How to Estimate Depreciation for the Real Estate License Exam
The Real Estate License Exam will have questions that ask you to estimate depreciation. Depreciation is the loss in value to any structure due to a variety of factors, such as wear and tear, age, and poor location.
The term accrued depreciation means the total depreciation of a building from all causes. You should also note that accrued depreciation isn’t the kind of depreciation that concerns accountants when they depreciate a building or a piece of equipment for tax purposes.
Licensing exams generally ask two types of questions about depreciation: A question asking for the definition of a particular type of depreciation and a question giving you an item of depreciation and asking you what type of depreciation that item represents. Occasionally you may get a question that asks you to calculate depreciation using a very simple technique known as the straight-line method.
Physical deterioration (curable and incurable)
Physical deterioration is the normal wear and tear that a building experiences as it ages and it depends on the original quality of construction and the level of ongoing maintenance. The two categories of deterioration, curable and incurable, have more to do with economics than the actual physical possibility of correcting something:
Curable deterioration: Refers to a form of deterioration that’s economically feasible to repair. In other words, the increase in value exceeds the cost of repair. Painting is a good example of something that generally adds more value than it costs.
Incurable deterioration: If the cost of repairing an item surpasses the value it adds to the structure, the item is considered incurable even if you can fix it. Usually these forms of deterioration are physical items associated with the structure of a building — significant foundation repairs probably would be classified as incurable. They’re incurable because you wouldn’t benefit economically by fixing them
Outmoded design in older structures or unacceptable design in newer structures usually points to a type of depreciation known as functional obsolescence. It too is separated into curable and incurable categories relating to economic feasibility.
An older home that has four bedrooms but a single bathroom located off the kitchen suffers from functional obsolescence. This example shows incurability because the cost of constructing an entirely new bathroom probably exceeds any increase in value to the house it may generate.
A newer home built with only two bedrooms and a room for a home office would suffer from curable functional obsolescence. Most people want at least three bedrooms. Adding a closet to the home office space and converting it into a bedroom would be relatively easy. So the value of the house increases by an amount greater than what you spent to build the closet.
External obsolescence is a form of depreciation caused by factors external to the land itself. It’s always incurable because land can’t be moved. This form of depreciation can be caused by economic or physical, usually called locational, features. A gas station adjacent to a single-family house is a source of external obsolescence. Unusually bad market conditions can also be considered external obsolescence.
The straight-line method of calculating depreciation
The straight-line method of calculating depreciation is one of the few math questions you might be asked about the cost approach.
The straight-line method for estimating depreciation presumes that a structure deteriorates at the same rate each year. This method, which also is called the economic age life method, involves an estimate of what are called the total economic life of a building and its effective age. These numbers are somewhat subjective estimates that appraisers make when using the straight-line method.
For exam purposes, remember the definitions and how to do the calculations. The economic life of a building reflects the number of years it contributes to the value of the land. The effective age is an estimate of how old the building appears to be, given wear and tear, maintenance, and upgrades.
The calculation presumes that a building deteriorates at an equal rate during its economic life; therefore, if you estimate the economic life of a building to be 50 years, in one year it deteriorates 2 percent of its total value. In effect, it uses up 2 percent of its total economic life. The fraction 1/50 also is 2 percent.
So the building depreciates at the rate of 2 percent per year because of physical deterioration. Just in case you get thrown a question with a different total economic life, say 40 years, the calculation would be 1/40. If you divide 1 by 40 you get 2.5 percent. Whatever the total economic life, if you divide the number one by the total economic life, you get the annual percentage.
The next step is where effective age comes in. Say the effective age of a building is ten years. If the building’s economic life is 50 years and from the previous calculation you know it depreciates at 2 percent per year, all you do is multiply the effective age by the annual percent of depreciation to get the total depreciation.
In the example:
10 years effective age x 2 percent per year depreciation = 20 percent total depreciation
The final piece of the formula is multiplying the total percent of depreciation by the reproduction or replacement cost. To continue the example, say your reproduction cost was $100,000. The formula follows as:
$100,000 reproduction cost x 20 percent (0.20) = $20,000 total depreciation
$100,000 reproduction cost – $20,000 depreciation = $80,000 depreciated cost of improvements
For the test, you need to be able to do all these calculations when given the appropriate data.