The difference between property value and depreciation -- explained

Before working in real estate, I worked as systems consultant at one of the big accounting firms. Although I never worked as an accountant or earned a CPA, I had to know accounting for designing systems.

To be honest, I always found accounting a little weird. Balance sheets never made as much sense to me as net worth statements. Accrual accounting seemed like “make believe” compared to cash accounting.

But over time, I caught on and began to better understand the double-entry system; general ledgers, accounts receivable versus accounts payable and, of course, the concept of depreciation.

Defining depreciation

Depreciation is a noun that is defined by Random House Dictionary as:

1. decrease in value due to wear and tear, decay, decline in price, etc.
2. such a decrease as allowed in computing the value of property for tax purposes
3. a decrease in the purchasing or exchange value of money
4. a lowering in estimation

If I had a dollar for every time a seller said to me, “I have spent $XX on this house, and I’m not going to sell it for less than what I have ‘invested’ in it,” I would be a very wealthy agent.

So many sellers have the misguided thought, that a 10-year-old, $40,000 kitchen has increased the value of their home by $40,000.

It hasn’t.

Every time they turn on the stove or open the refrigerator door, the value of those appliances depreciate. Every scratch on the cabinets or the stain on the counter-tops depreciates the value of those fixtures.

It’s no different than it is with a car — a used car is worth a lot less than a new car.

How does depreciation work?

Everything has a “useful life.” Roofs have about a 30-year life cycle. That means every year you would deduct one-thirtieth of the value of the roof. If you paid $10,000 for the roof last year, today that new roof is worth about $9,666.

I came across a depreciation guide on the internet. According to this chart, the useful life of a dishwasher is eight years. My dishwasher is 12 years old. That would seem to indicate to a buyer that my dishwasher is worth nothing. The fact that is a functioning dishwasher is worth something — but not much.

Real property appreciation comes from the increased market value of the land more than any updates made to the property.

For example, a quirky older home in an established neighborhood often sells for more that a brand new home in remote subdivision. It’s the land that’s worth more.

There is no question that certain things will improve the perceived value and marketability of a home.

A kitchen with more trendy finishes and appliances will be more marketable than the same aged kitchen with older finishes. However, the only intrinsic way to increase the actual value of a property is to increase its livable space — put on an addition, finish an attic, finish a basement, build out over the garage, etc.

Although new kitchens and baths certainly help, keep in mind that after 10-12 years, they are not new anymore — they have depreciated with usage.

It’s an exercise I need to go through with sellers every time I evaluate the price of their property. When they provide me with a list of improvements they’ve made to the house, I ask for the date, too.

With some discussion they begin to understand those improvements have depreciated with time and are not “investments” that are going to add real value to the property. When factoring in the improvements made to a home, sellers also need to factor in the depreciation of those improvements.

It’s a hard lesson to lesson for a lot of sellers to understand. Yes, they have spent money in improving the house — 10 years ago. But that means nothing today.

The reality is that a house is worth what a buyer is willing to pay for it — not what a seller has “invested” in it.

Ann Jones has been a respected Realtor on the North Shore of Chicago for nearly 15 years. Her primary market is the Lake Forest/Lake Bluff area but serves clients along the shore as well. Follow her blog at anns-blog.com or on Pinterest.