How Do Appraisers Determine Depreciation?
The other day we were asked a question about what the percentage of depreciation would be for a foundation on a home. Unfortunately, there is not a simple answer to that question and I couldn't just give a quick percentage number for determining depreciation for the foundation.
When appraisers are performing an appraisal, they will observe the property being appraised. Appraisers become very skilled at observing and noting items and their condition. My husband and I are both real estate appraisers. Recently, we were at a restaurant he noted some interesting items that were obscurely posted on the back wall that we found entertaining. I told him he had to be the most observant man I know and his response was, "Well, I am an appraiser". True! He is by far the expert when it comes to observation and the field work part of the appraisal process. That said, appraisers will observe different types of depreciation when at the property being appraised. Did you know there are different types of depreciation?
Types of Depreciation
There are 3 different types of depreciation that an appraiser will look for:
- Physical depreciation- this is where the foundation in question would be categorized. Physical depreciation can be the result of normal wear and tear on a home as it ages or it can be from defects at the time of construction. If a home is damaged by natural disasters such as flooding, hail damage, fire, high winds, etc., the physical depreciation would be greater than normal wear and tear that comes from age. Physical depreciation is the most common and understood form of depreciation.
- Functional obsolescence- this form of depreciation has to do with the functionality of a property. A loss in value is present when certain items become outdated and not accepted in a market. An example of functional obsolescence would be when a home was originally built with one bathroom. Most homes in the market area have been updated and improved to include a second bathroom. Two bathrooms then become what is expected in the market. The market now demands at least two bathrooms in a home. A home with only one bathroom would suffer from functional obsolescence in certain markets where two bathrooms are expected.
- External obsolescence- this form of depreciation comes from economic or external factors that adversely impact the value of a home. An example of an economic factor would be when a large factory that employed 40% of the residents of a small town closes and job opportunities become scarce. Another example would be when city zoning changes restricting the uses of a property resulting in having an adverse impact on the value of a property. Perhaps the city decides to put a large landfill next to a residence. This would have a negative impact depreciating the value of the home.
Once an appraiser determines that some depreciation exists, then how do appraisers determine the amount or percentage of depreciation?
Ways to Determine Depreciation:
- Age- life method- this is the most common method for calculating depreciation. The effective age of the home (which can be more or less than the actual age depending on the amount of wear and tear and upkeep) is divided by the total economic life to determine the percentage of depreciation. Example- A home is 25 years old but has an effective age of 20. The remaining economic life of the home is 70. The percentage of depreciation is: 20 / 70 = 0.29 or 29% depreciation.
- Market- extraction method - The market- extraction method can be a good way to determine depreciation if you have a large number of similar sales to be used for comparison. I will not go into the details of how appraisers calculate this, (after all appraisers take hours of classes to learn how to do these types of calculations), but I will say that depreciation is determined by taking out the land value of similar comparable sales to determine the depreciated value of a home. This is then subtracted from the reproduction cost of the improvements to determine the amount of depreciation. This is then converted to a percentage and then the same process is performed for several other properties. A consistent pattern for a depreciation rate should begin to appear which would be then be applied to the property being appraised.
- Break down method. This method involved "breaking down" all items of depreciation individually and then adding the individual estimates together and deducting the sum from the estimated reproduction or replacement cost. This can be cumbersome for some properties and can get complicated as the items have to be determined if they are curable or incurable. Again, I will not just turn this post into a real estate appraisal class but suffice it to say this method is less common due to the time to break down each item but if time is afforded it can be a meaningful form of determining depreciation.
I hope that this gives you some idea of the ways that appraisers will determine depreciation and the amount of depreciation. Can you see why I couldn't just give a quick "rule of thumb" answer to the amount of depreciation for a foundation?
What other appraisal questions do you have? What have I left out here? Please feel free to comment on this blog or contact us for questions and for any real estate appraisal services.
Types of Depreciation
- Physical depreciation- this is where the foundation in question would be categorized. Physical depreciation can be the result of normal wear and tear on a home as it ages or it can be from defects at the time of construction. If a home is damaged by natural disasters such as flooding, hail damage, fire, high winds, etc., the physical depreciation would be greater than normal wear and tear that comes from age. Physical depreciation is the most common and understood form of depreciation.
- Functional obsolescence- this form of depreciation has to do with the functionality of a property. A loss in value is present when certain items become outdated and not accepted in a market. An example of functional obsolescence would be when a home was originally built with one bathroom. Most homes in the market area have been updated and improved to include a second bathroom. Two bathrooms then become what is expected in the market. The market now demands at least two bathrooms in a home. A home with only one bathroom would suffer from functional obsolescence in certain markets where two bathrooms are expected.
- External obsolescence- this form of depreciation comes from economic or external factors that adversely impact the value of a home. An example of an economic factor would be when a large factory that employed 40% of the residents of a small town closes and job opportunities become scarce. Another example would be when city zoning changes restricting the uses of a property resulting in having an adverse impact on the value of a property. Perhaps the city decides to put a large landfill next to a residence. This would have a negative impact depreciating the value of the home.
- Age- life method- this is the most common method for calculating depreciation. The effective age of the home (which can be more or less than the actual age depending on the amount of wear and tear and upkeep) is divided by the total economic life to determine the percentage of depreciation. Example- A home is 25 years old but has an effective age of 20. The remaining economic life of the home is 70. The percentage of depreciation is: 20 / 70 = 0.29 or 29% depreciation.
- Market- extraction method - The market- extraction method can be a good way to determine depreciation if you have a large number of similar sales to be used for comparison. I will not go into the details of how appraisers calculate this, (after all appraisers take hours of classes to learn how to do these types of calculations), but I will say that depreciation is determined by taking out the land value of similar comparable sales to determine the depreciated value of a home. This is then subtracted from the reproduction cost of the improvements to determine the amount of depreciation. This is then converted to a percentage and then the same process is performed for several other properties. A consistent pattern for a depreciation rate should begin to appear which would be then be applied to the property being appraised.
- Break down method. This method involved "breaking down" all items of depreciation individually and then adding the individual estimates together and deducting the sum from the estimated reproduction or replacement cost. This can be cumbersome for some properties and can get complicated as the items have to be determined if they are curable or incurable. Again, I will not just turn this post into a real estate appraisal class but suffice it to say this method is less common due to the time to break down each item but if time is afforded it can be a meaningful form of determining depreciation.
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