Functional and External Obsolescence

Chapter: Functional and External Obsolescence

This chapter delves into two critical aspects of depreciation in real estate appraisal: functional and external obsolescence. Understanding these forms of depreciation is crucial for accurately estimating the value of a property using the cost approach.

1. functional obsolescence❓: When the Property is Out of Step

Functional obsolescence arises when a property’s inherent characteristics are no longer in line with market expectations. It signifies a loss in value due to deficiencies or superadequacies within the property itself. These issues can stem from outdated designs, inefficient layouts, or features that are either lacking or excessive compared to prevailing standards.

• 1.1 Scientific Underpinnings

  The concept of functional obsolescence is rooted in the principles of economic utility❓ and consumer preference. A property derives value from its ability to provide utility to its occupants or users. When a property’s design or features fail to meet current market demands or standards, its utility diminishes, resulting in a corresponding decline in value.

  • 1.1.1 Utility Maximization: Economic theory posits that consumers strive to maximize their utility, i.e., their satisfaction or benefit derived from a good or service. In real estate, this means buyers seek properties that offer the most desirable features, layouts, and amenities for a given price.
  • 1.1.2 Market Efficiency: An efficient market reflect❓s the collective preferences and expectations of buyers and sellers. When a property exhibits functional obsolescence, it deviates from the standards established by the market, leading to a reduced willingness to pay.

• 1.2 Classifying Functional Obsolescence

  Functional obsolescence can be categorized into two primary types:

  • 1.2.1 Deficiencies: These are shortcomings or inadequacies within the property that detract from its value. Examples include:

    • Poor floor plans that hinder efficient use of space.
    • Inadequate ceiling heights for modern equipment.
    • Lack of essential amenities, such as an elevator in a multi-story building.
    • Outdated electrical or plumbing systems.
    • Insufficient parking spaces.
    • Use of outdated materials.

  • 1.2.2 Superadequacies: These are features or components that exceed market expectations or are unnecessary for the property’s intended use, resulting in added cost without a commensurate increase in value. Examples include:

    • Oversized heating or cooling systems for the property’s size.
    • Excessive parking spaces beyond what is required.
    • High-end finishes or fixtures in a neighborhood where they are not typical.
    • An in-ground swimming pool in a climate where it is rarely used.

• 1.3 Estimating Functional Obsolescence: A Problem-Solving Approach

  Estimating functional obsolescence involves a systematic process of identifying the problem, determining its impact on value, and considering potential solutions. The following steps are commonly employed:

  1. Identify the Functional Problem: Conduct thorough market research, interview buyers and brokers, and analyze comparable properties to pinpoint the specific functional deficiency or superadequacy.

  2. Identify the Component: Determine the specific part of the property that is causing the problem.

  3. Identify Possible Corrective Actions and Costs: Explore potential remedies to address the functional issue and estimate the costs associated with each option.

  4. Select the Most Appropriate Corrective Measure: Choose the most cost-effective and market-appropriate solution.

  5. Quantify the Loss Caused by the Functional Problem: Determine the difference in value between the subject property and comparable properties without the functional issue.

  6. Determine if the Item is Curable or Incurable: Assess whether the functional obsolescence can be economically rectified.

  7. Apply the Functional Obsolescence Procedure: Utilize a structured framework, like the one detailed below, to calculate the depreciation attributable to the functional obsolescence.

• 1.4 Functional Obsolescence Procedure Illustrated

  The following framework assists in quantifying functional obsolescence:

  Step 1: Estimate the Cost of the Item (C)
  * Represents the cost of the existing item causing the problem. If the item is missing, the cost is $0.

  Step 2: Less the Depreciation Already Charged (D)
  * Represents physical deterioration to prevent double-counting. If the item is missing, the amount is $0.

  Step 3: Plus the Cost to Cure, or the Present Value of the Loss (CC or PVL)
  * If the item is curable, it is the cost to cure.
  * If the item is incurable, it is the present value of the future additional expenses or lost income.
  * PVL = Annual Loss / Capitalization Rate

  Step 4: Less the Cost (if Curable) or Depreciated Cost (if Incurable) of the Proper Item if Included in New Construction (PC)

  Step 5: Equals the Depreciation Attributable to Functional Obsolescence (FO)

  Equation: FO = C - D + CC (or PVL) - PC

• 1.5 Practical Applications and Examples

  • 1.5.1 Curable Deficiency - Elevator Example (Exhibit 29.6 Referenced): A three-story office building lacks an elevator in a market that demands one. Installing a new elevator today costs $200,000. If the building had an elevator when new, it would have only cost $75,000. Similar properties with elevators sell for $210,000 more.

    • C = $0 (no elevator currently)
    • D = $0
    • CC = $200,000
    • PC = $75,000
    • FO = $0 - $0 + $200,000 - $75,000 = $125,000

  • 1.5.2 Incurable Deficiency - Excess Parking Example (Exhibit 29.7 Referenced): A retail center on a five-acre site has excessive parking due to outdated requirements. The excess land cannot be sold off due to the building’s placement. The highest and best use of the site would include two outlots worth $50,000 each that cannot be built.

    • C = $0
    • D = $0
    • PVL = $100,000 (lost value from the outlots)
    • PC = $0
    • FO = $0 - $0 + $100,000 - $0 = $100,000

  • 1.5.3 Curable Deficiency Requiring Substitution - Lighting Example (Exhibit 29.8 Referenced): An office building has outdated, inefficient lighting. Replacing the old fixtures with energy-efficient units costs $29,000, while the existing fixture cost $20,000 and are 50% depreciated. The newer units, if installed originally, would have cost $25,000. The more efficient units reduce the power bill by $40,000 per year, capitalized at 9%.

    • C = $20,000 (cost of existing fixtures)
    • D = $10,000 (50% depreciation)
    • CC = $29,000 (cost to replace with efficient units)
    • PC = $25,000 (cost of efficient units if new)
    • FO = $20,000 - $10,000 + $29,000 - $25,000 = $14,000

  • 1.5.4 Curable Superadequacy - Oversized Water Heater (Exhibit 29.9 Referenced): A building retrofitted from a restaurant to a shoe store retains an oversized, energy-inefficient water heater. Replacing it with an appropriately sized unit costs $1,000. The current unit costs $5,000 and is 66% depreciated. The annual extra operating cost is $200, with a capitalization rate of 10%.

    • C = $5,000 (Cost of existing water heater)
    • D = $3,333 (Depreciation already charged)
    • CC = $1,000 (Cost to cure by replacing)
    • PC = $1,000 (Cost of a new, proper water heater)
    • FO = $5,000 - $3,333 + $1,000 - $1,000 = $1,667

  • 1.5.5 Incurable Superadequacy - Unwanted Pool (Exhibit 29.10 Referenced): A recently completed house has a new in-ground swimming pool that adds no value in this cold climate area. The pool costs $45,000.

    • C = $45,000
    • D = $0 (pool is new)
    • CC = $0 (removing the pool would not add value)
    • PC = $0
    • FO = $45,000 - $0 + $0 - $0 = $45,000

• 1.6 Related Experiments & Data Analysis

  • Paired Sales Analysis: Compare sales prices of similar properties with and without the functional issue to isolate its impact on value. For example, analyze the sales of similar office buildings, some with and some without elevators, to determine the market’s perception of the elevator’s value.
  • Survey Analysis: Conduct surveys of potential buyers to gauge their preferences and willingness to pay for specific features or amenities. This data can help quantify the market’s perception of functional deficiencies or superadequacies.

2. External Obsolescence: Outside Influences

External obsolescence results from factors outside the property itself. These are typically locational or economic conditions that negatively impact the property’s value. Unlike physical and functional obsolescence, external obsolescence is often difficult for the property owner to remedy.

• 2.1 Scientific Underpinnings

  External obsolescence is linked to broader economic and geographic principles. The value of a property is influenced by its accessibility, surrounding environment, and the overall economic climate. Negative external factors can reduce the property’s desirability and limit its potential for income generation, leading to a decline in value.

  • 2.1.1 Location Theory: This theory emphasizes the importance of location in determining the value of real estate. Factors such as proximity to transportation networks, schools, employment centers, and amenities significantly influence property values.
  • 2.1.2 Economic Cycles: Real estate markets are susceptible to fluctuations in the broader economy. Recessions, interest rate changes, and changes in employment rates can all negatively impact property values.

• 2.2 Types of External Obsolescence

  • 2.2.1 Locational Obsolescence: This type arises from negative influences in the immediate vicinity of the property. Examples include:

    • Proximity to undesirable land uses, such as landfills, industrial plants, or busy highways.
    • High crime rates or safety concerns in the neighborhood.
    • Poor access to transportation or amenities.
    • Changes in zoning regulations that negatively impact the property’s use.

  • 2.2.2 Economic Obsolescence: This type is caused by broader economic downturns or changes in market conditions that affect the value of real estate in a particular area. Examples include:

    • Decline in the local economy or job market.
    • Increased interest rates that reduce affordability and demand.
    • Overbuilding or excess supply in the market.
    • Changes in demographic trends that negatively impact demand.

• 2.3 Estimating External Obsolescence

  Estimating external obsolescence typically involves market analysis techniques that isolate the impact of the external factor on property values. Common methods include:

  • 2.3.1 Paired Data Analysis: Compare the sales prices of similar properties that are affected by the negative external factor with those that are not. The difference in price represents the estimated loss due to external obsolescence. This is best achieved when the only difference between comparable properties is the existence of the external influence.

    • Equation: EO = Sale Price (Unaffected Property) - Sale Price (Affected Property)

  • 2.3.2 Capitalized Income Loss: For income-producing properties, estimate the reduction in rental income or occupancy rates caused by the external factor. Capitalize this income loss to determine the impact on property value.

    • Equation: EO = (Potential Gross Income - Effective Gross Income) / Capitalization Rate

  • 2.3.3 Survey Analysis: Surveying local market participants, such as buyers, sellers, and real estate agents, can provide valuable insight into the effects of an external factor.

• 2.4 Allocation of External Obsolescence

  A key consideration is that external obsolescence often affects both the land and the building. The appraiser must allocate the overall loss to these two components based on their relative contributions to the property’s value.

  • Example: Paired sales analysis reveals a $50,000 loss due to proximity to railroad tracks. The building represents 80% of the property’s total value, and the land represents 20%.
    • Loss allocated to the building: $50,000 * 0.80 = $40,000
    • Loss allocated to the land: $50,000 * 0.20 = $10,000

• 2.5 Practical Applications and Examples

  • A residential property located near a noisy factory experiences reduced market value. Paired sales analysis of similar homes, some near the factory and some in quieter locations, shows an average price difference of $30,000. This $30,000 represents the estimated external obsolescence.
  • A retail property in a declining commercial area experiences reduced rental income due to lower foot traffic. Capitalizing the loss in rental income provides an estimate of the economic obsolescence affecting the property.

• 2.6 Related Experiments & Data Analysis

  • Geographic Information System (GIS) Analysis: Use GIS software to map the spatial distribution of properties affected by a specific external factor. This can help visualize the geographic extent of the obsolescence and identify trends in property values.
  • Regression Analysis: Perform statistical regression analysis to quantify the relationship between property values and various external factors. This can provide a more precise estimate of the impact of external obsolescence, while controlling for other variables.

3. Interplay of Depreciation Forms and the Cost Approach

It is vital to remember the interplay between Physical Deterioration, Functional Obsolescence, and External Obsolescence. Total Depreciation is the sum of these three components. The accurate identification and measurement of each form are essential for reliable application of the Cost Approach in real estate appraisal.

4. Important Considerations

• Reproduction vs. Replacement Cost: When estimating depreciation from the market, ensure consistency in the cost-estimating method. Using reproduction cost for the subject requires reproduction cost for the comparables as well.
• Market Relevance: All depreciation estimates must❓❓ be supported by market data and reflect the actions and expectations of typical buyers and sellers in the subject property’s market.

5. Conclusion

Understanding functional and external obsolescence is crucial for accurate real estate appraisal. These forms of depreciation represent significant reductions in value and require careful analysis and market-based estimation techniques. By mastering these concepts, appraisers can provide reliable and defensible valuations, especially when utilizing the cost approach.