Economic obsolescence

What Is Economic Obsolescence?

Economic obsolescence refers to the loss in value of a property due to external factors that are beyond the control of the property owner. This type of obsolescence falls under the broader financial category of real estate valuation and is a key consideration in appraisal. Unlike other forms of obsolescence, economic obsolescence stems from adverse economic, locational, or environmental changes outside the property itself, making it impossible for an owner to cure or reverse. It directly impacts the property's market value by reducing its desirability or utility to potential buyers or tenants.

History and Origin

The concept of economic obsolescence evolved within the appraisal profession as a necessary component for accurately assessing property value. As economies industrialized and urbanized, it became increasingly clear that a property's value was not solely determined by its physical condition or internal design. External forces, such as shifts in supply and demand, changes in transportation infrastructure, or the decline of a local industry, could severely diminish a property's utility and marketability. The Uniform Standards of Professional Appraisal Practice (USPAP), which serves as the generally recognized ethical and performance standards for appraisers in the United States, incorporates the identification and analysis of all forms of obsolescence, including economic obsolescence, to ensure credible appraisal results.⁶, ⁷ This framework, authorized by Congress in 1989, provides guidelines for a comprehensive valuation process.⁵

Key Takeaways

• Economic obsolescence represents a loss in property value due to external, uncontrollable factors.
• It stems from changes in the surrounding economy, location, or environment.
• Property owners cannot mitigate economic obsolescence through property improvements.
• It is a critical component in accurately determining a property's fair market value during an appraisal.
• Examples include declining industries, unfavorable zoning changes, or increased vacancy rates in a specific area.

Formula and Calculation

Economic obsolescence is typically not calculated using a direct formula but rather estimated as part of a broader depreciation analysis within property appraisal. Appraisers often use the "capitalization of income loss" method or the "paired sales analysis" method to quantify its impact.

In the capitalization of income loss method, the appraiser estimates the total loss in net operating income (NOI) attributable to the external factors causing economic obsolescence. This income loss is then capitalized at an appropriate capitalization rate to arrive at a value loss.

Where:

• Annual Income Loss = The estimated reduction in a property's annual cash flow or net operating income due to external factors.
• Capitalization Rate = The rate of return used to convert income into value, reflecting the market's expected return on similar properties.

This method requires careful analysis to isolate the income loss specifically caused by external factors from other forms of depreciation or operational inefficiencies.

Interpreting Economic Obsolescence

Interpreting economic obsolescence involves understanding the underlying external forces that diminish a property's value and assessing their permanence and severity. Appraisers analyze market trends, economic cycles, and shifts in local demographics to identify the causes of this value loss. For instance, a rise in interest rates can impact property valuations across an entire sector by making financing more expensive and reducing investor demand.⁴ The presence of significant economic obsolescence can indicate that a property's highest and best use may have changed or that its current use is no longer economically viable in the long term. This assessment is crucial for both property owners and potential investors to make informed decisions regarding acquisition, disposition, or redevelopment.

Hypothetical Example

Consider an aging manufacturing plant located in a region that has experienced a significant decline in its industrial sector due to global trade shifts and a lack of new industries moving in. The plant itself is structurally sound and well-maintained, but the demand for manufacturing facilities in that area has plummeted.

An appraiser evaluating this plant determines that its value is significantly lower than similar, physically identical plants in other, more economically vibrant regions. This value disparity is primarily due to economic obsolescence. The appraiser identifies that the decline of local manufacturing jobs, the closure of key suppliers, and the general economic downturn in the area have reduced the pool of potential buyers or tenants for this type of commercial real estate. Even if the plant were updated with the newest machinery, the external economic environment would still hinder its ability to generate sufficient income or attract a buyer at a competitive price, illustrating the impact of economic obsolescence.

Practical Applications

Economic obsolescence is a critical factor in various real-world financial contexts. In real estate investment, understanding this concept helps investors identify properties at risk due to changing market conditions or avoid overpaying for assets in declining areas. For instance, the ongoing challenges in the commercial real estate market, particularly in the office sector due to increased remote work, highlight a widespread form of economic obsolescence impacting valuations.³ Banks and financial institutions consider economic obsolescence when underwriting loans for commercial properties, as it directly affects the collateral's long-term value and the borrower's ability to generate cash flow for debt service.²

Furthermore, in property tax assessments, economic obsolescence can be a basis for appealing a higher valuation if external factors are demonstrably diminishing a property's utility. The decline of traditional industries, such as coal mining in certain regions, can render previously valuable land or industrial facilities economically obsolete, prompting discussions about repurposing these sites for new uses like geothermal heating.¹

Limitations and Criticisms

One of the primary limitations of economic obsolescence is the difficulty in precisely quantifying its impact. Distinguishing economic obsolescence from other forms of depreciation, such as physical deterioration or functional obsolescence, can be challenging. Appraisers must exercise considerable judgment in attributing value loss solely to external externalities, which can introduce subjectivity into the appraisal process.

Critics also point out that while economic obsolescence is by definition incurable by the property owner, broader economic shifts or governmental interventions could potentially alleviate its effects over a longer timeframe, making a current assessment potentially temporary. For example, a revitalization effort or the introduction of new infrastructure might mitigate some external factors previously causing economic obsolescence. However, from an immediate valuation standpoint, the impact is considered present and real.

Economic Obsolescence vs. Functional Obsolescence

Economic obsolescence and functional obsolescence both represent forms of value loss in a property, but they differ fundamentally in their origin and curability.

While economic obsolescence focuses on external factors like an entire neighborhood's decline, functional obsolescence addresses a property's internal inefficiencies or outdated design that make it less desirable compared to modern standards. For example, a house with only one bathroom in a market where two are standard would suffer from functional obsolescence. If that same house were in a town where the primary employer shut down, it would also suffer from economic obsolescence, illustrating how both can impact a property's value simultaneously.

FAQs

What causes economic obsolescence?

Economic obsolescence is caused by factors outside the property itself, such as a decline in the local economy, changes in zoning or land use regulations, shifts in supply and demand for a specific property type, or adverse environmental changes in the area.

Can a property owner fix economic obsolescence?

No, a property owner cannot directly fix economic obsolescence because the causes are external. Improvements made to the property itself will not address the underlying economic or locational issues affecting its value.

Is economic obsolescence a form of depreciation?

Yes, economic obsolescence is considered a form of depreciation in property appraisal. It represents a loss in value due to external factors, distinct from physical deterioration or functional obsolescence.

How is economic obsolescence different from external obsolescence?

The terms "economic obsolescence" and "external obsolescence" are often used interchangeably in appraisal practice. Both refer to value loss caused by factors outside the property.

How does economic obsolescence affect an investment property?

Economic obsolescence can significantly reduce the cash flow and overall market value of an investment property. This can lead to lower rental income, decreased occupancy rates, and a diminished return on investment, making it less attractive to investors.