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How Depreciation Works

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What is the primary reason a newly built home has a higher market value than the same home that is older? In a word, depreciation. What is depreciation? Simply stated, it is loss in value.

There are three basic causes of depreciation for homes. Physical, functional, and external obsolescence. What do they indicate and how do appraiser’s measure depreciation? Let’s talk about it.

PHYSICAL DEPRECIATION

Physical depreciation is the most common cause of loss of value. All homes, that are not new, suffer from physical depreciation, because all homes are only new once. Even if they are completely renovated, they are still not considered to be new. As a home ages, it begins to deteriorate.

Physical depreciation is a loss of value due to aging as well as wear and tear on a home. Homes suffer from physical deterioration at different rates depending on how well the home is maintained and improved.  

FUNCTIONAL DEPRECIATION

Functional depreciation results when buyers pay less for a home, in comparison to other similar homes, because some aspect of it is less functional than other generally similar homes. For instance, a home with two bedroom, in an area where most similar homes have three bedrooms, might be a functional issue. Another functional issue might be a home that utilizes a heating system that is not adequate to properly heat a home, or a heat source that the market views as being adequate or desirable, and therefore will pay less for.

An inadequate heat source could be considered a functional issue resulting in a loss of value.

A functional issue may also include a home with inadequate facilities for its size. For instance, a three-thousand square feet, four-bedroom home, that only offers one bathroom, might be functionally inadequate. Most people looking to buy a home with four bedrooms will expect the home to have more than one bathroom. Therefore, people may pay less for the home with only one bathroom. This is an example of depreciation due to a functional issue. 

EXTERNAL DEPRECIATION

Depreciation from external influences is a loss of value that is attributed to some external situation that is outside of the subject’s property, but that has a negative impact on market value. External depreciation is incurable because it is out of the control of the homeowner to change the situation, that is, without moving the home, which is probably not cost effective.

One example may be a home that is located next to a major highway, or some undesirable location, for which buyers are paying less because of the location. Another example may be an economic situation. During the Great Recession, home prices were falling rapidly due to an over-supply of inventory, which was out of the control of individual homeowners. This is an example of an external influence that causes depreciation.  

CURABLE AND INCURABLE OBSOLESCENCE

Obsolescence can cause a loss in home value. It can be curable or incurable.

Curable obsolescence, as the name denotes, is something about the home that can be changed by the homeowner, that can slow down the rate of depreciation. For instance, remodeling a kitchen or bathroom typically improves a home’s market value, which in turn, reduces a home’s loss in value. Many improvements made to a home will help to slow its rate of depreciation. Some more than others.

Incurable obsolescence is a different story. It is something that causes a loss in value, but cannot be changed by the homeowner, at least at the time. Or, it could be a situation that is not economically feasible to change.

For example, an incurable obsolescence can be seen in some repairs that may be needed to a home. When the cost to make a repair exceeds the amount that the item contributes to the value of the property, this is considered to an incurable physical obsolescence. Some repairs may be considered incurable short-lived items, and others incurable long-lived items. 

When the cost or repairs exceed the contributory value, this is considered to an incurable.

Another example of an incurable functional obsolescence is when an improvement exceeds what the market is willing to pay for the additional amenity. It is an improvement in which there is little if any return in value for the cost of the improvement. In an appraisal report, it may be called an over-improvement or something that is super adequate.

The market may not be willing to pay more for a home with a five-car garage than one with a three car garage.

A good example may be a home with a five-car garage, in an area in which most competing homes only have three car garages. In doing some market research, an appraiser may determine that buyers are not paying more for a five-car garage than they are for a home with a three car garage. Therefore, the five-car garage is considered to be super adequate for the market. This is a form of incurable obsolescence.  

Of course, things may change in time. In the future, buyers may be willing to pay more for those additional garage spaces. In this case, those additional spaces would no longer be viewed as super adequate, or an over-improvement. It really all depends on what the market is willing to pay for the amenity. 

AGE-LIFE METHOD

There are several methods appraisers use to measure depreciation. The most common for residential appraisers is the age-life method. How does it work?

The age-life method measures the percentage difference between the replacement cost of the home and its improvements with what the market is currently paying for homes that are comparable, that is, their market value. The value of the land and site improvements are not included in this difference because land does not depreciate. It may fluctuate down a little, but technically, land does not depreciate. That’s a topic for another article.

The chart below shows how the age-life method works. This is from a home I recently appraised. At the top is the market value of the home. When measuring the depreciation of the comparable sales, the market value is the sales price of the home. In the example below, the indicated market value is my opinion of the market value of the home I appraised. The next line is my opinion of the market value of the land. In this case, I used vacant land sales.

The “as-is” value of the site improvements reflects the value of the improvements made to the land, such well and septic, or in this case, public water and sewer lines, that are necessary to convert the vacant land into a usable site to build upon.  

Example of The Age-Life Method

The land value and the “as-is” value of the site improvements are deducted from the market value, which gives us the depreciated cost of the improvements. Next, the appraiser will develop the replacement cost of the improvements, using different data sources. In the example above, based upon the data source I used, to build the same home today would cost $630,385 (not including the land).

The data sources for determining the replacement costs must be from a reliable source, or the measurement of depreciation will not be accurate. The percentage difference is the amount the home has depreciated, which is indicated in red. This information is incredibly valuable to the appraiser in the appraisal process for many things. That is also a topic for a future article.

The age-life method measures the total depreciation from all of the sources of depreciation we discussed earlier. So, if one home has a higher level of depreciation than other generally comparable homes, the appraiser must determine what is causing the additional depreciation, or conversely, less depreciation, for a seemingly similar home. A more extensive method may need to be used, such as the breakdown method, which measures depreciation more precisely. 

The cause of the additional depreciation may be more than just physical deterioration. It may be due to a functional issue or some external influence. On the other hand, a home may have less depreciation because it offers something that is more desirable than other seemingly comparable homes offer. It could be a more desirable view, location or amenity. The appraiser must determine the cause of these differences in rates of depreciation.

WHO DETERMINES DEPRECIATION?

That’s kind of a trick question. Appraisers don’t determine depreciation. We only measure it. The market determines the rate of depreciation. As we discussed earlier, depreciation is measured by the relationship between the sales price (market value), that is, what people are paying for the home, and the replacement cost of the home. (Less the land value and site improvements)

In a neighborhood where homes are selling for relatively low prices, in comparison to their replacement cost, the depreciation is going to be higher, or vice versa. While the physical aspects of a home do play a role in the amount of accrued depreciation, what we are measuring is economic depreciation. That’s why sales price is one of the key elements in measuring depreciation using the age-life method. It’s how appraisers extract depreciation from the market.

CHANGES IN DEPRECIATION

The causes of depreciation can change for many reasons. For instance, changes in market conditions may impact the rate of depreciation. There are times when the people are not paying less for a home with a seemingly negative external influence, when in the past, they were. For instance, in the current market, in some neighborhoods, I have noticed that some homes located on busy streets, are not selling for any less than comparable homes located on streets that do not experience heavy traffic. Why?

Will buyers pay less for a home on a busy street? Maybe yes, maybe no.

There is such a shortage of housing inventory right now, that at times, at least in my market, buyers really don’t care about this type of external influence. When this is the case, a home may not be suffering depreciation from this external influence, due to this location not causing a loss in value currently.

However, at many times in the past, the market may have paid less for that same home due to its being on a busy street. In the past, this external influence did cause depreciation, while currently it is not. And while right now it may not be suffering from deprecation due to this external influence, when market conditions change, it may suffer depreciation from this external influence in the future.

What is causing a home to lose value today, may be something different tomorrow. That’s why appraisers must measure depreciation on every appraisal. It is a major aspect of our developing our opinion of the market value of a property.

When appraisers develop their opinion of value for a property, there is a lot of work involved behind the scenes, for which most people have no idea. That is why I thought you might enjoy learning a little more about this topic. I hope you did!  

To end this week’s post, enjoy this little video that features some exotic places to visit right here in the United States! Pretty cool. It is so nice to see people being able to travel again! 

 

 

Have a great long weekend everyone!


 

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I am a member of the National Association of Appraisers. If you’re an appraiser, and you’re looking to join an appraisal organization, please check them out. The NAA is made up of fantastic appraisers from across the country who are working hard to keep their fellow appraisers up to date on what’s happening.

Click here to visit their website.

 


Here are some links to other articles I’ve enjoyed recently! I hope you will also… 

Inflating Human Interactions With Housing – Housing Notes by Jonathan Miller

The invasion of institutional investors in the housing market Sacramento Appraisal Blog

6 Reasons You Should Not Be Using Price Per Square Foot To Price Your Listings – Birmingham Appraisal Blog

Appraiser Capacity During the Pandemic – APPRAISAL TODAY

Is Statistics Always Scary? – George Dell’s Analogue Blog

Taking Some Time Off – DW Slater Company Blog

Three (3) Points of Inconsistency – The Appraiser’s Advocate with Tim Andersen (PODCAST)

Do Multiple Offers Matter? – Real Estate Appraisal Between The Lines with Brian C. Lee (PODCAST)

2 thoughts on “How Depreciation Works”

  1. Nice job as always Jamie. Hope you are really well these days. As for me I feel my body depreciating… (sorry not sorry). Actually I took a walk this morning and I’m feeling great.

    1. Thank you my friend! I am doing good! Hanging in there! I am right there with ya. The aging, aka depreciation process can be brutal. I’m glad you are staying active with some awesome walks! I love your Instagram post s of your walks. Way to slow down your depreciation! I need to do more of that.😁

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