Functional Depreciation
Definition
Functional Depreciation, also known as Functional Obsolescence, is the loss in property value arising from issues inherent within the property itself, such as outdated design, inadequate systems, layout inefficiencies, or superfluous features that fail to meet current standards or market preferences. It contrasts with physical depreciation (wear and tear) and external obsolescence (effects of external factors).
Examples
- Outdated Electrical Systems: A property designed with a 60-amp electrical service where modern homes typically require at least 200 amps.
- Inefficient Floor Plans: Properties with small, compartmentalized rooms instead of modern open floor plans.
- Undesirable Architectural Designs: Older homes with multiple smaller bedrooms and a single bathroom compared to modern preferences for fewer, larger bedrooms and multiple bathrooms.
- Non-functional Additional Rooms: Properties with an excess number of small rooms or spaces with peculiar designs, making them impractical for use and unattractive to potential buyers or tenants.
Frequently Asked Questions
What differentiates functional depreciation from physical depreciation?
While functional depreciation stems from design flaws or inefficiencies, physical depreciation results from the regular wear and tear a property undergoes through usage and passage of time.
Can functional depreciation be remedied through improvements?
Yes, functional depreciation can often be mitigated through renovations or redesigning features to align with modern standards and preferences.
Is functional depreciation a concern in commercial real estate?
Yes, functional depreciation affects both residential and commercial real estate, diminishing desirability and functionality across all property types.
Does functional depreciation impact property tax assessments?
Functional depreciation may be considered during property appraisals and tax assessments, potentially influencing assessed value and property taxes.
How can investors assess the risk of functional depreciation?
Investors can evaluate risk by conducting thorough due diligence, including property inspections, market trend analysis, and consulting real estate professionals.
Physical Depreciation: The reduction in property value due to material wear and tear.
External Obsolescence: Loss of property value caused by external factors such as changes in the surrounding areas or economic shifts.
Market Obsolescence: Similar to functional obsolescence, but specific to changes in market demands and preferences.
Economic Obsolescence: Devaluation caused by factors unrelated to the property itself, such as changes in economic conditions.
Online Resources
- Hud.gov: Information on property standards and valuation factors.
- IRS.gov: Guidelines on property depreciation for tax purposes.
- CRE.org: Resources on real estate market dynamics and depreciation.
References
- “Real Estate Investing for Dummies” by Eric Tyson and Robert S. Griswold.
- “Principles of Real Estate Practice” by Stephen Mettling and David Cusic.
- “The Real Estate Game: The Intelligent Guide to Decisionmaking and Investment” by William J. Poorvu.
Suggested Books for Further Study
- “The Intelligent REIT Investor” by Stephanie Krewson-Kelly and R. Brad Thomas.
- “Property Valuation Techniques” by David Parker.
- “A Guide to Commercial Real Estate Investment” by Susie Rogers and Brian Hennessey.
Real Estate Basics: Functional Depreciation Fundamentals Quiz
### Does functional depreciation refer to the property's physical condition?
- [ ] Yes, it refers to physical wear and tear.
- [x] No, it refers to design inefficiencies and outdated features.
- [ ] Yes, it includes both physical wear and design flaws.
- [ ] No, it only pertains to external factors affecting the property.
> **Explanation:** Functional depreciation specifically relates to inefficiencies and outdated features within the property's design, as opposed to physical depreciation, which pertains to wear and tear.
### Can functional depreciation be corrected through property renovations?
- [x] Yes, it can often be remedied with appropriate updates.
- [ ] No, it is irreversible.
- [ ] Sometimes, but only in commercial properties.
- [ ] Yes, but it requires demolishing the property.
> **Explanation:** Functional depreciation can generally be mitigated through property renovations or updating features to meet current standards and market preferences.
### What is an example of functional depreciation?
- [ ] Paint chipping off the walls.
- [x] A home with a non-functional floor plan.
- [ ] A property located next to a busy highway.
- [ ] A property affected by economic downturns.
> **Explanation:** Functional depreciation is exemplified by factors such as non-functional floor plans or outdated designs that reduce a property's utility or appeal.
### Which is not a cause of functional depreciation?
- [ ] Inefficient building layout.
- [ ] Outdated property amenities.
- [ ] Prudent property management.
- [x] Natural disasters affecting the area.
> **Explanation:** Functional depreciation specifically pertains to internal issues like inefficient layouts and outdated amenities, not external factors such as natural disasters.
### Does functional depreciation impact property value?
- [x] Yes, it reduces the property's value.
- [ ] No, it has no effect on property value.
- [ ] Yes, but only if it is a commercial property.
- [ ] No, it only increases renovation costs.
> **Explanation:** Functional depreciation reduces the property's value due to its diminished utility and appeal.
### Functional depreciation is also known as?
- [x] Functional Obsolescence.
- [ ] External Depreciation.
- [ ] Physical Depreciation.
- [ ] Market Decline.
> **Explanation:** Functional depreciation is synonymous with functional obsolescence, which reflects a decline in property value due to internal inadequacies.
### Which of the following best describes the impact of changing market preferences on functional depreciation?
- [x] Market preferences can latter-induced obsolescence within a property, reducing its value.
- [ ] Market trends have no impact on functional depreciation.
- [ ] Functional depreciation is only technical and isn't influenced by market trends.
- [ ] Long-term market trends elevate the impact of basic physical conditions of a property.
> **Explanation:** Shifted market preferences can emphasize functional inadequacies within a property, accelerating obsolescence and devaluing the property due to misaligned features.
### Which department might include functional depreciation in property assessments?
- [ ] Transportation Department.
- [ ] Real Estate Brokers Office.
- [ ] Internal Revenue Service (IRS).
- [x] Local Tax Assessment Office.
> **Explanation:** A local tax assessment office may evaluate functional depreciation factors when determining property value assessments.
### Who can be affected by functional depreciation?
- [x] Both residential and commercial property owners.
- [ ] Only residential property owners.
- [ ] Only commercial property owners.
- [ ] Primarily tenants of a property.
> **Explanation:** Functional depreciation can impact both residential and commercial properties by reducing their overall value and functional attributes.
### When determining to invest, what would an investor do to assess functional depreciation risk?
- [ ] Focus solely on property aesthetics.
- [ ] Discount any modern real estate trends and avoid renovations.
- [x] Perform detailed inspections, analyze layouts, and compare it with current market preferences.
- [ ] Rely exclusively on historical property value records.
> **Explanation:** Investors should conduct detailed property inspections and analyze whether the property meets current design standards and market preferences to assess functional depreciation risks.
