Physical Deterioration

The loss in value of a real estate property due to the physical wearing out of a building

What is Physical Deterioration?

Physical deterioration refers to the loss in value of a real estate property due to the physical wearing out of a building. It can also describe the normal wear and tear that buildings experience as they age. For example, the heating and cooling systems wear out at some point in the future. The wear and tear on a property can be caused by naturally-occurring elements such as water, wind, extreme temperatures, termites, or earthquakes. Wear and tear can also be caused by humans through vandalism, neglect, fire, etc.

 

Physical Deterioration

 

The level of deterioration depends on the level of ongoing maintenance on the property, as well as the original quality of construction. A building that was built using durable original materials stands a better chance of withstanding deterioration compared to a building constructed using low-quality materials. Also, property owners who carry out regular fixing of worn-out items and improvements such as repainting and changing roofing material to modern types of roofing reduce the level of the property’s deterioration.

 

Quick Summary

  • Physical deterioration refers to the wear and tear that buildings experience as they age, which results in a loss of value.
  • Physical deterioration may be due to the action of elements such as floods, earthquakes, fire, ultraviolet sunlight, wind, etc.
  • The deterioration may be curable or incurable, depending on the economic feasibility of carrying out the repairs.

 

Categories of Physical Deterioration

The following are the two main categories of physical deterioration of a real estate property:

 

1. Curable deterioration

Curable deterioration is a type of deterioration that is economically feasible to cure. The economic feasibility is indicated if the increase in the value of a property exceeds or is equal to the anticipated cost of repairing the property. The cost of making the replacement or restoring the item is used as a realistic measure of the curable deterioration.

Measuring the curable deterioration involves estimating the value of items that need to be repaired, such as window replacements, repainting, weatherstripping, roof repair, loose tiles fixing, faulty wiring, and repairs to the heating or cooling system. The measurements should only include the items above if the gain in the value of a property will offset the cost of repairs. For example, if the estimated cost of roof repair and loose tile fixing costs $8,000, a prospective buyer can reduce their offer price by the same value to cover the cost of doing such repairs.

 

2. Incurable deterioration

Incurable deterioration is a type of depreciation that is considered incurable even if the repairs were to be made. In simple terms, the cost of repairing the item(s) exceeds the value it would add, and, therefore, there is no economic benefit to fixing them.

Incurable deterioration can also be grouped into short-term and long-term. Short-term items refer to the items with a shorter life span than the improvements themselves, while long-term items are those whose life span is equal to or more than the improvements conducted. For example, if the foundation of a building is faulty, such a repair would be considered an incurable deterioration, since it would require rebuilding the whole structure from scratch. The cure exceeds the anticipated increase in the value of the property.

 

Real Estate Deterioration

 

Other Forms of Property Deterioration

Apart from physical deterioration, the following are other forms of deterioration that affect real estate properties:

 

1. Functional obsolescence

Functional obsolescence is a form of deterioration due to a feature in the property that is no longer useful or functional, and that results in a loss of value for the entire property. The deterioration can be due to a variety of factors, such as changing market requirements, evolving technology, outdated amenities, architectural design, local economic conditions, etc.

The loss of value is due to the assumption that a specific feature is not cost-effective to replace or cannot be changed. An example of functional obsolescence is a seven-story building with no elevator(s). Adding an elevator will be considered curable if the increase in the value of the house exceeds the cost of installing the equipment.

 

2. External obsolescence

External obsolescence refers to the loss in the value of a property due to external factors that the owner has little to no ability to change. Some of the external factors may include recession, zoning changes, regional loss of jobs, new developments that negatively affect property values (such as the construction of dense low-income housing, county jails, and sewer treatment plants near the property), environmental restrictions, and negative changes in traffic patterns.

The abovementioned factors are almost impossible to change since they are exterior to the property. It will be expensive or virtually impossible to change the adverse effects that are not on the property. For example, it is outside the power of a homeowner to relocate a county jail.

Similarly, if the property depends on one major employer, and that employer shuts down, there will be a devastating impact on property values in the area. Such a factor is impossible to rectify, and it may be beyond the financial strength of the property owner.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Depreciation Expense
  • Negative Externalities
  • PP&E
  • Straight Line Depreciation

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