A building has a replacement cost of $800,000. Physical deterioration is estimated at $120,000, functional obsolescence at $60,000, and external obsolescence at $40,000. What is the depreciated value of the building?
Correct Answer
A) $580,000
Using the breakdown method, depreciated value = Replacement cost - Total depreciation. $800,000 - ($120,000 + $60,000 + $40,000) = $800,000 - $220,000 = $580,000.
Why This Is the Correct Answer
Option A ($580,000) correctly applies the breakdown method formula: Replacement Cost - Total Depreciation = Depreciated Value. The calculation is $800,000 - ($120,000 + $60,000 + $40,000) = $800,000 - $220,000 = $580,000. This method requires adding all three types of depreciation together first, then subtracting the total from the replacement cost. The answer represents the current value of the building after accounting for all forms of value loss.
Why the Other Options Are Wrong
Option B: $680,000
Option B ($680,000) incorrectly subtracts only $120,000 from the replacement cost, suggesting the candidate only considered physical deterioration and ignored functional and external obsolescence, resulting in an overvaluation of the property.
Option C: $740,000
Option C ($740,000) incorrectly subtracts only $60,000 from the replacement cost, suggesting the candidate only considered functional obsolescence while ignoring physical deterioration and external obsolescence, leading to a significant overvaluation.
Option D: $620,000
Option D ($620,000) incorrectly subtracts $180,000 from the replacement cost, suggesting the candidate may have miscalculated the total depreciation by either double-counting one category or making an arithmetic error in addition.
PFE Subtraction Rule
Remember 'PFE' - Physical deterioration, Functional obsolescence, External obsolescence. Think 'PFE = Problems From Everything' and subtract ALL problems from replacement cost.
How to use: When you see a breakdown method question, immediately identify the three PFE categories, add them together to get total depreciation, then subtract from replacement cost. Never subtract categories individually from the original amount.
Exam Tip
Always double-check your arithmetic by adding all depreciation amounts first, then performing one subtraction from replacement cost - don't subtract each type of depreciation separately as this leads to calculation errors.
Common Mistakes to Avoid
- -Subtracting each type of depreciation separately instead of adding them first
- -Forgetting to include all three types of depreciation in the calculation
- -Confusing replacement cost with reproduction cost in the initial calculation
Concept Deep Dive
Analysis
This question tests the breakdown method of calculating depreciation in the cost approach to real estate valuation. The breakdown method requires identifying and quantifying three types of depreciation: physical deterioration (wear and tear), functional obsolescence (design deficiencies or outdated features), and external obsolescence (negative influences from outside the property). All three types of depreciation are subtracted from the replacement cost to determine the depreciated value. This is a fundamental calculation that appraisers must master for accurate property valuation using the cost approach.
Background Knowledge
The cost approach is one of three primary valuation methods in real estate appraisal, estimating value by calculating what it would cost to replace a property minus any depreciation. The breakdown method is the most detailed depreciation analysis, requiring separate identification and quantification of physical deterioration, functional obsolescence, and external obsolescence.
Real-World Application
An appraiser evaluating a 20-year-old office building would assess physical deterioration (roof repairs needed), functional obsolescence (outdated HVAC system), and external obsolescence (declining neighborhood), then subtract all depreciation from current construction costs to determine the building's contributory value to the overall property.
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