Journal of Valuation

BUILDING DEPRECIATION AND PROPERTY APPRAISAL TECHNIQUES

FRANCIS SALWAY
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To cite this document:
FRANCIS SALWAY, (1987),"BUILDING DEPRECIATION AND PROPERTY APPRAISAL
TECHNIQUES", Journal of Valuation, Vol. 5 Iss 2 pp. 118 - 124
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(1984),"THE DEPRECIATION OF BUILDINGS", Journal of Valuation, Vol. 2 Iss 1 pp. 5-13 http://
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(1986),"A NOTE OF THE ANALYSIS OF DEPRECIATION AND OBSOLESCENCE", Journal of
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 BUILDING DEPRECIATION AND
PROPERTY APPRAISAL
TECHNIQUES

Received: November 1985

FRANCIS SALWAY
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Key Words
Investment appraisal — valuation — depreciation

Summary
The impact of accelerating technological change in recent years has been to
shorten the useful lifespan of many commercial buildings. Shorter income flows
and increasing yields have resulted in a rapid descent towards site values.
The response to changing investment circumstances such as this will first be
reflected in the subjective investment appraisal, which will precede changes in
reactive market valuation methodology.
This paper presents and compares three alternative methods of appraisal which
might allow explicit analysis of building depreciation. Treating the building element
of property as a wasting asset akin to a leasehold is rejected for its simplistic
assumptions and lack of flexibility. A cost based approach is similarly flawed. The
recommended approach is an explicit cash flow projection which reflects the fact
that rental growth will decline over a holding period, considering alternative resale
prices based upon site value, value for refurbishment, or value if re-let unimproved.

1. Introduction
Over the last two or three years, the property industry has come to acknowledge
that the pace of economic and technological change is tending to shorten the useful
life span of many commercial buildings. This trend has inevitable implications for
the values attributed to property investments. As the typical life span of buildings
becomes shorter, the impact on values is felt in two areas: firstly, there will be a
more marked weakening of yield levels as buildings age to reflect the more rapid

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descent towards site value or residual value for refurbishment; and, secondly, the
values ascribed to new buildings will tend to be depressed in the knowledge that
the duration of income flow from the original bricks and mortar will be that much
shorter.
The increasingly dynamic relationship between land value and building value
presents a challenge for investors in their appraisal of property assets. Investment
success will hinge, in part, upon investors' ability to reflect changes in the typical
lifespan of buildings in the prices they pay for properties. Traditional valuation
techniques will not be of great assistance in this respect as valuation is a reactive
exercise: it merely reflects the actions of market participants. (The reactive nature
of valuation can be understood by considering what would happen if all market
participants were to pitch their offers in accordance with the strict valuation
criterion of referring to the price paid for a directly comparable property — the
outcome would be a totally static market place.) So, if investors are to respond to
changes in the anticipated life span of buildings, they must do so through the more
subjective medium of investment appraisal. Once investors have shown the way in
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terms of the appropriate response to changes in investment prospects, then valuers

will follow.
The distinction between the subjective exercise of investment appraisal and the
more objective test of valuation is an important one. The appraisal techniques
discussed below are not put forward as valuation technqiues per se; they must be
seen as tools of analysis which, at best, may act as an aid to valuation in circum-
stances where directly comparable evidence (in terms of buildings of like age) is
lacking.

2. Appraisal methods
This paper now examines the merits of three methods of investment appraisal
which purportedly allow explicit analysis of building depreciation.
Before examining each of these three methods, brief consideration is given to the
precise effects of building depreciation which the appraisal methods are being
expected to monitor. Building depreciation's impact on property returns is felt in
two ways:
(1) The rate of rental growth will tend to be adversely affected by mounting
obsolescence and physical decay; and
(2) Injection of new capital for purposes of refurbishment or redevelopment will
eventually be required to restore rental growth or, in extreme cases, to ensure
continuation of a positive income flow.
Building depreciation, of course, affects property investment not only in terms
of levels of return, but also in terms of levels of risk. Depreciation's impact on
risk arises out of the unpredictability of obsolescence. As obsolescence takes over
from physical decay as the principal cause of building depreciation, so the risk
implications of building depreciation are heightened.

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The assessments of the three methods of appraisal given below concentrate on

their ability to quantify the value implications of depreciation's impact on property
returns. The risk aspect is not examined in detail, which is perhaps a sad continua-
tion of the general lack of empirical and theoretical work on risk in property
investment.*

Method 1
Treating the building element of property as a leasehold interest
Prima facie, the logical way to make allowance for the effects of building depre-
ciation would be to treat the building element of a property as a short or medium
term leasehold interest. The technique would involve the following steps.
(a) Apportion rental income or rental value between the land and the building.
(b) Value the proportion of income attributable to the land in perpetuity.
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(c) Select a suitable yield for the 'land income' to reflect its growth prospects.
(d) Value the income attributable to the building for a limited duration equiva-
lent to the expected useful life of the building.
(e) Apply a higher yield to the 'building income' to reflect the fact that future
growth will be inhibited by building decay and obsolesence.
Such an approach is likely to appeal to traditional valuers in that it avoids the
more subjective judgments required in explicit cash flow analysis (for example,
assumptions about future growth rates, discount rates etc). Subjective judgment
is only required in the choice of length of life for the building.
However, closer examination of this method reveals that it suffers from a number
of shortcomings:
(i) It is not possible to apportion rental value between land and buildings until
the total value of the whole property has been established. This is because
rental evidence of sites (ground rents) is hard to come by, whereas capital
values may more easily be estimated and then de-capitalised. The first stage
in the appraisal process can therefore only be completed if one has know-
ledge of the final answer.
(ii) The method does not allow for a declining rate of rental growth as the
building ages; this is in spite of the fact that the proportion of rental income
attributable to the building is valued at a 'low growth' yield. The problem
arises because as the building grows older the proportion of rental income
attributable to the land increases and the proportion attributable to the
building decreases. The outcome is that, with increasing age, a higher
proportion of rental income is valued at a 'high growth' yield — implying
that rental growth prospects improve as the building ages.
(iii) Typically commercial buildings do not have one simple uninterrupted life
span. Many buildings will be refurbished several times before they are

* See Journal of Valuation 5:3, in which the theme is property investment risk [editor].

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 SALWAY

finally demolished. It is therefore unrealistic to ascribe a fixed number of

years as representing a building's life span.
For these reasons this method is not favoured.

Method 2
A cost based approach
Sykes (1984) saw the problem of building depreciation in terms of the expendi-
ture required on periodic refurbishment or redevelopment in order to maintain
rental growth. He proposed a method of analysis which involves estimating the net
present cost of future outgoings on refurbishment/redevelopment and then adding
this cost figure to the purchase price so as to arrive at the long term total investment
outlay. The two key variables are the frequency of refurbishment/redevelopment
and the cost of refurbishment/redevelopment expressed as a percentage of new
property value. By dividing the rental value of the property by the total outlay
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figure, Sykes aimed to identify the 'net of depreciation' investment yield. Then, by
relating this yield figure to the opportunity cost of money, he went on to show the
true rental growth assumptions implicit in the purchase price of a property.
The principal limitation of Sykes's approach is that he makes no allowance for
the fact that the rental growth experienced between periodic refurbishments is
likely to be adversely affected by obsolescence. If the rental growth was not held
back by obsolescence, there would generally be no need to carry out a refurbish-
ment scheme. Thus the implied rental growth rate identified by Sykes's method is
not a true 'net of depreciation' growth rate. It understates that rate by an amount
equal to 'd' in the equation:

Rn = Ru ( l + d ) y
where Rn = rental value of brand new building
Ru = rental value of an unimproved property immediately before refurbish-
ment/redevelopment
y = number of years between refurbishment/redevelopment
d = annual rate of depreciation in rental value.
In circumstances where refurbishment is carried out at frequent intervals such as
every ten years, Ru may be only a little different from Ru; this may, for example,
be the case with shopping centres. However, in more normal circumstances where
refurbishment programmes are linked to lease expiry dates at 25 yearly intervals,
the difference between Ru and Rn is likely to be material. For example, the data
obtained in the CALUS study (Salway, 1986) from 32 office locations showed
that, on average, the rental value of a 20 year old office building was just 55 per
cent of the rental value of a brand new building. This implies a relative depreciation
in rental value ('d') of 3 per cent per annum. A relative fall off in rental value of
this magnitude is clearly significant in the appraisal of property investments and,
for this reason, the CALUS study attempted to develop Sykes's approach to account
for the relative fall off in rental value which is experienced as buildings age.

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Method 3
The approach recommended in the CALUS study
The method of appraisal recommended in the CALUS study is similar to Sykes's
proposal in its reliance on DCF techniques. The difference is that it enables allow-
ance to be made for the fact that the rental growth produced by an ageing building
is likely to be less than that seen on an index of rental values for new buildings.
The method involves the carrying out of a DCF appraisal over a limited time
period equating to the anticipated life of the building in its existing form. Allowance
is made for the effects of depreciation in two ways:

(a) The appraiser chooses a suitable 'new building' or 'net of depreciation'

growth rate and then specifies the percentage of the 'new building' rental
value which he expects to be achieved by the ageing building at each succes-
sive rent review; and
(b) The terminal capital value is taken to be the estimated residual value of the
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property for refurbishment or redevelopment. (This figure is based on

present day prices and then automatically inflated over the relevant time
period at the specified 'new building' growth rate.)

In effect, the method involves building up a realistic cash flow projection for a
property, working backwards from the performance which could be expected from
a non-depreciating asset.
One of the potential difficulties with this method is the prediction of precisely
how long a building will remain in its existing form. However, it will often be the
case that the time period is dictated by the length of lease(s). Therefore, as a
general rule it may be sensible to take the period of income flow as equating to
the duration of the current lease or leases. The terminal value will then be repre-
sented by:

EITHER site value

OR residual value for refurbishment
OR investment value if re-let unimproved.

The investor may use his own judgment to assess which of these is the most appro-
priate. In cases of uncertainty, use can be made of probability techniques, as shown
below:

Capital value Probability

Site value £300,000 0.2

Residual value for refurbishment £400,000 0.5
Investment value if re-let unimproved £450,000 0.3

In this example, the terminal value to be used in the appraisal would be:

(£300,000 x 0.2) + (£400,000 X 0.5) + (£450,000 X 0.3) = £395,000

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Having built up the projected cash flow, it can then be analysed by use of
discounted cash flow techniques to identify one of the following parameters:
(a) The net present value (given a discount rate and a projected 'net of depre-
ciation' growth rate); or
(b) The required 'net of depreciation' growth rate (given a discount rate and a
present value/purchase price); or
(c) The anticipated internal rate of return (given a value/purchase price and a
projected 'net of depreciation' growth rate).
Such DCF appraisals are best carried out using a computer program as this will
offer the greatest degree of flexibility in terms of the choice of input figures.
Some considerable time was spent during the CALUS study in examining whether
it was feasible to prepare valuation tables based on this appraisal method. Sample
pages of tables were prepared, but the project was eventually dropped because of
two drawbacks: the number of variables at play meant that the tables would be
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excessively long (over 600 pages) and, even at that length, there could be no choice
in the rate of fall-off in rental growth. It was also appreciated that it would be
ironical for a study on obsolescence to produce an inflexible set of tables when
greater sophistication was readily available through the use of computer programs.
An essential requirement of any proposed method of appraisal is that it is
generally acceptable to those involved in the property industry. In light of previous
correspondence in property journals, there was some apprehension that a DCF
approach might not be acceptable to a sufficiently broad spectrum of investors.
However, interviews carried out as part of the CALUS project suggested that this
may not be the case: over 60 people involved in property investment at senior level
were asked whether they felt that, in the face of rapid obsolescence of buildings,
discounted cash flow appraisal techniques should be used as an aid to property
valuation. The responses were:
YES 80 per cent
NO 20 per cent
Furthermore, just over 50 per cent of the investors interviewed said that they
already make some use of DCF appraisal techniques. It was therefore concluded
that the elaboration of the straightforward DCF approach, which was being recom-
mended in the CALUS study, was likely to be of some relevance and practical use
to property investors.

3. Conclusion
The realisation that many buildings constructed only 20 years ago are now
obsolete has been grasped in positive fashion by developers and architects, who
foresee the business potential in the creation of a new generation of buildings.
The response from those involved in property investment and valuation has been
rather slower; this is perhaps not surprising as, from the investor's point of view,
the implications of accelerating depreciation of buildings are mainly negative.

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However, if property is to maintain its position amongst competing investment

media, it is essential that the property industry can be seen to have faced up to the
implications of accelerating depreciation. The adoption of a depreciation-sensitive
method of appraisal can only help in the presentation of a clean bill of health. Of
the three appraisal methods outlined above, it is the latter one which is preferred
by virtue of its ability to focus on the true 'net of depreciation' growth expecta-
tions. For it is this statistic which permits meaningful comparison between property
and other investment media.

References
Salway, F. W. (1986) Depreciation of Commercial Property, CALUS.
Sykes, S. G. (1984) 'Periodic Refurbishment and Future Rental Value Growth ', Journal of
Valuation 3:32.
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 This article has been cited by:

1. Professor Norman Hutchison Richard Grover Department of Real Estate & Construction, Faculty
of Design, Technology & Environment Oxford Brookes University, Oxford, United Kingdom.
Christine Grover Winchester Business School, Faculty of Business, Law and Sport, University of
Winchester, Winchester , United Kingdom. . 2015. Obsolescence – a cause for concern?. Journal of
Property Investment & Finance 33:3, 299-314. [Abstract] [Full Text] [PDF]
2. Cathy Hughes, Cath Jackson. 2015. Death of the high street: identification, prevention, reinvention.
Regional Studies, Regional Science 2:1, 237-256. [CrossRef]
3. Building Obsolescence and Reuse 95-120. [CrossRef]
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