- METHODS OF CALCULATING ACCRUED DEPRECIATION
Accrued depreciation is depreciation which has already occurred up to the date of value. Remainder depreciation is depreciation which will occur in the future. Accrued depreciation may be classified either as curable or incurable. The measure between curable and incurable is economic feasibility. It is possible to physically restore or cure most depreciation such as by expensive restoration of old homes. However, in most circumstances, cure of deficiencies is measured by the economic gain (increased rents) compared with the cost of the cure. Three methods of estimating accrued depreciation are discussed next.
Straight line or age-life method is depreciation which occurs annually, proportional to the improvement's total estimated life.
For example, an improvement with an estimated total life of 50 years would be said to depreciate at an equal rate of 2 percent per year. (2 percent x 50 years equals 100 percent depreciation.)
The effective age of the building is generally used instead of the actual age. Effective age is the age of a similar and typical improvement of equal usefulness, condition and future life expectancy. For example, if a building is actually 25 years of age but is as well maintained and would sell for as much as adjoining 20-year-old properties, it would be said to have an effective age of 20 years.
The straight line method is: easy to calculate; used by the Internal Revenue Service; and easily understood by the lay person.
However, in actuality, buildings do not depreciate in a straight line at a stated percentage each year, but will vary according to maintenance and demand for the type of structure.
The cost-to-cure or observed condition method (breakdown method) involves:
- Observing deficiencies within and without the structure and calculating their costs to cure. The cost to cure is the amount of accrued depreciation which has taken place.
- Computing an amount for physical deterioration or deferred maintenance for needed repairs and replacements.
- Determining and assigning a dollar value to functional obsolescence due to outmoded plumbing fixtures, lighting fixtures, kitchen equipment, etc.
- Measuring functional obsolescence which cannot economically be cured (e.g., poor room arrangements and outdated construction materials) and calculating the loss in rental value due to this condition.
- Calculating external obsolescence (i.e., caused by conditions outside the property) and determining the loss of rental value of the property as compared with a similar property in an economically stable neighborhood. The capitalized rental loss is distributed between the land and the building.
This is the most refined method of examining complex causes and cures of depreciation. However, it can be difficult to calculate minor or obscure depreciation accurately. Also, measurement by rental loss is sometimes difficult to substantiate.
A combination of the straight line and cost-to-cure methods may be used to:
- determine the normal depreciation as if the property is not suffering from undue depreciation; and,
- add any excess deterioration and obsolescence
For example: a house is 20 years old and has a remaining life estimated at 40 years for a total life of 60 years, thus depreciating at a rate of 1.67 percent a year. Effective age due to condition estimated at 15 years.
1. Normal deterioration:
67 percent x 15 years = 25 percent
25 percent x $105,000
2. Excessive physical deterioration:
New roof, exterior painting
3. Functional obsolescence, curable:
4. Functional obsolescence, incurable:
Poor room arrangement results in rental loss of
$40 per month when compared to normal house.
Monthly gross multiplier 100.
$100 x $40 a month
5. External obsolescence:
Estimated monthly rent of subject if located in ideal neighborhood
(after curing physical and functional deficiencies)
Estimated rental loss due to external causes
Yearly rental loss is 12 x $50 = $600
Capitalization rate applicable to properties in ideal neighborhood
(ratio of annual rent to value) = 10.5 percent
Capitalized rental loss:
$600 divided by 10.5 percent = $5,700
Ratio of land to building value:
in ideal neighborhood, land 30 percent, building 70 percent.
70 percent x $5,700
|Total Estimated Depreciation||=||$ 43,140|
|Depreciated Value of the House||=||$ 61,860|