Sunk costs and the measurement of commercial property depreciation

Developments in property markets greatly influence economic growth, monetary policy, productivity measurement, inflation measurement and hence welfare payments to the disadvantaged. Property price bubbles often lead to financial crises; those experienced during the 20th century were often triggered by commercial property price movements. Yet property poses significant challenges for national accountants in producing key economic variables used in informing policy assessment and formulation. To address these challenges, this paper formalizes a framework for measuring prices and quantities of capital inputs for a commercial property. In particular, it addresses problems associated with obtaining separate estimates for the land and structure components of a property, a decomposition of property value that is important for the national accounts, productivity measurement and taxation. A key contribution is to address the problem of estimating structure depreciation taking into account the fixity of the structure. We find that structure depreciation is determined primarily by the cash flows that the property generates rather than physical deterioration of the building. Finally, we provide a framework for the determination of the optimal length of life for a structure.