Schweser’s first mock exam had a question where we are supposed to use the cost approach. Despite no hint that there is a structural problem or anything indicating incurable deterioration the correct answer assumes that we factor it in.
I was only able to select the proper answer because a cost approach without incurable deterioration didn’t fit any of the choices.
Simple question : Are we always to assume that there is incurable deterioration? Or should we (as I until now thought) only factor it in if the vignette somehow implies it?
@lockheed I was suspecting as much too! But I think that I ran into some question somewhere where although the ages are given the correct answer did not account for incurable deterioration since nothing implied there is any. So I decided to look for indications ever since.
Yes always assume incurable deterioration. Basically back out anything given that can be fixed, this is then the new building base and then back out depreciation. well Schweser dosen’t call it depreciation but this is how I think of incurable deterioration. We have a new building base after the currable stuff is backed out. Now we just need to get the effective (as opposed to actual) age of the building as a percent of the total building life. (Note that if the building is falling apart or has other damage than its effective age will be more than its actual age.) We can think of this amount as depreciation and back it out of the new building base. Once we get this out of the way we start to back out obsolescence items, finally add back in land value.
You add replacement cost plus builders profit per sq.ft (175+15)* 240000sqft = $45,600,000 2) Remove from that curable deterioration ($5,000,000) = $40,600,000 3) Then to find incurable, multiply the above value by the fraction (effective/total life = 1/5) = $8,120,000
No cap rates are used for either incurable or curable deterioration. For the other types of obsolescences it should be obvious whether you need to use the cap rate as the magnitude of the number should be close to the other costs.
Panos please see cfa book man their exmaples they are using cap rates .Suppose annual function obsolesce loss is 1 million and cap rate is 10%. So they have reduces cost by 10 million
If there is a deterioration it is either curable or incurable and I am quite sure that no cap rate is ever involved
If there is an obsolescence (either functional, locational or economic) then we use the cap rate assuming we were given annual cost of obsolescence and not just a total value in which case we dont need to use the cap rate at all.
By definition, we do not use BOOK VALUES for NAV calculation. We will either use market value of assets - liabilities or, in abscence of a reliable estimate for the fair value of assets, we use capitalized NOI. Just be careful to use next year’s NOI for this.
Curable obsolescence (does not go on in perpetuity) = no cap rate involved
Incurable obsolescence (will cost us an amount of money for every year in the future) = Use cap rate to find the total perpetual cost.
There will never be a cap rate for deterioration. There might be a cap rate for obsolescences and it depends on whether its a one-time fix or something that will go on forever.
Thats why I gave you a wrong answer in the beginning, I apologise. I thought u were referring to incurable deterioration. Incurable obsolescences go on in perpetuity so they will involve a cap rate.
