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Economic Life

DEFINITION

Period of time where improved real property financially benefits the owner. Economic life is important for investors in determining whether an upgrade is worth its investment.

EXPLANATION

Every property has an economic life, that is the period of years the property is believed to last. The natural wear and tear of a property, coupled with the amount of use of the people living there and the weather conditions the property has to endure affect its economic life. The loss of value of a property is known as real estate depreciation.

Depreciation measures how much a property diminishes in value during the property’s expected lifeline. Wear and tear, how much and how intensely a property is used, and the amount of years its been currently used for affects its expected lifeline.

How to Measure Economic Life of a Property

The physical life of a property is not the same as its economic life. Real estate investors determine the economic life of a property to decide on whether an investment is worthy of investing money in. This is particularly important when a business considers a property to purchase to use as a retail store or factory. This is because for retail businesses and factories, it is vital that the store or factory can remain open for a while before its economic life expires otherwise the business would lose money.

Businesses must consider the price of the property, how long the property will last for, when it must be renovated or fixed, and the amount of effort, time and money it takes to maintain the property. One must also consider the cost of paying for permits.

The economic life of a property is directly connected to its depreciation rate. The straight-line method is a method that measures the depreciation of a property. It involves dividing the value of the property by the economic life of the property, which is the expected life of the property in years. The calculation helps determine the average yearly decrease in the property value. The rate of depreciation may decrease with good maintenance, repairs and keeping the property in good working condition. The calculation divides the cost and indicates the cost of decrease per year.

Why Economic Life is Important to Understand

The economic life of a property is very important for lenders prior to issuing a mortgage. This is the case because if the economic life of a property is only 15 years old, the lender likely not consider giving a 30-year mortgage.

Appraiser’s use the economic life of a property to help them determine its value. Appraiser’s typically use the economic life to determine its depreciation using the cost base approach. The economic life of a property is determined by subtracting the economic life by its effective age. A property that is in good condition and is relatively new (under 20 years typically) has a high economic life with a low effective age and vice versa.

The housing of urban development (HUD) has created information relating to the economic life of property. They state that the property’s value needs to be determined by how long the property will remain and ultimately affect the value of neighboring property’s.

HUD further recommends appraiser’s to use the following to determine the value of property:

Condition of property

Current market activity

Whether the subject property is common or similar to neighboring property’s

Example

A clothing manufacturing company purchases a property to expand its manufacturing business. They spend $600,000 to construct the factory to their specifications. The economic life of the building is projected at 50 years and the property is already 25 years old. The effective age of the building is 25 years. How much will the building depreciate over the next 25 years?

$600,000/50 = $12,000 depreciation per year

$12,000(25 years) = $300,000 total depreciation

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