Economic Life Concepts

by Max J. Derbes, Jr., MAI

INTRODUCTION
The late David Montana, MAI, said that anyone who understood time would
make a good appraiser. The concept of time in the valuation art is more
difficult to comprehend than most appraisers realize. Time is now; it is a
moment in the past; and it is a moment in the future. Time is a span of
moments.
An appraisal is like a photograph. At a given instant of time, what is in
front of the camera when the shutter is triggered and the flashbulb explodes is
what the film captures. In an appraisal, the present worth of future ben -fit is
in the minds of the players in the market at the time of valuation. What takes
place later cannot be accounted for when taking the value "photograph."
Appraisals are usually dated. Technically, however, an appraisal is
made at a certain time of day on a specific date. Because the date of the
valuation has passed when the report is delivered, the appraiser is typically
not concerned about the time of day at which the valuation was made. It is
possible, though, that an appraisal could be made in the morning, and the
improvements burn to the ground in the afternoon or evening the same day.
Most real estate appraisals deal with periods of time, often relative
periods of physical and economic usefulness in terms of the market. The

Max J. Derbes, Jr., MAI , is president of Max J. Derbes, Inc.. a real estate appraisal, industrial brokerage,
and consulting firm in the New Orleans area. He Is a contributor to the 4th edition ot Industrial Real Estate and
his articles appear in numerous real estate publications. Mr. Derbes has been teaching the Institute's
Industrial Valuation Course since 1967.

216
 concept of time is critical and often misunderstood in the analysis of all three
approaches sales comparison, income capitalization, and cost.
ECONOMIC LIFE
Economic life is defined as "the period over which improvements to real
property contribute to property value." 1 Remaining economic life is "the
estimated period over which improvements will continue to contribute to
property value."2 Effective age is "the age indicated by the condition and
utility of a structure."3 These are difficult concepts that can easily be misap
plied in measuring accrued depreciation in the cost approach.
The concept of economic life was created in simpler times to explain
buyer attitudes toward capital recapture. Later it was used to explain age-life
concepts of accrued depreciation, which were tied together in concept, but
differed in usage.
A number of decades back, prior to "Pete" Ellwood's theories of capital j
recapture in relative short holding periods, there were theories of the return i
on and of an investment. An investor was said to require an interest return,
plus the money invested in the improvements returned over a given period.
The interest return on the investment might be 5%, 6%, or more. The return
of the investment was conveniently over 20, 25, 33'A, 40, or 50 years to
correspond with 5%, 4%, 3%, 2.5%, or 2% per annum recapture under
straight-line depreciation theories.
Time concepts of future economic life were incorporated in the Internal
Revenue Code decades ago. The deduction of depreciation allowed for i
business and real estate investors varied, depending on whether the asset was
real or personal property, such as machinery and equipment. Various classes
of real and personal property were allowed varying years of recapture, with
short-life items tied somewhat into their probable physical life.
With the Economic Recovery Tax Act of 1981 the term depreciation was
changed to capital recapture. This provision gave all tangible assets much
shorter lives, to encourage investments in real estate, industrial plants, and
equipment. These recapture periods were subsequently lengthened. None- -f
theless, both the prior and the 1980 codes expressed depreciation in terms of
years. If a property had a 15-year life, the per annum deduction allowed was
6.67%; an 18-year life, 5.56%; a 31.5-year life, 3.1746%'. The interrelation
ship of years and the percentage of capital recapture allowed per annum on a i
straight-line basis is elementary.
In valuation, the total economic life at the time of appraisal depends on '
the quality of construction, the stability of the location, the age of the

1. American Inst. of Real Estate Appraisers, The Dictionary of Real EsUUe Appraisal (Chicago: Amer
ican Inst. of Real Estate Appraisers, 1984). 103.
2. Ibid.. 255.
3. Ibid., 104. |
i i
I Derbes: Economic Life Concepts 217
 property improvements, and local market conditions. A small commercial
building in a city with an abundance of capital might have an economic life of
40 years, whereas in a Midwest city with fewer capital resources, it might
have an economic life of 33 Vi years.
The life of a property is a function of the age of the improvements. A
newly constructed investment property is considered to have a longer eco
nomic life than an older one. A new apartment complex would have an
expected economic life of 40 years, while the same property 15 years later
might have an economic life of only 33 l/3 years. In this example, the actual or
chronological age of the property was 15 years, but the remaining economic
life was reduced by only 62/i years between the new and the 15-year-old
project. Actual age and the effective economic life used for older improve
ments do not go hand in hand.
The basic assumption underlying the return of the investment in im
provements is that improvements wear out or become economically obso
lete. In the real estate economy prior to World War II, there was probably
more justification for the "throw-away economy" syndrome than currently
exists. Renovation, including remodeling, restoration, and modernization,
conforms to our current preservationist attitudes and tax incentives. These
measures extend the useful life of properties, particularly through their
effects on the shell of a building.
OVERALL AGE-LIFE DEPRECIATION
Eventually the economic life concept became part of the process of measur
ing accrued depreciation. An improvement that is 15 years old, but with an
overall age-life depreciation of only 25%, might be rated on the basis of an
effective age of 10/40, with 30 years remaining economic life. This means that
the effective age is only 10 years rather than the actual age of 15 years, and
that the total accrued depreciation is 25%, not 15/40, or 37.5%.
This analysis might be better understood if we use a slightly more precise
definition of effective age, such as effective age is equivalent to the chrono
logical age of typical properties having the same utility and in the same
condition as the subject. This links effective age to the market, and makes it
clear that effective age will reflect the current level of maintenance related to
typical practices and any changes in the state of the art. Such a definition
emphasizes the dual aspect of forces that influence effective age-physical
deterioration, and obsolescence.
For example, in much of the country in the early 1950s, major oil
companies adopted a standard two-bay service station with office, rest-
rooms, and a small utility room, built out of concrete blocks and faced with
porcelainized metal panels. This facility was placed on a lot approximately
125 feet by 100 feet with pumps within a few inches of the same location on
each site. For 10 to 12 years, virtually all new units were constructed from the

218 The Appraisal Journal, April 1987

 same standard plan. When analyzing these properties in terms of functional
obsolescence, only physical deterioration was considered because all were
brand new.
Due to community and business pressures in the early 1960s, the ranch-
style station was adopted. Almost overnight the stations built over the
previous decade were functionally 10 years old.
As a consequence, for almost a decade the analysis of service stations,
whether one or 10 years old, indicated an effective age between zero and
three years. Suddenly because of the additional impact of obsolescence, all
service stations, whether they were one or 10 years old, had an effective age
of approximately 10 years.
Relative maintenance, stability of location, market conditions, and so
forth affect thinking about the overall effective age and remaining economic
life of a property at any given time. Similarly, general economic conditions
can also affect the economic age-life concept as investors reduce the time
within which they require total return of their investment in a specific type of
properly in a particular area.
The transfer of economic age-life concepts to the cost approach has
drawn criticism from some appraisers because of the latitude of judgment in
the application of accrued depreciation to the new cost of improvements.
This criticism is justified when the breakdown method of estimating accrued
depreciation is employed using economic age-life concepts. Market-oriented
overall economic age-life concepts are substituted for the measurement of
overall percentage accrued depreciation. However, the use of overall
economic age-life concepts for the measurement of incurable physical de
terioration is erroneous, because overall economic life includes the effect of
both deterioration and obsolescence. The application of accrued deprecia
tion in the cost approach should not be undertaken using the overall econom
ic age-life concept associated with the income capitalization approach.
BREAKDOWN METHOD OF ACCRUED DEPRECIATION
Methodologies have a way of being applied to the three approaches to value
as if all three are identical. This is not the case when applying economic age-
life concepts to the breakdown method of the cost approach. This
cause-effect measurement for the loss in value that has occurred up to the
date of the appraisal is an attempt to measure the difference between repro
duction or replacement cost and value, at the time of appraisal.
Use of the breakdown method of measuring accrued depreciation iden
tifies the following:
Curable physical deterioration
Incurable physical deterioration
Curable functional obsolescence
Incurable functional obsolescence

Derbes: Economic Life Concepts 219

 I
External obsolescence
Curable physical deterioration is measured by the cost to cure the
defect. If the walls need painting or the roof fixing, the amount of curable j
physical deterioration is the cost of these repairs. Only items that a typical
purchaser at the time of purchase would cure are considered curable at the
time of valuation. The test for curability is economic feasibility.
Incurable physical deterioration, caused by wear and tear and the ele- '
ments, is the difference in value between a reproduction and the existing
building. The overall economic age-life concept is not applicable for measur
ing physical deterioration by the breakdown method, because it does not ,
permit quantification of the physical deterioration of long- or short-life
items. !
There are a number of components of improvements that can be classi
fied as short-life items, that is, their total physical life can be estimated with
some degree of accuracy. Physically or functionally, they will not last as long
as the structural components of the property such as the foundation, slab,
frame, and roof. Their life is shorter than the economic life of the im- ,
provements.
The air conditioner, heating unit, roof covering, carpeting, painting,
light fixtures, and so forth all have physical lives that can be gauged along
with the physical life used. If the roof covering is 15 years old and has a total
physical life of 25 years with normal maintenance, the roof covering is said to
be 60% used. This is an example of how the physical age-life used of short-life
items is calculated. J
The problem of quantifying incurable physical deterioration also applies |
to long-life items. For some time, the measurement of the physical age-life
used of the bone structure of buildings, that is, the long-life items, has been ,
the effective economic age-life used. For instance, assume that a building is
15 years old but is considered to have an effective age of only 10 years, and a
total economic life of 40 years. The bone structure accrued depreciation is '
considered to be 10/40, or 25%, of the cost new of the bone structure (a total
of all long-life items). If the total cost new is $100,000 and the bone structure
is 83.82% of the cost new, the effective economic age-life accrued deprecia
tion would be $83,820 x .25, or $20,955. '
The usual source of the economic life used concept is sales comparisons.
Similar buildings that have been sold are analyzed by making an allotment
from the purchase price for the land value, yard improvements, and other
minor buildings. The residual is the estimated price paid for the building. If
an estimate is also made of the current cost new of the building, the amount
of accrued depreciation can be estimated based on the difference between \
the cost new and the estimated price paid for the building. This typically gives >
the overall rate of depreciation, and the appraiser can convert this into the
physical age-life. If there is a 25% overall depreciation, the appraiser '
i

220 The Appraisal Journal, April 1987

 assumes that this is 7.5/30, or 10/40, or 12.5/50 of total economic life used.
Where the error occurs in the breakdown method is transposing this overall
economic age-life to the long-life items in order to measure incurable physi
cal deterioration.
The error that occurs when incurable physical deterioration is based on
overall economic age-life is illustrated in Table 1.

TABLE 1
Physical Deterioration Based on Overall Economic Age-Life

Reproduction cost new = $100,000

Accrued depreciation-physical deterioralion:

Short-life items:
Roof 15/25x $6,400 = $3,840
A/C compressor 7/1 Ox $1,800 = $1,260
Heating unit 15/30x $2.400 = $1,200
Electrical 15/30x $1,600 = $800
Decoration 3/5 x $600 = $360
Plumbing 15/25x $2,100 = $1,260
Flooring 15/15x $1.280 = $1,280'
$16,180

16,180-10.000 = .62 (Overall

percentage tor physical deterioration
of short-life items.)

$16,180 x, 62 = $10,000
Long-life items:

$83,820 x .25 = +$20,955

Total incurable physical deterioration = $30,955"

$100,000
-30.955
Value indicated = $69,045

* This would be curable physical deterioration.

" The martel indicated only 25% overall physical deteriorate, or $25,000 total.

The above accrued depreciation calculation on long-life items is

erroneously based on the percentage of overall economic age-life used. The
market indicated that the overall depreciation rate was 25%, not 30.96%.
That the short-life items are more than 25% depreciated indicates that the
long-life items must be less than 25% depreciated.

Derbes: Economic Life Concepts

221
THE ALTERNATE SOLUTION
Because the error illustrated in Table 1 cannot be attributed to the calcula
tion of incurable physical deterioration in the short-life items, it must be in
the calculation of the long-life items. A potential solution to quantifying the
amount of incurable physical deterioration properly indicates that the con
tribution of the future useful physical life of most building shells is consider
ably longer than the limited economic life of 30, 40, or 50 years (the period
over which, at the time of valuation, the investor wants his or her capital
returned).
The basic problem of calculating incurable physical deterioration in
volves improvements that typically last, as economic units, much longer than
the 25, 33VS. 40, or even 50 years projected by the investor when new. The
bone structures of improvements do not deteriorate physically, nor are they
typically functionally obsolete in a half century or less. While a few are torn
down and replaced by higher or different uses, most real estate improve
ments can physically last much longer than the typical economic life in the
mind of the investor or buyer of real estate. This is particularly true in light of
current renewal economics.
It is ironic that in making an estimate of return requirements, investors
still hedge in wanting their capital recaptured in a relatively short time frame.
However, most buyers and developers of real estate improvements expect
the value of the improvements to go up in proportion to the devaluation of
the dollar rate, not down. They also believe that the investment will be viable
much longer than their capital recapture period. Some evidence of this belief
is found in the 75- and 99-year leases demanded for ground leases involving
significant improvements.
Incurable physical deterioration should be based on a more realistic
time frame than the typical economic life determined by the investor. Using
the data from Table 1, the residual incurable physical deterioration that
actually took place with regard to the long-life items is as follows:

TABLE 2

Total amount of accrued depreciation

Irom the market @ 25% $25,000
Estimated short-life items $16,180 x 62% = 10,000
Residual long-life items incurable physical
deterioration: $83,820 x 17.9 % (15/83.8 yrs.) = $15,000
(15 years chronological age divided by .179 = 83.8 years)

Many buildings will last 100 or even 200 years if maintained properly.
There are buildings in some of America's older cities that are 100 or 150 years
old, which are still functional and usable. Many of these older properties

222 The Appraisal Journal, April 1987

 have been renewed once or twice in their history.
The effective long-life of certain building components will last beyond
the economic age-life of the building. The question is, how much longer?
What if the typical, stable location improvement lasted two economic lives
rather than one? For a building to be deemed as having a "second" economic
life, the improvements would have to be renewed after 30 or 40 years. This
would give the long-life items a physical life of roughly double the economic
life from the perspective of the investor. On this basis, the incurable physical
deterioration could be measured on the basis of two 40- or 50-year periods.
The subject property would be 15/80, or 15/100 deteriorated. The 15/83.3rd
years that are residual in Table 2, tend to confirm the double economic life
premise for the measurement of incurable physical deterioration of long-life
items.
There is considerable evidence demonstrating that substantial manufac
turing plants have a double life. Many are renewed or refitted for a more
modern industrial use, and some of the older warehouse buildings have been
remodeled into condominiums. A 50-year-old mill building is converted into
a modern office with minimal bone structure improvements, resulting in an
expected life of 50 years. The concepts of double or triple life can be added to
the theory of "longer than economic life" for the measurement of incurable
physical deterioration for long-life items. In most cases it can reasonably be
anticipated that major rehabilitation or remodeling will occur once or twice
during the physical life of the long-lived items.
In the case of very old structures, why not three lives? Many of the older
structures in the French Quarter of New Orleans are on their third economic
life. They have been renewed at least twice to achieve that status. Many have
undergone radical change of use all of the Bourbon Street entertainment
establishments were once homes, or stores on the lower level and homes
upstairs. Unlike historic buildings, in which the physical life can be extended
several times, the typical commercial building, apartment, and so forth, are
so subject to functional or external obsolescence that the market at most will
reflect two economic lives. A third life is speculative in most buildings less
than 40 years old.
Another way of looking at the bone structures of substantial buildings is
that 30 or 40 years hence, at the end of their current economic lives, their
shells will undoubtedly add value to the ground. This can be thought of as the
residual value. For instance, if the bone structure costs $83,820 and is 50%
used up at the expiration of the first 40-year economic life, will it be worth
$41,910 as a shell that can be rehabilitated or remodeled at that time?
The current methodology of estimating incurable physical deterioration
of the long-life items based on the economic age-life concepts of the investor
actually includes more than physical deterioration. Because the overall eco
nomic age-life concept includes all forms of accrued depreciation, its use in

Derbes: Economic Life Concepts

223
 measuring deterioration of long-life items also includes functional and exter
nal obsolescence. Most improvements have a longer useful life than that
inferred in the single economic life concept, particularly those short periods
used in the income capitalization approach which are investor oriented.
There is, however, a limit to the total number of years of physical life, except
in buildings in which ages have proved themselves. That limit is somewhere
between a double life and 100 years. Extending physical life beyond this time
frame is highly speculative for all but very old structures. Fortunately for
appraisers, the arithmetic when using longer lives only slightly affects the
value estimate. If a building has an initial economic life of 40 years, the sec
ond economic life on renewal is probably slightly less than 40 years, say 35
yearsi
A substantial multistory office building constructed in the 1920s or 1930s
needs considerable rehabilitation and modernization. Most such buildings
have a bone structure that allows for renewal. If the economic life was
originally 50 to 60 years, the new life will probably be another 40 years.
An alternate method of calculating the physical life used for the bone
structure would be to estimate the probable effective physical life used of the
total estimated useful physical life. A 120-year-old historic structure may
have an effective life used of only 50%. A 40-year-old apartment building
may only have 20 years remaining useful economic life at the time of
valuation; therefore, it would have two-thirds bone structure deterioration
(life used).
In the breakdown method of estimating accrued depreciation, curable
functional obsolescence, incurable functional obsolescence, and external
obsolescence do not involve time-value concepts. It is important that any
measurement of these elements of loss in value do not duplicate the estimates
of incurable deterioration. The use of the overall age-life concept, which can
be derived from comparable sales, usually contains all three forms
deterioration, and functional and external obsolescence.
CONCLUSION
Time concepts in valuation analysis permeate the three approaches and are
difficult to comprehend. Regardless of the system used to measure incurable
physical deterioration of long-life items, the application of effective physical
life used for the bone structure will be different from the overall effective
economic age-life of the property. Therefore, the measurement of incurable
deterioration for long-life items should not be based on investor economic
age-life of the overall structure, but rather on that part of the total useful
physical life of the property that has expired. This can be based on a double
or triple life concept, or the percentage of effective useful physical life used,
rather than on the investor concept of economic life used.

The Appraisal Journal, April 1987