Economic Life: Why We Need to Stop Ignoring Economic Life as Part of the Depreciation Equation
By Ryan Janzen
The buildings in Kansas are getting older. This is by no means a ground-breaking revelation. But what are we doing to account for these aging buildings?
Most jurisdictions rely on the Cost Approach for a large majority of their commercial properties. The cost of the improvements is comprised of two components: the replacement cost new (RCN) and depreciation. One major component of depreciation is economic life, or the amount of time the improvements are expected to contribute positively to the property’s value.
Below is a breakdown showing the average age and economic life of four common commercial occupancies in Kansas, based on information from 98 of the 105 counties in the state.
| Occupancy | Average Year Built | Average Age in 2018 | Average Economic Life |
|---|---|---|---|
| Multi Family Living | 1974 | 44 | 49 |
| Retail | 1932 | 86 | 46 |
| Office | 1961 | 57 | 48 |
| Storage Warehouse | 1969 | 49 | 42 |
Three of the four occupancies shown, on average, are older than their economic life. This is important to note because when depreciation tables are being calibrated, on average, half of these commercial occupancies are going to only hit one depreciation rate, which will be the bottom out rate for that model.
So how do we address this? One way is to begin using effective age rather than actual age when determining remaining economic life. Using an effective age has its own challenges as it is very subjective and can be difficult to defend. The alternative is to continue using actual age while conducting a study to gauge what the market is saying the economic life of these improvements are.
By comparing the relationship between the loss in value for the property over time and the RCN, it can be determined what the total depreciation percentage is. Then by dividing the depreciation percentage by the age of the improvement at the time of the sale we can determine the amount of depreciation per year. The length of time it takes a building to contribute no value to the property and reach 0% good while using the annual rate of depreciation will give the market’s indication of what the economic life is on that property.
Reviewing economic lives needs to be a part of the depreciation study on commercial properties. The valuation guide used in Kansas is constructed on the basis of effective age, while Kansas takes an actual age approach. This is the equivalent of putting a square peg into a round hole when establishing what the economic life needs to be for a commercial improvement. If economic life is not reviewed, Kansas counties, particularly in older, aging jurisdictions, will begin to drift further and further away from effectively valuing commercial properties. Reviewing economic lives, and adjusting them as necessary, will begin to improve commercial sales ratios and values making them more representative of market value.
