RESEARCH JOURNEY

Canadian Edition

Depreciation - Appraisal
Accrued Depreciation (Appraisal)
Physical Deterioration
Curable Depreciation
Incurable Depreciation
Short-Lived Items (Appraisal)
Long-Lived Items
Actual Age
Effective Age
Economic Life
Remaining Economic Life
Economic Obsolescence
Locational Obsolescence
Functional Obsolescence
Economic Age-Life Depreciation Method
Economic Age-Life Depreciation Method (Modified)

Manitoba Edition

The age-life depreciation method, sometimes referred to as the economic age-life depreciation method, was selected for illustration purposes, given its relative simplicity for an introductory program in appraisal. This method determines depreciation based solely on the life expectancy of the structure and is generally viewed as a rule of thumb rather than a precise measurement. Fee appraisers frequently use more complex variations to ensure higher degrees of accuracy; e.g., age-life depreciation method (modified). Accrued depreciation involves three broad categories:

  • Physical deterioration: The impairment of the physical condition of an improvement due to wear and tear, decay, and structural defects.
  • Functional obsolescence: The loss of utility and hence value; e.g., poor design, unacceptable style, etc.
  • Locational obsolescence: The loss of value due to negative influences from external factors; e.g., railway tracks, commercial uses directly adjacent to the property, etc.
The age-life depreciation method only addresses physical deterioration and not functional or locational obsolescence. The observed condition (breakdown) method is frequently used when addressing obsolescence. The quantifying of obsolescence requires expertise that goes beyond the scope of this introductory program.

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Other Methods of Estimating Accrued Depreciation

  • Age-Life Depreciation Method (Modified): Identifies selected components and estimates physical deterioration using appropriate life expectancies, with the balance of the improvements based on the life expectancy of the entire structure
  • Observed Condition (Breakdown) Method: A detailed approach involving physical deterioration, functional obsolescence, and locational obsolescence.

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Age-Life Depreciation Method - Rules to Follow:

  • Estimate effective age and remaining economic life of building
  • Effective age + remaining economic life = economic life of building
  • Effective age/Economic life x Replacement Cost = Accrued Depreciation
Age-Life Depreciation Method - Reminders
  • Effective age may or may not reflect actual age, since maintenance, upgrading, design, or other factors may affect the aging process.
  • Effective age, remaining economic life, and economic life may vary for various parts of a structure; e.g., main structure (house), recent change to structure (addition), other improvements (garage, pool, etc.)
  • Age-Life Method only takes physical deterioration into account.

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Some Depreciation Terms

A number of terms arise in discussions of depreciation. Here's an introductory list to help in the exercises and assignments.

  • Curable refers to items that the typical purchaser would repair or replace immediately; e.g., when taking possession of a property.
  • Incurable are those items that have suffered loss of value, but are not economically sound to cure. To put it in other words, the cost of effecting the cure is greater than the anticipated increase in utility.
  • Short-lived components of a house are those items that will require replacement before the end of the economic life of the structure.
  • Long-lived components will not require replacement during the economic life of the structure.
  • Cost to cure is the measurement of the loss in value or depreciation. Cost to cure is used in determining depreciation for physical depreciation-curable.
  • The effective age/life expectancy ratio is used to determine depreciation for physical depreciation- incurable.
  • Life expectancy and economic life are used synonymously in this workbook.

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Confused about the three types of Depreciation?
Perhaps the following explanation will help. But first, what is obsolescence? It is derived from the adjective obsolescent which means becoming obsolete, ageing, declining, on the wane, on the way out, past its prime, waning.

Functional Obsolescence
Even though we know what is meant by obsolescence, we usually don't apply a mathematical formula to it. Think of the buyer who walks into the kitchen and says: Now this place needs work. I haven't seen cupboards like these in 20 years. That's functional obsolescence. Bang your head on a low ceiling joist in the basement, put your hand against the window and feel a draft, try to park your new van in an antiquated garage (built in the 1930s), or add some new appliances in a kitchen served by a 60-amp service. Some such things can be easily fixed - others can't. Appraisers group them under curable and incurable.

Flip to Functional Obsolescence in the Encyclopedia to better understand the process.

External Obsolescence
This category is probably the easiest to understand. Loss doesn't just relate to the actual property, but also to things around it. A nearby gas station affects value. Appraisers broadly group such loss into:

  • Locational: what's nearby the property
  • Economic: what's impacting all properties in the area
A home might suffer from both if situated at a busy intersection and also impacted by economic conditions in the area. Interestingly, external obsolescence can even impact new houses. Consider the situation in which too many houses are built and the market slows at the same time. The price of new homes may be reduced to attract buyers. The loss in value is attributed to economic obsolescence.

Now look up External Obsolescence as well as its defined types: Locational Obsolescence and Economic Obsolescence. In Phase 3, you will not be expected to complete detailed external obsolescence calculations, but be prepared to discuss terminology.

Accrued Depreciation
Look up accrued depreciation in the Canadian Edition of the Real Estate Encyclopedia. Depreciation is simply a loss in value, sometimes referred to as diminished utility. But loss can't be grouped under one topic as many different types exist. That's why appraisers developed terminologies and practices that fine tune the process.

Consider some examples. A frame house that hasn't been painted in years results in a loss of value. Compare that loss to the lack of marketability when a kitchen is outdated. Further, some causes may be external to the property. What about a home abutting a 24-hour, self-serve gas station with bright lights illuminating adjacent residential properties? Under the direct comparison approach, the adjusted sale prices would reflect such issues. But, how does the appraiser using the cost approach account for such issues? That's where loss in value and depreciation fit in.

To handle such circumstances, the age-life depreciation method (modified) is typically used. Now go to the detailed illustration referred to under Accrued Depreciation and carefully review the three possible depreciation types - physical deterioration, functional obsolescence, and external or locational obsolescence. Don't be concerned about how the calculations are made because that won't be tested in Phase 3 - it is covered in the Principles of Appraisal course. However, know the terminology.

Physical Deterioration
Deterioration is as it sounds - things are gradually falling apart. Appraisers group these items into:

  • curable; and
  • incurable
Curable makes sense to correct, e.g., a paint job, replacing a damaged door, etc. Incurable ones don't make financial sense to correct, but nevertheless impact value.
Incurable depreciation can be further fine-tuned under:
  • short-lived; and
  • long-lived.
Think of short-lived in terms of out-of-date features; e.g., ageing built-in appliances. They still work but ideally should be replaced. A buyer isn't going to pay much for them, hence a loss in value. Longer-term depreciation typically addresses structural matters and associated ageing.

Now, with that as background, look up Physical Deterioration in the Encyclopedia.

Example - Main Building A single family residence has an actual age of 15 years, an estimated effective age of 10 years, and a remaining economic life of 30 years. The Replacement Cost is $83,500. The accrued depreciation is:

Effective Age: 10 years
Remaining Economic Life: 30 years
Economic Life: 40 years
Accrued Depreciation: Effective Age/Economic Life x Replacement Cost = Accrued Depreciation

10/40 x $83,500 = $20,875 Graphically, this calculation can be portrayed as follows:

Example - Main Building (Home) and Accessory Building (Garage)

A single family residence has an actual age of 15 years, an estimated effective age of 10 years, and a remaining economic life of 30 years. The Replacement Cost is $83,500. A frame garage was added to the property ten years ago and has an effective age of 10 years with a remaining economic life of 15 years. The Replacement Cost is $15,500. The accrued depreciation for both main and accessory structures is:

Main Building (Home)
Effective Age: 10 years
Remaining Economic Life: 30 years
Economic Life: 40 years
Accrued Depreciation: 10/40 x $83,500 = $20,875

Accessory Structure (Garage)
Effective Age: 10 years
Remaining Economic Life: 15 years
Economic Life: 25 years
Accrued Depreciation: 10/25 x $15,500 = $6,200

Total Accrued Depreciation $27,075

Graphically, this calculation can be portrayed as follows:

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The calculation of accrued depreciation is a complex topic. Students are expected to be familiar with depreciation terminology and capable of performing age-life depreciation calculations as set out in the following exercises. More complex procedures, referenced in the Encyclopedia Links, are for those interested in pursuing more detailed treatment of appraisal techniques.

EXERCISES

EXERCISE 7. Accrued Depreciation: 1371 Lakeside Drive

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EXERCISE 8. Accrued Depreciation: at 194 Main Street

  View Exercise 8

 
EXERCISE 9. Accrued Depreciation: 38 Vista Way

  View Exercise 9

 
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