The Depreciation Factor in Structural Valuations
By Jeff Blevins, Manager of Property Loss Consulting
The most common insurance valuations for structures are based on Actual Cash Value (ACV) or Replacement Cost Value (RCV).
Replacement Cost is generally based on the estimated reconstruction cost of the existing building.
Actual Cash Value is generally based on Replacement Cost Value minus depreciation.
Depreciation can be based on numerous factors. Insurance companies will use objective criteria such as the type of construction, condition, age and expected service life of the property. Subjective assessment based on the surveyor’s inspection, observations and experience also is used to determine the extent of depreciation.
Three Types of Obsolescence
Depreciation is the loss in value of a structure from all causes and occurs primarily from three forms of obsolescence: physical, functional and economic.
Physical obsolescence is the deterioration of building components such as paint, carpets or roofing. Good judgment is required to evaluate how the level of maintenance or rehabilitation will reduce or extend the anticipated physical life of a building. Standard depreciation tables usually focus on the specific condition, age and expected service life of a building.
Functional obsolescence is due to some deficiency or flaw in the building. For example, inadequate bathrooms, not enough bedrooms, an outdated kitchen or awkward floor plan can contribute to functional obsolescence of a house. Agriculture and commercial buildings that are no longer used for their original purpose may also have functional obsolescence. Standard depreciation tables based on physical life don’t consider functional obsolescence.
Economic obsolescence is caused by conditions that occur offsite and are beyond control of the owner. Examples of economic obsolescence include a store in an area of declining economic activity or obsolescence caused by governmental regulation, such as zoning. This type of obsolescence can be difficult to measure and is not considered in standard depreciation tables based on physical life.
Effective age considers all forms of deprecation. It may be less than chronological age, if recently remodeled or improved, or more than actual age, if deterioration is particularly bad. Effective age in many cases will provide a better picture of a structure’s life than the physical age.
Limitations
Estimating is not an exact science and there is room for legitimate disagreement on what the “right” cost or valuation is. It is not uncommon to see detailed appraisals from two different sources have a variance of 10% or more.
Cost guides can help determine a reasonable replacement or construction cost on most buildings. A cost guide should help arrive at an informed opinion for insurance purposes but it is not intended to substitute for judgment or as a replacement for sound professional practice.