In estimating property value using the cost approach, depreciation is subtracted from the total value. Depreciation as used in real estate appraisals has a slightly different meaning than in has in taxation. Depreciation is simply the loss of value due to all causes. In most cases, land does not depreciate, unless it is degraded by erosion, improper use, or perhaps zoning changes.
Depreciation is either curable or incurable. Curable depreciation is a loss of value that can be corrected at a cost less than the increase in property value that would result if it were corrected, whereas an incurable depreciation either cannot be corrected or would cost more than any appreciation of property value.
Depreciation can be classified according to its cause:
- Physical deterioration is the deterioration of structures due to wear and tear.
- Functional obsolescence is a loss of value associated with features that have been discounted by the market, such as unfashionable design features, outdated plumbing, electrical, or heating systems, or inadequate insulation.
- External obsolescence is a loss of value caused by external factors, such as the surrounding property, environment, or other factors that may decreases the property value, such as the municipality in which the subject property is located.
Although the different types of depreciation can suggest improvements, it is difficult to calculate the actual amount, so a simplified straight-line method (aka economic age-life method) is used, that simply assumes that depreciation is linear over the lifespan of the structure, decreasing in value at a constant rate. The amount of annual depreciation is calculated by dividing the cost of the structures by their expected lifetime.
Example — Straight-Line Method of Depreciation
If an office building that cost $250,000 with the land valued at $50,000 was expected to last 40 years, then the annual depreciation would be calculated thus:
- Value of Office Building = Property Price – Land Price = $250,000 – $50,000 = $200,000
- Annual Depreciation = Value of Office Building / Expected Lifetime of Office Building = $200,000 / 40 = $5,000.