Thursday, December 22, 2005
Depreciation
There is a special and direct economic relationship in real estate between Time and Value: as land becomes scarcer and appreciates, the improvements on the land are subject to obsolescence and depreciate. Obsolescence is an economic variable used by governments, economists, appraisers and Realtors that reflects the fact that the building sited on a piece of land ages with time, just like me. And, unlike wine, a building that ages with time does not get any better, again just like me. No wonder that I am in real estate – but I digress.
There are two types of depreciation when it comes to real capital assets: physical and functional. And both physical and functional depreciation can be categorized as either curable or incurable.
[ ] Physical Depreciation
Physical depreciation represents the accumulated loss in market value caused by physical wear and tear since the date the building was completed. Physical curable depreciation refers to damage which can be corrected economically, and it includes such items as poor decorative conditions, broken fittings, outdated or worn out carpeting, faded or old paint, appliances not in a proper working order as well as aging roofs. On the other hand physical incurable depreciation includes wear and tear of structural members and foundations where repair or replacement is likely to involve significant cost. These two kinds of depreciation are treated differently. The dollar amount of the deduction required for physical curable depreciation is generally based on the required cost of carrying out the repairs. Conversely, the allowance for physical incurable depreciation is more difficult to estimate, with the principal cause of such difficulty lying in the determination of the remaining life of the building.
There is no precise way to estimate the cost of correcting physical incurable depreciation. Generally speaking the cost of this kind of corrections is so great that in terms of economics the structure should either be left in its present state or totally rebuilt. Governments tend to estimate the economic life of buildings in terms of straight-line depreciation, but this is so merely because it makes the estimate of capital gains and losses, as well as their recapture, a little easier to determine from an accounting point of view. Appraisers and experienced Realtors, on the other hand, will tend to make an educated guess more often than not as to the value of the physical incurable depreciation based upon visual observation while economists will base it upon knowledge of regional comparable market data.
[ ] Functional Depreciation
This type of depreciation describes the loss of value caused by outmoded or inadequate design. Here too it is necessary to distinguish between curable and incurable functional depreciation. Functional curable depreciation includes items such as the cost of replacing old-fashioned fittings, installing an additional bathroom or otherwise making alterations to the existing plan by, for example, creating new doorways and blocking old ones, or by following market trends such as enhancing the visual appearance of rooms with open layouts and light-play. Again, the amount by which market value is reduced is in direct function of the cost involved in carrying out the necessary updates.
And, like before, the amount by which market value is reduced because of functional incurable depreciation is entirely a matter of judgment and cannot be determined with an arithmetical calculation. There are, of course, limits to what can be done to cure functional depreciation. For example, if an architectural style has gone out of fashion, nothing can be done and a higher factor of deduction will be applied. The opposite is true, of course, of plans that never go out of style. For instance, residential ranchers are always high on the list of demand and very much sought after by elderly and younger couples alike but for opposing reasons: a lack of stairways for the first and easy maintenance for the latter.
Luigi Frascati
Real Estate Chronicle
