Depreciation (Appraisal)

Definition

Depreciation (Appraisal): A charge against the reproduction cost (new) of an asset for the estimated wear and obsolescence. Depreciation recognizes the loss in value due to factors such as wear and tear, outdated design, or reduced demand caused by changes in the environment. It is crucial in real estate appraisal to accurately reflect the remaining value of a property.

There are three types of depreciation:

Physical Depreciation: The loss in value caused by wear and tear over time.
Functional Obsolescence: The loss in value due to outdated features or design, which impact functionality.
Economic Obsolescence: The loss in value caused by external economic factors affecting the area, such as changes in the neighborhood or market conditions.

Examples

Example 1: The estimated reproduction cost (new) of a theater being appraised is $500,000. Wear and tear sustained during its life is estimated at $100,000. Functional obsolescence caused by lack of air conditioning and high ceilings causes an estimated loss of $100,000. It is in a decaying area of the city, estimated at causing $100,000 of economic obsolescence. Total depreciation is estimated at $300,000.
Example 2: An office building has an estimated reproduction cost of $1,000,000. Over its lifetime, it has sustained $200,000 in wear and tear. Its outdated elevators lead to $50,000 in functional obsolescence. Additionally, it is located in a market with declining property values, resulting in $150,000 of economic obsolescence. Total depreciation is estimated at $400,000.

Frequently Asked Questions (FAQs)

Q1: What factors contribute to physical depreciation?

A1: Physical depreciation is caused by everyday wear and tear, age, and usage of the asset.

Q2: How is functional obsolescence identified in a property?

A2: Functional obsolescence is identified when a property’s features or design are outdated, leading to reduced functionality or desirability.

Q3: Can economic obsolescence be reversed?

A3: Economic obsolescence is typically difficult to reverse as it is caused by external factors like changes in market conditions or neighborhood quality.

Q4: How does depreciation (appraisal) impact property valuation?

A4: Depreciation reduces the assessed value of a property, offering a more accurate representation of its current market value.

Q5: Is depreciation (appraisal) the same as tax depreciation?

A5: No, depreciation (appraisal) focuses on property valuation, whereas tax depreciation refers to an income tax deduction based on the property’s reduced value over time.

Reproduction Cost: The cost to construct an exact duplicate of the property at current prices.
Obsolescence: The reduction in property value due to outdated technology, design, or external economic factors.
Appraisal: The process of evaluating and estimating the value of a property.
Property Valuation: The method of determining the fair market value of a real estate asset.

Online Resources

References

Schiffman, D. R. (2019). Real Estate Principles: A Value Approach. McGraw-Hill Education.
Clapp, J. M., & Carmichael, B. (2004). The Economics of Commercial Property Markets. Routledge.

Suggested Books for Further Studies

“Real Estate Appraisal Principles and Procedures” by James A. Graaskamp
“Appraising Residential Properties” by the Appraisal Institute

Real Estate Basics: Depreciation (Appraisal) Fundamentals Quiz

### Which type of depreciation is caused by outdated features that reduce a property’s functionality? - [ ] Physical Depreciation - [x] Functional Obsolescence - [ ] Economic Obsolescence - [ ] Market Wear > **Explanation:** Functional obsolescence is caused by outdated features or design elements of the property that reduce its overall functionality or efficiency. ### How does physical depreciation differ from economic obsolescence? - [ ] Physical depreciation is caused by external factors, while economic obsolescence is due to wear and tear. - [x] Physical depreciation is due to wear and tear, while economic obsolescence is due to external factors. - [ ] Both have the same underlying causes. - [ ] Physical depreciation always decreases property value more than economic obsolescence. > **Explanation:** Physical depreciation is due to the natural wear and tear of the property, whereas economic obsolescence is due to external factors negatively impacting the property's value. ### What kind of obsolescence results from adverse changes in the surrounding area? - [x] Economic Obsolescence - [ ] Physical Depreciation - [ ] Functional Obsolescence - [ ] Structural Wear > **Explanation:** Economic obsolescence occurs due to external factors, like adverse changes in the neighborhood or market, leading to a drop in the property's value. ### Which type of depreciation would include issues such as outdated electrical systems within a property? - [ ] Economic Obsolescence - [ ] Physical Depreciation - [x] Functional Obsolescence - [ ] General Wear > **Explanation:** Functional obsolescence includes outdated systems like old electrical wiring that make the property less desirable or less functional. ### Total depreciation of a property is the sum of which types of depreciation? - [ ] Physical, environmental, and aesthetic depreciation - [x] Physical, functional, and economic obsolescence - [ ] Structural, aesthetic, and environmental depreciation - [ ] Mechanical, natural, and social depreciation > **Explanation:** Total depreciation is the sum of physical depreciation, functional obsolescence, and economic obsolescence. ### Does the basic wear and tear come under physical depreciation or functional obsolescence? - [ ] Functional Obsolescence - [x] Physical Depreciation - [ ] Economic Obsolescence - [ ] Neighborhood Depreciation > **Explanation:** Basic wear and tear come under physical depreciation as it refers to the natural deterioration of the property over time. ### Can the location of a property contribute to economic obsolescence? - [x] Yes, if the neighborhood quality declines. - [ ] No, location does not affect economic obsolescence. - [ ] Only if the property is commercial. - [ ] Only if the property is under municipal redevelopment. > **Explanation:** Yes, the location and the impact of changes in the neighborhood can significantly contribute to economic obsolescence. ### Why is it important to consider all three types of depreciation in an appraisal? - [ ] To achieve a higher property value. - [ ] To overestimate the property's issues. - [x] To accurately reflect the property's current market value. - [ ] To satisfy loan requirements. > **Explanation:** Considering all three types of depreciation (physical, functional, and economic) is crucial to provide a realistic and current market value of the property. ### What type of depreciation involves losses from external market conditions? - [ ] Physical Depreciation - [ ] Functional Obsolescence - [x] Economic Obsolescence - [ ] Internal Wear > **Explanation:** Economic obsolescence involves losses from external market conditions that affect the value of the property. ### Does functional obsolescence affect rental properties or can it also impact owner-occupied homes? - [x] It can affect both rental properties and owner-occupied homes. - [ ] It only affects rental properties. - [ ] It only affects owner-occupied homes. - [ ] It is irrelevant in residential appraisals. > **Explanation:** Functional obsolescence can affect both rental properties and owner-occupied homes by reducing their functionality and appeal due to outdated features.