The Concept of Depreciation in Real Estate
Dan Harkey, at DanHarkey.com writes great articles about everything related to real estate on his website. You can read more articles by visiting his website. In this article, he asks the question: “The Concept of Depreciation in Real Estate.”
Here is the article in full:
“From the moment a building or improvement is completed, the value and “usability” of the improvements begins to decline. Physical deterioration, functional obsolescence, and even economic obsolescence reduce improvement value over time. Depreciation is the loss in property value from any cause.
Why do we care? It leads to “successful transactions” in a lot of ways. Any property that you are looking to buy, make a loan on, or improve will be affected by both the, physical aspects of depreciation and by the potential income tax aspects benefits.
Here are some basics to work with:
- Curable- Things that can be corrected reasonably such as deferred maintenance, wear and tear, cracks, paint, roofing, dry rot, and infestation.
- Incurable- Things that cannot be practically or economically corrected, such as settling of a building or structure, or when the property is old and too worn out that it is not economically practical to repair it.
- Curable- Design defects and outdated buildings.
- Incurable- Deficiencies that are not practically fixed, such as retail and office buildings lacking offsite parking, apartments without garages or with less-than adequate parking.
- Issue caused by negative influence outside the site. Examples include, zoning changes, business district moving away, freeway offramps close by, employment base changing or eliminated. A legal nonconforming use is a use of lands or structure which was legally established according to the applicable zoning and municipal building laws at the time, but which does not meet current zoning and building regulations. A use or structure can become legal nonconforming due to rezoning, annexation, or revisions to the Zoning Code.
- Accounting terminology referring to the owner’s tax efforts to recapture the investment by writing off the physical structures. Also, depreciating the associated business personal property is used. Owners attempt to reduce taxable income through what is referred to as “tax incentive Investments.”
Here are a few actual examples that I have encountered while dealing with depreciation:
Physical curable: When assessing upgrading of a property, the cost usually makes economic sense to fix-up rather than replace the structure. There is a current entire industry based upon the concept, called the fix-and-flip industry. Fix ups are common because all properties physically deteriorate over time and need a face lift. Millions of homes were built post WWII that were between 1000 and 1500 square feet, row homes in symmetrical neighborhoods that were designed for middle-class family expansion during the 1950’s and 60’s. The houses generally had a small kitchen, small dining room, and small living room all designed for separateness. Lots were generally large enough for add-on rooms and patios. The cluster feeling of small rooms have been now changed to “open concept floor plans” with fewer walls, sitting level kitchen counter tops, giving the feeling of a bigger home where all the family can gather together in a larger space. By re-configuring the floor plan, adding modern appliances and equipment the owner can revitalize the economic viability, and make the home more livable. The renovation was cost effective and updated to a modern feeling.
An income property built around 1970 had a kitchen separated with Formica counter tops, and ceiling hung cabinets designed to hold dishes and glasses. It made the room feel small and clustered. The sink was placed against a blank wall. The whole kitchen felt like a dark and dank bad dream. By replacing the counter tops, removing the ceiling cabinets and relocating the sink to a location under a window it opened the entire room! The kitchen and living area were combined and by installing a small island with storage cabinets below. The kitchen went from dark and dank to bright and new!
Physical incurable: This is a way more complex subject because the defects are known, but there is not practical or cost-effective method of fixing the problem. Examples include residential rentals and commercial units built with little or no on-site parking. Low ceiling Hight’s for industrial buildings. Lack of dock-highs in industrial buildings.
I once made a loan on the Dana Villa Motel in Dana Point California. The property was built in 1928 when Dana point was first subdivided into a beach community. It was located on Pacific Coast Hwy, close to the shore line of Doheny State Beach. Remember the Safaris? “Down in Doheny were the surfers all go, there’s a big bleach blondie, named Surfer Joe.” What do you do with a picturesque Spanish stucco and tile roof, with a back drop of the Pacific Ocean? I immediately sold to a new opportunistic developer who had his own vision about the future of this property. After multiple construction bids, test for dry-rot, water table study, interaction with the city planning department, it was obvious that it would cost as much to fix it up as to demolish and build a new building. It took a while because community’s “Surfer Joes”, wanted it rehabilitated, so that they could drive by and romanticize about their youth, and days gone by. The owner took the heat, obtained a permit and demolished the pile of junk. Problem solved!
A duplex was originally constructed in the 1970’s. The decision had to be made whether to rehab or demolish and reconstruct a new building. In the 1970’s city zoning ordinance allowed 4 units per 4000 sq. ft lot. Later there was a down-zoning that only allowed 2 units per 4000 sq. ft. Then later, another down-zoning occurred only allowing 1 unit per 4000 sq ft. The city kept a provision for rehabilitating property, by taking down to the frame, then starting on the reconstruction. The decision was made to build a new modern duplex, much better floor plan, with panoramic ocean views. One lowly wall was left to satisfy the city requirement. That wall somehow disappeared and was replaced when the insulation, and drywall was installed. The result was an economically more feasible modern building with much higher rent.
Economic Obsolesce: “Get your kicks – on Route 66.” I came to California from Arkansas in 1954 in a 1950 Chevy pick-up truck, six-cylinder, three speed on the floor with no air-conditioning, which made crossing the Arizona/California desert at 110 degree heat a not so enjoyable drive. Route 66 is reflected in history books and revisited by people like me for cultural remembrance. Chuck Berry, Nat King Cole, among others sang “Get your kicks on Route 66.” All the business, commercial, retail, and many residential buildings were displaced by the new “grand highway’s” leaving Route 66 behind in the dust. If you were the politically powerful you could re-direct growth toward your property. If you couldn’t, you were out of luck.
Commercial retail properties that suffer from lack of driveways with only one source of ingress/egress are problematic as well. Residential properties that were built in a neighborhoods decade ago now sadly back up to a freeway, or busy street causing these properties to be valued less than properties that did not suffer the same fate.
Book depreciation: Current depreciation’s schedules are referred to as “straight line” and the cost of improvements is generally deducted over 28 years. With investment property, you will declare a loss in value of the improvements over a period of time. First, you separate the land value from the improvements/structures, as they can be depreciated for federal and state tax purposes. The tax advantage is now marginal at best, but still enable owners to shelter some of their rental income from taxes.”