Quantifying and Addressing Obsolescence in Real Estate Appraisal

Chapter: Quantifying and Addressing Obsolescence in Real Estate Appraisal

Introduction

This chapter delves into the crucial topic of obsolescence within the context of real estate appraisal, specifically focusing on its quantification and methods for addressing it. Obsolescence, a form of depreciation, represents a loss in value due to factors other than physical deterioration. Accurately identifying, measuring, and accounting for obsolescence is paramount for arriving at a credible and defensible property valuation. This chapter provides a scientific understanding of obsolescence, differentiating its types, exploring relevant economic principles, and presenting practical methods for its quantification in appraisal assignments.

1. Defining and Differentiating Obsolescence

Obsolescence, in real estate appraisal, represents the reduction in property value stemming from factors external to physical wear and tear. It reflects a misalignment between a property’s features or characteristics and the demands or expectations of the market. There are primarily three distinct types of obsolescence:

• Functional Obsolescence: This arises from deficiencies or superadequacies within the property itself. It relates to the property’s utility and ability to perform the function for which it was designed, relative to current market standards.
• External (Economic) Obsolescence: This originates from negative influences outside the property’s boundaries. These influences can be locational (e.g., proximity to a nuisance) or economic (e.g., declining neighborhood).

Understanding the nuances between these types is critical for correct identification and valuation.

2. The Scientific Basis of Obsolescence

Obsolescence is deeply rooted in economic principles, particularly the concepts of:

• Supply and Demand: Changes in market demand, influenced by consumer preferences, technological advancements, or economic conditions, directly impact obsolescence. A feature once considered desirable can become obsolete due to changing tastes.
• Opportunity Cost: Functional obsolescence can be viewed through the lens of opportunity cost. A deficiency implies the property owner is foregoing potential income or experiencing higher operating costs compared to a property with modern features.
• Substitution: The principle of substitution dictates that a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. If a property suffers from obsolescence, its value will be capped by the cost of a more modern, functionally equivalent property.

The effect of obsolescence on market value is determined through experimentation of the market and extraction of the proper obsolescence influence.

3. Quantifying Functional Obsolescence

Functional obsolescence is classified into deficiencies and superadequacies, each requiring specific quantification approaches.

3.1. Deficiencies

These are shortcomings or missing features that reduce a property’s desirability and utility. The quantification process typically involves the following steps:

1. Identify the Deficiency: Thorough market research and property analysis are essential to pinpoint the specific functional problem. Interviewing typical buyers in the market is critical to obtain this information.
2. Determine the Cost to Cure (if curable): This involves estimating the expense required to rectify the deficiency. This should include the hard costs (materials, labor) as well as any soft costs (permits, design fees).

3. Estimate the Loss in Value Due to the Deficiency: This can be done using:

   • Cost to Cure: If the deficiency is curable, the cost to cure, less any physical depreciation of the item replaced and any excess cost to cure, often provides a reasonable estimate of the loss in value.

   • Capitalization of Income Loss: If the deficiency leads to reduced rental income or increased operating expenses, the present value of the lost income stream can be calculated using an appropriate capitalization rate.

     Formula: Obsolescence = Annual Income Loss / Capitalization Rate

   • paired data analysis❓❓: Comparing sales of similar properties with and without the deficiency allows for direct extraction of the market’s perception of the value loss.

4. Account for Physical Depreciation: Avoid double-counting. Any physical depreciation already reflected in the value of existing components should be subtracted from the cost to cure. The functional obsolescence procedure (as illustrated in Exhibit 29.5 of the provided file content) shows how this should be done.

5. Calculate the excess cost to cure, if curable, or the depreciated cost, if incurable, of the proper item if included in new construction The excess cost to cure is the difference between the cost to cure and the cost of the proper item if included in new construction. This accounts for the loss in market value because of the deficiency.

Example: A three-story office building lacks an elevator in a market where elevators are standard. The cost to install an elevator today is $200,000, while the cost if installed at the time of construction was $75,000. Similar properties with elevators sell for $210,000 more. The functional obsolescence is calculated as follows:

Item Explanation
%stimate the cost of the item There is no item on site now, so this amount is $0.
,ess the depreciation already charged Again, since there is no elevator, this amount is also $0
Plus the cost to cure or the present value of the loss This is curable because the owner can spend $200,000 and return $210,000 in value.
,ess the cost, if curable, or depreciated cost, if incurable, of the proper item if included in new construction This has to be subtracted because the market is recognizing only a $210,000 difference in the value with and without the item, and the cost for this building is already starting out $75,000 less than a property that has an elevator.
%quals the depreciation attributable to functional obsolescence $125,000

3.2. Superadequacies

These are features that exceed the requirements of the market, providing little or no additional value but potentially incurring higher costs.

1. Identify the Superadequacy: Determine which features are not contributing to the property’s value.
2. Estimate the Cost of the Superadequacy: This is the cost of the component that is exceeding the market requirements.
3. Calculate the Loss in Value: In many cases, the entire cost of the superadequacy represents the loss in value. However, if the superadequacy provides some minimal benefit, this benefit should be considered.

Example: A residential property in a cold climate includes an in-ground swimming pool. The market does not typically value pools in this area. The functional obsolescence is equal to the entire cost of the pool since it does not provide value.
Example: The oversized water heater in the example from Exhibit 29.9 from the provided file content represents an example of a superadequacy.
Item Explanation
%stimate the cost of the item The cost of the existing oversized water heater.
,ess the depreciation already charged The existing units were not new. This adjustment prevents double-counting the physical depreciation.
Plus the cost to cure or the present value of the loss This is curable because it only cost $1,000 to put in the correct unit and the capitalized cost of the extra expense was $2,000.
,ess the cost, if curable, or depreciated cost, if incurable, of the proper item if included in new construction The cost of installing the more efficient units today during original construction.
%quals the depreciation attributable to functional obsolescence $1,667

4. Quantifying External Obsolescence

External obsolescence is typically more challenging to quantify, as it stems from external factors that are often difficult to isolate. The following methods are commonly employed:

1. Paired Data Analysis: This involves comparing sales of similar properties located in areas with and without the negative external influence. The price difference directly reflects the market’s perception of the external obsolescence. This is the most direct and reliable method.
2. Capitalization of Income Loss: If the external factor negatively impacts rental income or operating expenses, the present value of the lost income stream can be calculated using an appropriate capitalization rate. This method is most suitable for income-producing properties.
3. Expert Opinion: In some cases, a real estate appraiser may need to rely on expert judgement, supported by market data and analysis, to estimate the impact of external obsolescence. This approach is less precise but may be necessary when direct market data is limited.

Allocation of Loss: An important consideration in quantifying external obsolescence is the allocation of the loss between land and improvements. As the source material says, the allocation of a measured loss to the land and building is necessary in most cases. The loss is usually extracted from the market which included losses to the land and building. In the cost approach, the loss is only applied to the building. The appraiser should allocate the loss found in the market to the land and building value.

Example: A property is located near railroad tracks, resulting in noise pollution. Paired sales analysis reveals that similar properties away from the tracks sell for $50,000 more. It is found that the building represents 80% of the property’s value, therefore, the loss allocated to the building would be $40,000 ($50,000 * 0.80).

5. Addressing Obsolescence in the Cost Approach

The cost approach to value relies on estimating the cost to reproduce or replace a property, then deducting accrued depreciation. Obsolescence must be carefully considered within this framework:

1. Accurate Cost Estimation: The starting point is an accurate estimate of either the reproduction or replacement cost new of the improvements. This difference is illustrated in the provided material when it notes that “If replacement cost is used in the cost approach, some forms of functional obsolescence may be eliminated while others may not.”
2. Identification and Quantification of Obsolescence: As discussed previously, all forms of obsolescence (functional and external) must be identified and quantified using appropriate methods.

3. Deduction of Obsolescence: The quantified obsolescence amounts are then deducted from the cost new.

   Formula: Value = Cost New - Physical Deterioration - Functional Obsolescence - External Obsolescence

6. Practical Application and Case Studies

Real-world case studies are invaluable for solidifying understanding and developing practical skills in quantifying and addressing obsolescence.

Case Study 1: Retrofitting an Older Office Building

An older office building lacks modern energy-efficient systems. The cost to upgrade the HVAC and lighting is $150,000. However, the energy savings are estimated to increase net operating income by $15,000 per year. With a capitalization rate of 10%, the capitalized value of the income increase is $150,000, justifying the investment. The functional obsolescence is addressed by modernizing the building, leading to an increase in property value.

Case Study 2: External Obsolescence Due to Environmental Contamination

A residential property is located near a former industrial site with soil contamination. Paired data analysis reveals a 15% reduction in property values compared to similar properties in uncontaminated areas. The external obsolescence is quantified as 15% of the property’s market value, reflecting the stigma associated with the contamination.

7. Minimizing the Impact of Obsolescence

Proactive property management and strategic investment can help mitigate the impact of obsolescence:

• Regular Maintenance and Upgrades: Addressing minor deficiencies promptly prevents them from escalating into significant obsolescence issues.
• Strategic Modernization: Investing in upgrades that align with market trends can enhance a property’s appeal and functionality.
• Adaptive Reuse: Considering alternative uses for a property can overcome functional obsolescence by catering to evolving market demands.

8. Conclusion

Accurately quantifying and addressing obsolescence is a complex but essential skill for real estate appraisers. By understanding the different types of obsolescence, applying appropriate valuation methods, and considering market dynamics, appraisers can provide credible and defensible value opinions that reflect the true economic worth of a property. Continued education and professional development are crucial for staying abreast of evolving market trends and best practices in obsolescence assessment.