Commercial property valuation is a complex process that takes into account a variety of factors. One key element that can significantly impact commercial property value is depreciation. Understanding how to accurately account for depreciation is essential for arriving at a true market value.
How Depreciation Impacts Commercial Property Value
Depreciation refers to the decrease in value of real estate improvements over time due to wear and tear or obsolescence. As buildings and their components like HVAC systems, piping, and roofing age, they become less valuable. Depreciation directly reduces the worth of a commercial property.
For commercial buildings, depreciation is calculated in two ways:
- Physical deterioration – The actual physical wearing down of the building itself and its structural components.
- Functional obsolescence – A loss in value due to outdated designs, materials, or technologies that cause the property to be less functional or competitive.
Both physical deterioration and functional obsolescence can substantially decrease commercial property value over the lifetime of a building. As such, accurately estimating and accounting for depreciation is a pivotal part of arriving at current market value.
Depreciation Approaches for Commercial Valuation
There are several methods that commercial appraisers and valuers utilise to quantify depreciation for valuation purposes:
Age-Life Method
The age-life method calculates depreciation by looking at the chronological age of a building versus its economic life or lifespan. The percent depreciation is determined using the formula:
(Building Age / Total Economic Life) x 100
This simple method works well for newer buildings where the majority of depreciation occurs gradually over time. It has limitations when depreciation accelerates or the building undergoes renovations.
Breakdown Method
With the breakdown method, depreciation is calculated by assigning values to individual building components like the roof, windows, foundation, plumbing, electrical, etc. The appraiser estimates both the value and remaining useful life of each component. Total depreciation is the sum of the depreciated values for each building element.
A key advantage of the breakdown method is the ability to accurately gauge functional obsolescence of outdated or inadequate building systems. This method does require extensive knowledge of building costs by component.
Market Extraction Method
This method derives depreciation directly from recent sales of comparable commercial properties. The appraiser identifies comparable sales, then deducts total depreciation from the sales price to arrive at the estimated market value of the subject property.
The market extraction approach requires a robust set of truly comparable sales data to extract accurate depreciation figures. When reliable comps are available, this method can produce a strong valuation.
The Impact of Depreciation on Capitalization Rates
Capitalization rates are a key component of income valuation models for commercial real estate. Cap rates represent the ratio of net operating income to property value. As depreciation increases, capitalization rates also tend to rise to account for the increased investor risk related to wear and tear and ageing.
Accurately incorporating depreciation into cap rate analysis is vital for arriving at a true market value opinion. Utilising multiple methods to calculate depreciation can give the most precise picture of both physical and functional obsolescence.
In summary, properly accounting for depreciation is an essential part of commercial property valuation. Valuers and appraisers must thoroughly understand and apply the most appropriate depreciation approaches to reach a credible opinion of value. Correctly factoring in depreciation based on the unique aspects of each property is key for valuation accuracy.