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Editor’s Note: This story first appeared in Working RE, Spring 2013. Click here for subscription details.

Estimating Physical Deterioration

by Philip Spool, ASA

What I like about writing these articles is the research it takes for accuracy and current terminology.  For many years I was taught that accrued depreciation was depreciation from all causes, which consists of physical deterioration, functional obsolescence and external (locational and economic) obsolescence. This term is also used with those who value businesses within an accounting practice.  However, little did I realize, the term accrued depreciation is no longer used.  In its place is just the simple word depreciation.  Calculating depreciation is the most misunderstood concept in the cost approach.

Of the three forms of depreciation- physical, function and external, the easiest to calculate is physical deterioration.

Three Methods of Estimating Physical Deterioration
The three basic methods of estimating physical deterioration are (1) the market extraction method; (2) the age-life method (most often used method to calculate physical deterioration) and (3) the breakdown method.  I firmly believe that practically every appraiser utilizes the age-life method, and I will be discussing this method in more detail.  The market extraction method is acceptable if you have good land sales. The breakdown method is too complicated even to discuss and I seriously doubt that any appraiser utilizes this method except when performing a demonstration report where it is required to obtain an appraisal designation.

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Market Extraction Method
The market extraction method is similar to a “reverse” of the land extraction method (read my article Land Value: Extraction Method, WorkingRE.com; Library; Volume 30).  Find comparable improved sales similar to your subject property.  I suggest you find those sales with the least amount of added features, such as a covered patio, open patio or swimming pool. From the sales price, adjust for sales concessions, financing and conditions of sale, if any. Then, subtract the land (site) value at the time of its sale and any site improvements. This will give you the depreciated value of the improvements.

The next step is to determine the replacement cost new for the improvements (try Marshall & Swift residential handbook, Marshall Valuation Service commercial book or Building-Cost.net).  Subtract the depreciated cost of the improvements from the cost new and you will arrive at the total depreciation for that sale. Divide that number by the square footage of the improvements in order to get the depreciated value per square foot for each sale. Use this method for several sales, just like you would for the land extraction method.  Hopefully, there will be no functional or external obsolescence and the results will reflect only the physical depreciation.

Age-Life Method
The formula for the age-life method is the “effective age divided by the total economic life, times the total replacement cost new of the improvements.”  This is the easiest and most often used method to estimate physical deterioration. While the Fannie Mae form allows you to select either the replacement cost new or the reproduction cost new, and without going into a long explanation as to the difference between replacement versus reproduction cost new, choose replacement cost new.

What is Effective Age and How is it Determined?
My concept of effective age is based on the following principle: what you see is what you get.  The example I use, including in court, is to assume you are single and are going on a blind date.  You know your date is 40 years old and when you finally meet, you notice that your date takes good care of herself/himself and you think that your date looks ten years younger or 30 years old.  Actual age is 40 years and effective age is 30 years.  It is as simple as that.  In other words, effective age is your opinion as to the age of the property you are appraising.

Why Effective Age is Abused and Manipulated with Cost Approach
The abuse and manipulation of the effective age is an unfortunate reality.  Appraisers who are taught that the value by the cost approach has to be close to the value by the sales comparison approach simply are not doing the right thing.  What I mean by manipulation of the effective age, is when an appraiser adjusts the effective age higher or lower so that the result of the depreciation can either increase or decrease the depreciated value of the improvements, and ultimately the value when using the cost approach.

For example, you consider the effective age of a house to be 35 years with a total economic life of 65 years.  By the age-life method, the depreciation is 53.85 percent (35 years divided by 65 years).  If your replacement cost new is $300,000, the depreciation would be $161,550.  This might result in a higher conclusion of value by the cost approach. You want it to be closer to your sales comparison approach, so you arbitrarily raise the effective age to 45 years. The result would be a depreciation of 69.23 percent or $207,690 or a lower value by $46,140.

If you are going to change your effective age from your initial thinking, don’t do it for the result of comparing it to the sales comparison approach. One reason is that within the past few years, values have declined, in some cases, up to 50 percent from their peak.  A relatively fast drop in value would reflect a lower value by the sales comparison approach than the cost approach.  The effective age of the house, whether in bad times or good times, would not change. The only time the effective age would change would be due to the condition of the improvements.

If the house was foreclosed and not occupied for a while, then a higher effective age is justified.  In my upcoming third article of this series on depreciation and obsolescence, I will discuss the economic obsolescence component of external obsolescence.  A decline in the market more than likely will result in an economic obsolescence that has to be considered in the computation of total depreciation.  Therefore, your physical depreciation would not change but total depreciation would be higher due to the addition of economic obsolescence.

Supporting Economic Life in Your Report (and Workfile)
Marshall Valuation Service cost manual (the commercial book version) considers a non-high-end house to have a total economic life of 60 years and a high-end house to have a total economic life of 65 years.  While total economic life might vary for different areas and towns, the appraiser must find some support for the total economic life used within the age-life method of computing physical deterioration.  No matter what source you use when using the cost approach, make sure you keep a copy either within your workfile or somewhere in your office where you can reference its location in your workfile.  Remember, the Uniform Standards of Professional Appraisal Practice (USPAP) require you to either maintain a copy of the support for total economic life in your workfile or make reference in the workfile as to the location of the documentation (see Record Keeping Rule).

Economic Life versus Useful Life
Simply put, economic life is the amount of time which the improvements contribute to the property value.  Useful life is the amount of time which the improvements perform the function it was constructed for (i.e. a house).  A good example would be a house that is considered an interim use.  It may have reached or is close to its total economic life and its remaining economic life is either zero or close to zero.  However, it still may be livable and therefore have a useful life for several more years.  Economic life, not useful life, is used to calculate depreciation by the age-life method.

Remaining Economic Life and Why it is Important to Lenders
While the appraiser should not be too concerned with the remaining economic life, a lender considers it important when making a loan. If the loan is for 30 years and the remaining economic life is only 20 years, the lender considers the property to last ten years less than the loan amount. While most loans are not on the books for the full 30 years, it could be a concern to the lender.  Some appraisers are aware of this and adjust their remaining economic life so that it is 30 years or more.  An appraiser is not supposed to fashion their appraisal around the lender’s needs.

Is Cost Approach Necessary?
I would like to know why any appraiser even considers using the cost approach unless the property is proposed, under construction or newly constructed.  The only other logical reason is if there are no comparable sales and therefore the property is considered a special purpose building. What happens if your assignment is to appraise a house and there are no sales within the past year or two and none within the general vicinity?  It would not be considered a special purpose building but it might be reasonable to use the cost approach.  However, when I propose the question to other appraisers, as to why use the cost approach, inevitably they reply with “the AMC or lender requires me to do the cost approach.”  Why do they want you to do the cost approach?  Most likely it is because they want the appraiser to come up with the replacement cost new which is a code phrase for “insurable value.”

While the cost approach is part of the fundamental theory of appraising, appraisers have come to realize that buyers are not interested in the cost approach to value or the income approach if the property is a single family residence.  If the subject was built many years ago and the effective age is high, then the estimated depreciation of the improvements becomes too subjective.  This would be a very good reason why the cost approach is not utilized.  Remember, USPAP Standards Rule 2-2, whether it be 2-2 (a) for a Self-Contained Appraisal Report, 2-2 (b) for a Summary Appraisal Report or 2-2 (c) for a Restricted Use Appraisal Report, states it is a requirement that “any exclusion of the sales comparison approach, cost approach, or income approach must be explained.”

Functional and External Obsolescence
My next two articles will be on estimating functional and external obsolescence. Functional obsolescence is typically associated with a problem with the structure, whether it be an inadequacy or super adequacy or even a bad floor plan. I will discuss the different types of situations that are associated with functional obsolescence and how to estimate the amount of obsolescence. External obsolescence is divided into locational and economic obsolescence.  This type of obsolescence is the most misunderstood of all three types of depreciation/obsolescences.  I will discuss both locational and external obsolescence and the most effective way of calculating the obsolescence. Find Estimating Functional Obsolescence at WorkingRE.com, Current Edition (rigth column). Read Estimating External Obsolescence in the upcoming Working RE print, mailing at the end of November. Click here for subscription details.

About the Author
Philip G. Spool, ASA, is a State-Certified General Real Estate Appraiser in Florida, appraising since 1973.  Formerly the Chief Appraiser of Flagler Federal Savings and Loan Association, he has been self-employed for the past 20 years. In addition to appraising, he is an instructor with Miami Dade College, teaching appraisal courses and continuing education.  He is Vice President and Chairman of Real Estate Programs with the Greater Miami Chapter of the American Society of Appraisers.  He can be reached at pgspool@bellsouth.net.