If you’re reading through an appraisal report, and you make it to the Cost Approach, which is where appraisers report either the reproduction or replacement cost of the home they are appraising, you will see a little field that says, “Remaining Economic Life“.
What does this number indicate? At first, you might be thinking that this means the estimated years remaining before a house falls over, so to speak. But that is not correct. That would be the home’s total physical life. So, what is its economic life?
There is a clue in the word “economic”. The term “economic”, indicates that we are talking about money and profitability. Therefore, the remaining economic life of a home is the number of years remaining before the improvements on the site no longer contribute to the value of the property.
To make this determination, the appraiser must first determine the Highest and Best Use of the land. I wrote an article on that subject, that you can check out called “Highest & Best Use Analysis In The Appraisal Process“. The economic life of a home begins when the improvements are built and ends when they no longer contribute value. How can we determine how much time is left before a home no longer contributes value to the property? Let’s talk about it.
DETERMINING THE TOTAL ECONOMIC LIFE
First, we need to determine the total economic life of the home. How? There are several ways to make this determination. Here’s one way.
We are going to need to obtain reliable data to calculate the replacement or reproduction cost of a home. (The use of the word “home” in this article, is referring to the property “improvements”) There are several data sources that appraisers use to obtain this information. The three I use are Marshall & Swift Residential Cost Handbook, Craftsman National Building Costs, and DwellingCosts.com. These are just a few. They all have done their studies and have provided their analysis of what their data reflects the total economic life of a home to be based upon its quality of construction.
One observation I have made is that different cost data services may vary a little in their analysis of what the total economic life of a home is. Additionally, their replacement and/or reproduction costs for the different improvements also vary a little. When it comes to the total economic life of a property I am appraising, I usually use the total economic life that the data source I am using provides. After all, they have done a lot of research and analysis. In most cases, I find that their estimates are reliable.
There are other ways an appraiser can estimate the total economic life of a property. How?
To start with, we will need at least a few generally recent sales, that are comparable to the property we are appraising. Ideally, they should be comparable in terms of age condition, quality of construction, market appeal, and we must also ensure that these properties have no functional or external obsolescence because these things can impact the rate of depreciation of a property.
Once we have found some comparable sales, we will deduct the value of the land from the sales price of each sale. Therefore, for each sale, we must develop a reliable opinion of the value of its land. Once we deduct the land value from the sales price, what remains is the depreciated cost of the home. Say a comparable home just sold for $500,000. Its land value is $150,000. That means that the depreciated cost of the improvements is $350,000.
Next, we want to determine how much the home has depreciated since it was built. To do this we need to determine its replacement or reproduction costs, using a reliable data source(s). Once we know how much the home costs to replace, we can extract a percentage of how much the home improvement has depreciated. How?
Let’s say that in this example, the home that sold for $500,000 has a replacement cost of $425,000. If that is the case, the home’s improvements have depreciated approx. 17.5%. ($425K less 17.5% is around $350K which is what we determined is the depreciated cost of the improvements to be currently)
The next question we must ask is, how long did it take for the home to depreciate to 17.5% from the time it was built? That’s a key question in determining the total economic life. It reminds me of an hourglass. It starts when the home and other improvements are built and ends when the improvements no longer contribute to the land, based upon the land’s Highest and Best Use. In other words, how fast, or at what rate, is the home moving from one-hundred percent contribution, when it is new, to zero contribution to the property?
Let’s say that the home we are using in this example, is ten years old. That means that this home has depreciated approx. 1.75% per year over the past ten years. (17.5% divided by 10) Now, divide 100 (which reflects 100% contribution) by 1.75, and that gives us a total estimated economic life of 57 years.
It should be noted that the older a home gets, the more difficult it gets to estimate depreciation because there are a lot of additional factors to consider. I’m keeping it simple and using a relatively newer home in this example.
It should also be noted that if the appraiser’s opinion of the land value and/or replacement or reproduction costs are not realistic, it will skew the results. Therefore, an appraiser needs to have access to reliable replacement and/or reproduction cost data and be able to develop a supportable opinion of the value of the land.
We’ve just developed the total economic life for one of the sales. Now, we need to rinse and repeat this exercise at least a couple of more times with a couple more comparable homes. Each case will likely have a slightly different total economic life. Therefore, we will have developed a range, and we can reconcile the total economic life of the home we are appraising within this range by giving the most weight to the comparable sale that offers improvements that are most similar to the property being appraised.
Occasionally, I like to run this analysis to see how my data measures up to the total economic life estimates of the cost data services I use. And, often, my analysis is in the ballpark of theirs.
In this exercise, my calculations reflected a total economic life of 57 years. One replacement cost data service reflects the total economic life to be 55 years while another reflects 60 years old. Somewhere in that range is supportable. Interestingly, the cost data service with the lower total economic life estimate also offers replacement costs for the different improvements, that are a little lower than the replacement costs offered by the other data source which reflects a total economic life of 60 years. Which makes sense if you think about it.
There’s a lot more that can be involved in these calculations and in determining the total economic life of a home. This way of measuring depreciation is considered by many to be overly simplistic because it uses straight-line depreciation, which is not as precise as other ways of measuring depreciation. However, for residential appraising, I think it works well most of the time.
I’m just sharing the basics since this article is meant to educate the public on how appraisers can make this determination. I hope this makes some sense. I think that it’s important to note that the market drives deprecation by what they are willing to pay for the property. There are other factors that drive depreciation as well. Since depreciation rates change, the total economic life, effective age, and remaining economic life of a home can change.
CALCULATING REMAINING ECONOMIC LIFE
Now that we have determined the total economic life of the home being appraised, we have one piece of the puzzle that will help us to figure out the estimated remaining economic life. After all, that’s why you’re reading this article. Next, we need to estimate the effective age of the home being appraised. I wrote an article entitled, “How Depreciation Works”. In it, I discussed how appraisers develop the effective age of a home using the age-life method. Calculating the total economic life of a home is part of the age-life method for estimating depreciation. Once we have the effective age, we can calculate the remaining economic life of the home.
The total remaining economic life of a home is calculated by subtracting the effective age of the home from its total economic life. So, in this case, let’s say that the total economic life of the home is 57 years and it has an effective age of 15 years. That means that this home has a remaining economic life of 42 years, meaning that at the home’s current rate of depreciation, it would take 42 years before the home would no longer contribute value to the property, assuming that nothing was done to the home to improve it.
As you can see, there’s a lot of work that goes into these calculations. I think most people have no idea how much work goes into an appraisal. That is when the appraisal is developed correctly. That’s one reason why I write these articles. To help the public to realize that our work as appraisers, is not as simple as many who are not appraisers, say it is, or how simple things may look on paper.
REMAINING ECONOMIC LIFE FOR LENDING PURPOSES
Since we are on the topic of total remaining economic life, I think we should talk about how this may impact a bank’s decision on providing a loan. In appraisals completed for mortgage lending purposes, some lenders require that the total remaining life of a home not be less than the term of the mortgage. For instance, FHA requires that homes being funded FHA have a remaining economic life of at least the term of the loan.
I can tell you that in economically challenged areas, very often, the total economic life of many homes is less than the term of most traditional mortgages. So, what’s an appraiser to do? Fudge the numbers so that all goes well? NO! Whatever the number is, we must report it truthfully. Does that mean that if the home has a remaining economic life that is, say 20-years, and the term of a loan being applied for is 30-years, that this is a deal-breaker for the homeowner’s ability to secure an FHA loan? It depends.
The HUD 4000.1 Handbook, dated 10/27/2021 states the following:
“The Mortgagee must confirm that the term of the Mortgage is less than or equal to the remaining economic life of the Property. If the Property is located in an older, declining urban area and the remaining economic life produces an unreasonably short mortgage term by reason of its location, the Property may be acceptable under Section 223(e), provided:
• the area is reasonably able to support adequate housing and living conditions for families of lower-income levels;
• the location features adversely affecting the desirability and usefulness of the Property do not endanger the health and safety of its occupants;
• the Property is marketable to the typical occupant of the area;
• the physical life of the Property is greater than or equal to the term of the Mortgage; and
• the Mortgage represents an overall acceptable risk as determined by the Jurisdictional HOC.
All Mortgages to be insured under Section 223(e) must be submitted to the Jurisdictional HOC for prior approval.”
You may be wondering what Section 223(e) is. It refers to HUD “permitting the use of FHA mortgage insurance in older, declining urban areas where there is a need for affordable housing. A mortgage may be insured pursuant to Section 223(e) for the repair, rehabilitation, construction or purchase of properties in older, declining urban areas.”
I have appraised homes being financed using FHA financing, in which the remaining economic life was considerably less than the 30-year term, and FHA financing was able to be obtained because the property met the criteria above.
By the way, I’ve never had push-back from lenders in this situation. I have had lenders ask me to show them how I developed my opinion of the effective age of the home and its total remaining economic life. I don’t consider it to be “push-back” when one of my clients asks me to explain how I developed my opinions. And I don’t blame them for asking! Once I’ve shown them the data and how I developed my conclusions, they have always accepted my findings and analysis, even if they were not thrilled by my findings.
I can also tell you that I have appraised homes that have applied for FHA financing, where the total remaining economic life of the home was less than the term, and because the home did not meet the criteria noted above, the lender was not able to lend on the property, at least using FHA financing. In some cases, the lender has been able to change the term of the FHA loan, so that it is less than the total economic remaining life of the property. So, it all depends on the situation.
As appraisers, we simply report the facts. Whether it makes or breaks a loan is not up to us to decide, nor should we fudge numbers to make a loan work or to make our client happy.
With regards to Conventional financing, here’s what Fannie Mae has to say about the remaining economic life of a home, in their 2021 Selling Guide:
“Fannie Mae does not have any requirements related to the remaining economic life of the property. However, related property deficiencies must be discussed in the sections of the appraisal report that address the improvements analysis and comments on the condition of the property.
Fannie Mae’s appraisal report forms are designed to meet the needs of several different user groups; consequently, the report forms address the remaining economic life for the property being appraised. However, appraisers are not required to report this information. If appraisers report this information, lenders do not need to consider remaining economic life because any related property deficiencies will be discussed in the sections of the appraisal report that address the improvements analysis and comments on the condition of the property.”
I do know that there are some lenders that, despite Fannie Mae’s requirements, still require that the remaining economic life of a home not be less than the term of the mortgage. However, as I noted earlier, for appraisers, it doesn’t matter. We complete our research and analysis and then report what we find. Whether the lender wants to lend on the property or not, is up to them, not the appraiser.
That’s all I have to say on this topic, at least for now. I tried to keep this information as simple and brief as possible, though I feel I failed in that regard. I hope that you were able to learn a little about how the remaining economic life works. Photos from unsplash.com
Thanks so much for reading my articles! I appreciate you being here!
This week I leave you with a little Costco humor. I can totally relate!
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Here are some links to other articles I’ve enjoyed recently! I hope you will also…
Housing Balloons With Slow Leaks – Housing Notes by Jonathan Miller
Is the housing market going to crash? – Sacramento Appraisal Blog
On Widgets and Doohickeys and Old Mother USPAP – The Appraiser’s Advocate (PODCAST)
Does a Variable… Vary? (Part 1) – George Dell’s Analogue Blog
Desktop Appraisals: Pros and Cons – Birmingham Appraisal Blog
Sewer vs. Septic for Appraisers – Don’t get into trouble! – APPRAISAL TODAY
Can You Take COD for Lender Appraisals? – The Appraiser Coach (PODCAST)