According to the Dictionary of Real Estate Appraisal, published by the Appraisal Institute, depreciation is a loss in value due to any cause. This depreciation is applied to the replacement cost of the improvements in the cost approach as you will see in Chapter 10 on real estate appraisal.
The depreciation can come in three forms: physical deterioration, functional obsolescence, and economic or locational obsolescence. The first of these, physical deterioration, is probably what comes to mind when most people think of depreciation. This is the physical wearing out of the improvements. It is the chipped paint, the cracked plaster, or the missing roof shingles. When this form of depreciation is valued separately, it is usually based on the cost to cure. How much would it cost to repaint the rooms? How much would it cost to repair the plaster? Or how much would it cost to replace the roof?
The second form of depreciation may escape casual observers. They may not recognize it as depreciation, but they may respond that, "There is something funny about that house." That something funny is functional obsolescence. This is either something that doesn't function the way it should or something that is no longer desirable in the marketplace. It may be a dysfunctional floor plan, such as a bedroom off of the living room. It may be a stairway coming directly into a room rather than into a hallway. I think of my grandmother's kitchen when I think of functional obsolescence. She had these very large cupboard doors that were about four feet tall, reaching up to the high ceiling. Nobody could ever get anything down from the top two shelves. There were linoleum countertops in the kitchen, in a red swirl pattern as I recall, with a little aluminum band around the edge where all of the "gunk" got caught. Other examples of functional obsolescence would include shag carpet, avocado colored appliances, a gravity furnace, or a single-car garage.
A dollar value is a little more difficult to establish for this type of depreciation. The concept of curable versus incurable depreciation comes into play with functional obsolescence as well as for physical deterioration. The basic test is economic viability. If the change is not economically viable, the depreciation is incurable; if it makes economic sense, it's curable. It is pretty difficult to change a floor plan deficiency, which makes that incurable. Replacing shag carpeting makes economic sense.
The third form of depreciation is locational, or economic, obsolescence. Let's say you own a house in Hibbing, Minnesota, and the taconite plants are closed down. Suddenly there are scores of unemployed workers who decide they have to move to another town for employment. They all put their houses on the market at the same time. This tremendous increase in the supply of housing without a corresponding increase in demand will cause values to go down. This loss in value is simply the result of where the home is located—in Hibbing. This value loss, or depreciation, is pretty much incurable.
An appraiser will be asked to determine the loss in value that has resulted from these three forms of depreciation on the property. Some of the valuation service companies such as Marshall & Swift publish tables that have combined the different forms of depreciation into depreciation tables. Depreciation tables give a percentage of depreciation that should be taken based on the age of the structure and the original quality of construction. If a house has a construction cost of $200,000 new, and the depreciation tables recommend taking depreciation of 20%, then the house would have a depreciated cost as stated in Equation 8.9.
$200,000 x 0.20 = $40,000 and then $200,000 - $40,000 = $160,000
The depreciated cost of the improvements is equal to the cost times 1 minus the depreciation rate. This is the same calculation as shown in Equation 8.10.
$200,000 x (1 - 0.20) = $200,000 x (0.80) = $160,000
The question may be worded in reverse fashion. A house is currently worth $140,000 and has depreciated by 15% since it was purchased. What was its original value? The calculation then becomes Equation 8.11.
Rather than multiplying by 1 minus the rate as we did in Equation 8.9, you simply divide by 1 minus the rate of depreciation. Dividing the $140,000 by 0.85 gives us the value of $164,705.88. To check your answer, now multiply the $164,705.88 by 1 minus the rate, or $164,705.88 x (1 - 0.15), which is the same as $164,705.88 x 0.85, and get the correct value of $140,000.
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