A critical review of methodologies for measuring rental depreciation applied to UK commercial real estate

Abstract

Real estate depreciation continues to be a critical issue for investors and the appraisal profession in the UK in the 1990s. Depreciation-sensitive cash ¯ow models have been developed, but there is a real need to develop further empirical methodologies to determine rental depreciation rates for input into these models. Although building quality has been found to be an important explanatory variable in depreciation it is very dif® cult to incorporate it into such models or to analyse it retrospectively. It is essential to examine previous depreciation research from real estate and economics in the USA and UK to understand the issues in constructing a valid and pragmatic way of calculating rental depreciation. Distinguishing between `depreciation' and `obsolescence' is important, and the pattern of depreciation in any study can be in¯uenced by such factors as the type (longitudinal or crosssectional) and timing of the study, and the market state. Longitudinal studies can analyse change more directly than cross-sectional studies. Any methodology for calculating rental depreciation rate should be formulated in the context of such issues as `censored sample bias' , `lemons' and ® ltering' , which have been highlighted in key US literature from the ® eld of economic depreciation. Property depreciation studies in the UK have tended to overlook this literature, however. Although data limitations and constraints reduce the ability of empirical property depreciation work in the UK to consider these issues fully, `averaging' techniques and ordinary least squares (OLS) regression can both provide a consistent way of calculating rental depreciation rates within a `cohort' framework.

Commercial Property Price Indexes and the System of National Accounts

“…In our approach, it is increases in the price of land along with falls in cash flows that drives obsolescence. Dixon, Crosby and Law (1999;168-170) also noted that rental decline (i.e., falls in net operating income as the building ages) contributed to building depreciation and of course, this effect is also part of our approach. Crosby, Devaney and Law (2012) investigate the rental decline phenomenon for UK commercial properties and they also take into account post construction capital expenditures on the properties.…”

“…38 Baum (1991;59) and Dixon, Crosby and Law (1999;162) distinguished physical deterioration and obsolescence of the structure as the primary causes of depreciation (decline in the value of the building over time). In our approach, it is increases in the price of land along with falls in cash flows that drives obsolescence.…”

Refining the real estate pricing model

“…Jackson and Orr (2011) provide a review of studies of these stock-specific factors underpinning variation in return and risk levels, finding general consensus of the categories provided by Baum and Crosby. Drawing on these studies (for example, Wofford and Preddy, 1978;Dixon et al, 1999;IPD, 2000;Devaney and Lizieri, 2005;Blundell et al, 2005;Adair and Hutchison, 2005;Byrne and Lee, 2006), Jackson and Orr set out a conceptual model unravelling the chain of causal effects linking tenant, lease, location, building risk to asset returns and risk ( Figure 1). …”

A Conceptual Framework for Commercial Property Price Indexes

“…These difficulties were discussed by Dixon, Crosby and Law (1999) [22] and Crosby, Devaney and Law (2012) [6] and their papers contain extensive reviews of the depreciation literature as it applies to commercial properties. However, our suggested solution to these problems is quite different than the solutions presented in these publications.…”

“…42 Thus if an estimate for the construction cost of a new building 39 As Dixon, Crosby and Law (1999) [22] noted, basically three depreciation models have been considered for commercial structures: declining balance (or geometric) depreciation, straight line depreciation or one hoss shay (or light bulb) depreciation. The problem with the first two depreciation models is that the structure services provided by the building will approach zero as the building nears the end of its life.…”