Physical Deterioration

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

A physical deterioration in real estate is the exterior wear and tear visible in a building, referred to as the most obvious. Such degeneration causes a reduction in the asset value and is primarily a sign of age or declining building health.

It results from natural and human factors. The former includes weather, water, natural calamities, etc., while human factors include theft, lack of maintenance, vandalism, etc. There are two types of visible deterioration based on the economic feasibility of repairs – curable and incurable deterioration.

What Is Physical Deterioration?

Physical deterioration refers to the visible wear and tear of fixed assets such as buildings, machines, equipment, furniture, land, etc. It is of concern to businesses and real estate companies.
The problem with such deterioration is that they severely depreciate the asset's economic value. Even if some repairs can be undertaken to manage the visible deterioration, it might not be economically feasible.
Visible deterioration is often compared to functional and external obsolescence, which affect an asset's functionality and economic value.

Physical Deterioration Explained

Physical deterioration in real estate is a common phenomenon. It is possible to see buildings with broken windows, cracks in concrete, broken plumbing or sewers, etc. These factors contribute to the asset's depreciation and thereby reduce its value.

A unique characteristic of this type of deterioration is that it is the most obvious one. It can be seen from the outside and, therefore, will depreciate the asset to a significant extent. While some buildings can be fixed with repairs and appreciate the asset value, it might only be feasible for some.

Deterioration due to natural factors such as disasters, acts of God, etc., cannot be controlled. In such cases, the insurance coverage will aid homeowners. However, deterioration caused due to human neglect, vandalism, lack of regular maintenance, and other factors should be avoided.

Visible deterioration can indicate the age of a building. It can also signal the building's health or quality of construction. Therefore, it is important to inspect, repair, and renovate regularly.

Physical deterioration can also occur in other fixed assets, such as heavy equipment, plant, and machinery. Such assets can deteriorate when regular inspections and repairs are not done. It can also happen when they are not appropriately handled. When natural depreciation applies to these assets throughout their useful life, visible deterioration will further reduce their value.

Types

Physical deterioration can be classified into two categories based on the economic feasibility of managing the deterioration. These are curable and incurable deteriorations.

#1 - Curable physical deterioration

This type of deterioration is economically feasible. Once the repair works are completed, the increase in property value will be higher than or at least equal to the repair cost undertaken. Thus, there is a benefit to conducting the repair works.

The economic feasibility can be measured by determining the value of the cost of raw materials, fixtures, concrete, etc., and the cost of labor. It is compared against the estimated rise in the value of the property.

For example Zeal plans to sell her house. But her agent informed her that she could only demand up to $300,000 due to the pending painting work, which made the place look dull. Zeal decided to paint her house before listing it, as her agent mentioned that she could list the home for $350,000 if it is painted. Her contractor estimated $25,000 for the painting work. She was making a profit.

#2 - Incurable physical deterioration

This type of deterioration is not economically feasible. The cost of repairs will far exceed any appreciation in the asset's value. The owner will make a loss, let alone break even. Therefore, the owner will abandon any plans to repair the building. The economic feasibility can be measured and compared against the asset value by following the abovementioned method.

Suppose in the above example, Zeal also had to fix the roof, which cost an additional $30,000. In that case, she would be spending more than she could make. It would become an incurable deterioration.

Examples

Consider the following examples to understand physical deterioration.

Example #1

Greg works in London, England but owns a house in California. He decides to sell the house as he plans on permanently settling in London. However, due to a lack of maintenance, his house physically deteriorated. The concrete developed cracks and molds. The roofs were also leaky. Since Greg had no time to fix his house, he had to sell it at a lower price.

Example #2

The World Bank reported that physical damages caused by Turkey's earthquakes are estimated at $34.2 billion. This deterioration is a result of an act of God. The World Bank report also claims that the cost of recovery and repairs will be approximately twice as much as the damages, making it an incurable physical deterioration. The economic disruptions related to the earthquakes will also add to the cost.

Physical Deterioration vs Functional Obsolescence

These are two distinct concepts that affect the value and utility of assets. While both factors contribute to the depreciation of an asset over time, they arise from different causes and have unique characteristics. Let us understand them clearly.

Basis	Physical Deterioration	Functional Obsolescence
Definition	Visible wear and tear, decay, and deterioration of assets.	It relates to outdated design, technology, or features affecting utility.
Cause	Natural factors, lack of maintenance, vandalism, etc.	It pertains to technological advancements, user preferences, and industry standards.
Impact on value	It reduces asset value due to physical condition and appearance.	It diminishes asset value due to decreased usefulness or functionality.
Reversibility	Repairs or restoration can improve asset condition.	Often requires significant investments or complete replacements to address.

Frequently Asked Questions (FAQs)

1. Does depreciation measure the physical deterioration of an asset?

Yes. Depreciation measures physical deterioration, functional obsolescence, and external obsolescence. Standard depreciation methods will consider these three types of deterioration as they reduce the asset's value.

2. How do you calculate physical deterioration?

There is no commonly accepted method to calculate the visible deterioration undergone by assets. However, a simple approach would be to estimate the value of undertaking repairs that would fix the asset entirely and make them fully functional. Labor charges and other expenses should also be added to determine the total deterioration value.

3. Is physical deterioration obsolescence?

No. Obsolescence refers to a condition where an asset becomes outdated and useless. The asset has zero functional utility. But when assets deteriorate physically, the useful utility remains. Their value decreases due to the poor quality of supporting features or accessories. Nevertheless, if an asset undergoes visible deterioration to a significantly higher degree, it might become obsolete.