following:          

9.36

The 3 basement apartments have very poor floor plans which result in a rental loss of $25 per month each. Due to rent controls your analysis concludes that this factor creates a rental loss of $20 per month per unit. The Gross Income Multiplier has been derived from the market and is indicated to be 6.5. A major employer in this community recently closed down creating local economic problems which have resulted in an additional rental loss of $15 per month per unit. Immediate repairs required for this property would cost approximately $2,500, this represents $2,000 of the R.C.N. The bathrooms require modernization in 2 of the units at a cost of $2,000 per unit. The total value of the existing fixtures (both bathrooms together) have a value of $500. The nearby rail-road tracks reflect negatively on rents by $18 per month per unit. In this area, land typically represents 25% of property value. The remaining economic life of the building has been estimated at 40 years. Land value has been estimated at $4,200 per unit.

The Cost Approach Part III – Depreciation Estimates

The following items have a life expectancy which is less than the remaining economic life of the building: Item R.C.N. Eff.Age Life Exp. ____________________________________________________________ Heating boiler & furnace Roof covering Hot Water Tank Stoves Refrigerators

$15,000 12,000 2,500 7,200 7,800

10 yr 10 yr 10 yr 10 yr 10 yr

20 yr 20 yr 15 yr 12 yr 12 yr

NOTE: Carpeting was replaced about 1 year ago at a cost of $25,000. Its life expectancy is 10 years. The paved driveway, shrubs, and other site improvements are valued at $1,800. QUESTION: Calculate the depreciated value of this property by using the cost approach. Show all your work and use the suggested format for your answer. 7.

You have been asked to calculate the reproduction cost of a warehouse property in an industrial park in Hampshire. The following information is provided: Improvement size Basic per sq.ft. cost (excl. indirect costs) Local multiplier Adjustment for: area/perimeter height sprinkler Indirect costs (% of all other costs) Entrepreneurial profit (% of direct & indirect costs) Land value

8.

50,000 sq.ft. $40.00/sq.ft. 1.10 0.90 1.10 + $0.75/sq.ft. 25% 10% $330,000

(a)

Define reproduction cost, and explain how it differs from replacement cost.

(b)

Calculate the reproduction cost of this property, including entrepreneurial profit and land value, by means of the comparative-unit method.

A converted office building has excessively high ceilings, which are not the norm in the market, and are less preferred due to the additional heating and cooling costs associated with them. The following data are provided: Replacement cost as is Placement cost with acceptable ceiling height Physical deterioration already charged Annual cost incurred due to excess height (e.g. additional taxes, insurance, management) Building capitalization rate (RB)

$10,000 $8,000 40% $800 0.125

(a)

What is term used to describe the high ceilings, as it relates to depreciation?

(b)

Based on the information above, calculate the incurable functional depreciation caused by this feature.

9.37

Lesson 9

9.

The following information is provided on incurable short-lived building components: Short-lived Current Actual Total Useful Components Replacement Cost Age Life ____________________________________________________________ Roof cover Floor cover Ceiling

$2,000 $6,000 $5,000

10 years 5 years 7 years

20 years 15 years 15 years

Calculate the incurable physical deterioration in the short-lived components. 10.

A retail property suffers from its location in a declining neighbourhood. The following information is provided to you. Calculate the external depreciation in the subject improvements. NOI as is (after all curable physical and functional items have been cured) NOI without external influences (after all curable physical and functional items have been cured) $12,000 Overall capitalization rate Ratio of building value to total property value

11.

$10,000 10.0% 1:2

You have been asked to calculate the value of the fee simple interest in an office building using the cost approach. The following data is provided: Current replacement cost Building Improvements Site Improvements

$155,000 $25,000

Physical Deterioration Curable Incurable – short-lived Incurable – long-lived

$10,000 $25,000 $5,000

Functional Depreciation Curable Incurable

$5,000 $10,000

External Depreciation Depreciation of Site Improvements Land Value

$12,000 $5,000 $60,000

Calculate the value of the fee simple interest. 12.

9.38

The building being appraised has a current replacement cost of $600,000, an effective age of 10 years, and a total economic life of 50 years. The total cost to cure all curable short-lived items is $50,000. Calculate the incurable physical depreciation in the long-lived building components.

The Cost Approach Part III – Depreciation Estimates

13.

You are appraising a 15 year old single-family residence and have found the following three comparable sales: Sale #1 Sale #2 Sale #3 ____________________________________ Sale Price Site Value Current Replacement cost Age of Property (years)

14.

$99,000 $30,000 $119,000 15

$133,000 $40,000 $163,000 15

(a)

Using market extraction, calculate the lump-sum depreciation indicated by each sale as a percentage of the current replacement cost of the improvements.

(b)

What is your estimate of the average annual depreciation rate for the subject property?

Complete the following table.

Depreciation Method

Advantages

Disadvantages

Market Extraction

-

-

Age-Life

-

-

Observed Condition

-

-

15.

$122,800 $49,000 $205,000 20

Why might the estimate of depreciation from the observed condition (or breakdown) method differ from that of the other methods?

9.39

Lesson 9

ASSIGNMENT 9 CHAPTER 19: Depreciation Estimates

Marks: 1 mark per question. 1.

The cost to restore an item of deferred maintenance to new or reasonably new condition is known as: (1) (2) (3) (4)

2.

The period over which real estate improvements contribute to property value is called: (1) (2) (3) (4)

3.

Deferred maintenance requiring repair Deterioration in short-lived items Superadequacy requiring removal Deficiency requiring substitution or modernization

Windows in the subject house have an effective age of 25 years, and a life expectancy of 25 years. What category of the breakdown method of depreciation would be most appropriate for calculating the depreciation for the windows? (1) (2) (3) (4)

5.

the useful life. the physical life expectancy. the effective age. the economic life.

Which type of curable functional obsolescence is measured as the cost of installing a new modern component minus the remaining value of the existing component? (1) (2) (3) (4)

4.

cost to replace. deficiency. cost to cure. salvage value.

Physical curable deterioration Physical short-lived deterioration Physical long-lived deterioration Functional curable (modernization) obsolescence

Which procedure for estimating incurable physical deterioration is recommended in the breakdown method? (1) (2) (3) (4)

Market extraction Paired data analysis Application of an age-life ratio Capitalization of rent loss

Assignment 9 continues on next page 9.40

The Cost Approach Part III – Depreciation Estimates

THE NEXT 5 (FIVE) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: You have been contracted to appraise a 15 year old, ranch style brick bungalow in a single family residential neighbourhood. You will use the cost approach based on replacement cost. Note that land value has already been determined, so you only need to calculate the value of the building. Location

The subject property is immediately adjacent to an elementary school with playground noise levels and heavy vehicular traffic, not aspects typically desired by the general buying public. Site and Service

The subject site is well-landscaped with several mature trees and plantings. All services associated with residential style accommodations are available, i.e., water, sewers, gas, hydro, etc. Building Details

This bungalow has been well-maintained over recent years, with the exception of the following items which require immediate attention:  

Interior painting is required in two bedrooms, the bathroom, and the hallway. The R.C.N. of the painting is $440; the Cost to Paint is $610. You also notice that a basement window is cracked and would normally be replaced by a typical purchaser. The cracked window would cost $130 to install now; the R.C.N. would be $95.

After comparing the subject improvements to houses in the immediate area, you conclude that its condition is typical for houses of this age. The actual age of 15 years is, therefore, concluded to be representative of its effective age. Your investigation of competing structures leads you to the conclusion that the remaining economic life estimate is 45 years. You prepare a list of those items which, in your opinion, will require replacement prior to the estimated 45 year remaining economic life. These items are noted as follows: (a) The remaining interior painting and exterior painting will be required again in approximately 3 years. The R.C.N. of this work is calculated at $1,400. Typically, painting is required every 6 years. (b) The furnace is expected to last another 10 years and the R.C.N. of the furnace is $1,600. This is the original furnace and is in relatively good condition. (c) The roof shingles, which are now 12 years old, will require replacement in 3 years. The R.C.N. of the shingles is $4,000. (d) The hot water tank is now 3 years old and will require replacement in 7 years. This item would cost $750 installed if purchased at the date of this appraisal.

Assignment 9 continues on next page 9.41

Lesson 9

The bathroom fixtures are now out-of-date in terms of today's standards. Similar homes in the neighbourhood have been upgraded in recent times and the subject appears to have been neglected regarding these items. The R.C.N. or cost to cure of the fixtures is reported to be $950; the depreciated cost or old value of these fixtures is indicated at $130 (e.g., could be sold for that amount at a garage sale). As previously noted, the extra traffic and noise problems associated with the adjoining school would negatively impact on the potential rental income which this property could command on the open market. You estimate a rental loss of $50 per month as a result of these factors, assuming the subject property was available for rent as at the effective date of this appraisal. (a) Your analysis of land-to-building ratios in this area indicates that typically land represents 40% of the property value. (b) For the purpose of developing a gross rent multiplier, you have researched the market and located the following three transactions: Sale No. 1 2 3

Sale Price $180,000 $184,900 $175,000

Monthly Rent $1,500 $1,550 $1,450

(c) The subject improvements measure 10m  12m and include three bedrooms, one original bathroom, and a modernized kitchen. The downstairs (basement) area includes a finished recreation room which is typical of houses located in the neighbourhood. (d) The depreciated value of outside improvements, i.e., lawn, shrubs, sidewalks, etc., has been estimated at $5,200. (e) Use a replacement cost new of $845/square metre. In the following questions, you need to calculate the total depreciation under each category. 6.

What is the total curable deferred maintenance under physical deterioration? (1) (2) (3) (4)

7.

$427 $528 $570 $740

What is the total depreciation for the incurable short-lived items under physical deterioration? (1) (2) (3) (4)

$4,185 $5,085 $4,885 $7,750

Assignment 9 continues on next page 9.42

The Cost Approach Part III – Depreciation Estimates

8.

What is the total depreciation for the incurable long-lived items under physical deterioration? (1) (2) (3) (4)

9.

What is the total curable functional obsolescence? (1) (2) (3) (4)

10.

$130 $820 $950 $1,080

What is the total external obsolescence attributable to the building? (1) (2) (3) (4)

11.

$31,590 $29,104 $25,350 $23,279

$1,500 $2,400 $3,600 $6,000

Which of the following statements regarding methods of estimating depreciation are FALSE? A. B. C. D.

(1) (2) (3) (4) 12.

The age-life method typically reflects a straight-line method of depreciation. The market extraction method enumerates the components of total depreciation. Breakdown calculation is the primary method used by most appraisers to estimate the total depreciation in a property. The primary goal of depreciation analysis is to identify all forms of depreciation that could possibly be found in a property by the most detailed inspection from the most critical potential purchaser.

Only statements A and C are false. Statements B, C, and D are false. Statements A, B, and D are false. Only statements C and D are false.

During an inspection of an office building with a remaining economic life of 10 years, you notice that the boiler is deteriorating and has a remaining useful life of only 15 years. On the date of inspection, the boiler is operative and there is no need to replace it. What is the remaining life of the boiler that would be used in a depreciation analysis? (1) (2) (3) (4)

10 years. It would be treated as part of the long-lived incurable calculation. 15 years. It would be treated as part of the short-lived incurable calculation. 5 years. Its economic life in excess of that of the building would be depreciated. 0 years. It would be treated as part of the curable deterioration calculation.

Assignment 9 continues on next page 9.43

Lesson 9

THE NEXT QUESTION REFERS TO THE FOLLOWING TABLE: Sale 1 Sale price Less value of land Depreciated cost of improvements Cost new of improvements Less depreciated cost of improvements Lump-sum dollar depreciation Lump-sum percentage depreciation Age of comparable property

13.

2.00% 2.30% 0.50% 1.40%

$558,000 $512,000 $379,000 $246,000

When is the breakdown method typically NOT used? (1) (2) (3) (4)

16.

When an estimate of depreciation is required quickly and with minimal expense. When multiple elements of depreciation that exist in the subject property are not accurately reflected in available sales data. When the age-life method is too simplistic to account for the varied forms of depreciation present. When an appraisal requirement specifies that each form of depreciation must be accounted for.

Which method for estimating depreciation allocates depreciation among individual building components? (1) (2) (3) (4)

Observed condition method Age-life method Capitalization of rent loss method Market extraction method

Assignment 9 continues on next page 9.44

$790,000  125,000 $665,000 $930,000  665,000 $265,000 28.5% 19

You decide to closely examine the details of an appraisal report that utilized the cost approach. The value of the property was estimated as $937,000 and depreciation was estimated to be $133,000 using the age-life method. The total cost new of improvements is valued at $824,000, but the report seems to be missing the value of the land. Based on the information provided, what is the value of the land? (1) (3) (2) (4)

15.

$600,000  100,000 $500,000 $625,000  500,000 $125,000 20% 14

Sale 3

Consider a subject with improvements that are 10 years old. Which of the following is a reasonable estimate of average annual depreciation for the subject improvements? (1) (2) (3) (4)

14.

$950,000  140,000 $810,000 $900,000  810,000 $90,000 10% 8

Sale 2

The Cost Approach Part III – Depreciation Estimates

17.

An old, two-storey house that you have just inspected only has one electrical outlet in the living room. The cost of installing more outlets is greater than the added value and other existing items will still maintain their value if this work is not done. This is an example of a (an): (1) (2) (3) (4)

18.

Which of the following statements is FALSE? (1) (2) (3) (4)

19.

curable deficiency requiring a substitution. curable deficiency requiring modernization. curable deficiency requiring an addition. incurable deficiency.

The age-life method is typically the simplest way to estimate depreciation. In the market extraction method, the various components of depreciation are considered separately. Land value can suffer from external obsolescence. The breakdown method analyzes depreciation as being either physical deterioration, or functional or external obsolescence.

Which method of estimating accrued depreciation is the most directly verifiable from market evidence? (1) (2) (3) (4)

Breakdown Extraction Age-life All are equally based on direct market evidence

20. You are closely examining the details of an appraisal report that provided an estimate of the depreciation for an apartment building. An old air conditioning unit that no longer meets market standards was deemed to have brought $10,000 of depreciation for functional obsolescence to the apartment building (curable, caused by a deficiency requiring modernization). The air conditioning unit was already 40% depreciated and has a reproduction cost of $9,000. To currently install a new unit, it would cost $10,000. What is the total cost to cure the air conditioning unit? (1) $7,400 (2) $14,600 (3) $15,400 (4) $25,400 20

Total Marks

PLANNING AHEAD For Project 2, you will be required to calculate depreciation estimates for a residential property you are familiar with. See Project 2 for more details on what is expected in these depreciation calculations. A key component of Project 2 is the requirement for you to gather data for the direct comparison approach to value. You will have to collect a minimum of 3-5 comparable sales which you will use to appraise the value of the subject property you have chosen. To find these comparable sales, you will need access to market data. This will likely require you to make the acquaintance of a broker or appraiser in your area and ask for their assistance. You should begin this process well in advance of Project 2's due date, so that you are not scrambling for information as the due date approaches. End of Assignment 9 9.45