Economic obsolescence`

Economic obsolescence, also referred to as external obsolescence, represents a loss in the value of an asset or property due to external factors beyond the owner's control. This concept is crucial in fields such as real estate valuation and appraisal, falling under the broader financial category of property depreciation. It affects an asset's market desirability and utility, leading to a decline in its overall property value. Unlike other forms of depreciation, economic obsolescence stems from influences entirely outside the property itself, making it typically "incurable" by the property owner.⁵⁹, ⁶⁰, ⁶¹

History and Origin

The concept of obsolescence in asset valuation has evolved alongside economic understanding and appraisal practices. While physical wear and tear were always evident, the recognition that external market or environmental forces could diminish an asset's worth became increasingly important, particularly in the 20th century. As industries shifted and urban landscapes changed, appraisers began to formalize the impact of these external factors. The Internal Revenue Service (IRS) also acknowledges obsolescence as a factor in depreciation allowances, noting that it can render an asset economically useless regardless of its physical condition, due to "technological improvements and reasonably foreseeable economic changes."⁵⁸ This recognition underscores the long-standing understanding that an asset's value is not solely determined by its physical state or internal design, but also by its surrounding economic environment.⁵⁷

Key Takeaways

• Economic obsolescence is a loss of value caused by factors external to the property or asset.⁵⁵, ⁵⁶
• These external factors are typically beyond the property owner's control and include economic shifts, regulatory changes, or neighborhood decline.⁵³, ⁵⁴
• It is generally considered an "incurable" form of depreciation, as the owner cannot remedy the root cause.⁵¹, ⁵²
• Economic obsolescence significantly impacts a property's marketability and fair market value.⁵⁰
• Appraisers account for economic obsolescence, primarily within the cost approach to valuation, to reflect an accurate property worth.⁴⁸, ⁴⁹

Formula and Calculation

Economic obsolescence is not typically calculated with a single direct formula but is rather quantified as a loss in value within various appraisal methodologies. It represents the portion of an asset's diminished value that cannot be attributed to physical deterioration or functional obsolescence.⁴⁷

Appraisers often quantify economic obsolescence through methods such as:

• Paired Sales Analysis: Comparing the sales prices of similar properties, some affected by the external factor and some not, to isolate the value loss.⁴⁶
• Capitalization of Income Loss: This method estimates the present value of income lost due to the external factor. If an external event, like a factory closure, reduces the potential net operating income of a commercial property, the capitalized value of that income shortfall can represent economic obsolescence.⁴⁴, ⁴⁵
• Extraction Method: In the cost approach, after estimating the replacement cost new and subtracting physical and functional depreciation, any remaining difference between this depreciated cost and the property's market value may indicate economic obsolescence.⁴², ⁴³

While not a strict "formula," some representations exist to illustrate the percentage of loss:

$\text{Economic Obsolescence} = \frac{\text{Loss of Value}}{\text{Original Value}} \times 100$⁴¹

Where:

• Loss of Value is the decrease in property value due to external factors.
• Original Value is the initial value of the property before the external factor's impact.

Interpreting Economic Obsolescence

Interpreting economic obsolescence involves understanding how external forces translate into a tangible loss of property value. When an appraiser identifies economic obsolescence, it signals that the highest and best use of the property, or its ability to generate income, has been negatively affected by conditions in the surrounding market or environment.⁴⁰ For instance, if a neighborhood experiences a significant increase in crime rates or a major employer leaves the area, the desirability and hence the market value of properties there may decline, indicating economic obsolescence.³⁸, ³⁹ This loss is not due to the property's condition or design but rather its external circumstances, making it difficult for an owner to "cure" or fix.³⁷ It provides crucial context for determining a property's true fair market value in its current economic environment.

Hypothetical Example

Consider a small town where the primary industry was coal mining. A homeowner, Sarah, owns a house near the now-closed coal mine. When the mine was operational, the town thrived, jobs were plentiful, and property values were stable. However, with the closure of the mine, a significant portion of the population moved away, leading to a sharp decline in local employment and a surplus of available housing.

Sarah's house, while well-maintained and structurally sound, experiences a loss in value. This is not because of wear and tear (physical depreciation) or outdated features (functional obsolescence). Instead, the loss is due to the external economic shift: the decline of the local economy and population. An appraiser might determine that similar investment property in the town has seen its value drop by 20-30% simply because of the economic downturn, regardless of the property's individual condition. This loss in value, directly attributable to the external factor of the mine's closure and its ripple effect on the local economy, is economic obsolescence. Sarah cannot "fix" the closed mine or the departing population, so the obsolescence is incurable at her level.

Practical Applications

Economic obsolescence is a critical consideration across various financial sectors and real-world scenarios:

• Real Estate Appraisals: Professional appraisers routinely assess economic obsolescence to provide an accurate valuation of properties, particularly when using the cost approach.³⁵, ³⁶ They identify external factors such as changes in local demographics, economic downturns, or new, undesirable neighborhood developments (like a landfill or busy highway) that can diminish property worth.³³, ³⁴
• Property Tax Assessments: Local tax authorities may consider economic obsolescence when assessing property values for taxation purposes, especially if a region has experienced a significant economic decline.
• Eminent Domain Proceedings: In cases where private property is acquired for public use, economic obsolescence can influence the determination of just compensation, as external factors impacting the property's value must be accounted for.
• Financial Reporting and Business Valuation: For businesses holding significant real estate or other long-lived assets, economic obsolescence can necessitate asset impairment charges on financial statements if the external environment reduces the asset's future earning potential.³¹, ³²
• Investment Decisions: Investors, particularly in investment property, must analyze potential economic obsolescence risks. Factors such as shifts in local industries, changes in consumer demand, or new regulatory environments can significantly affect the long-term viability and return on investment of an asset.²⁹, ³⁰ For instance, changes in interest rates set by the Federal Reserve can influence the broader housing market and property values, impacting affordability and demand.²⁷, ²⁸

Limitations and Criticisms

While essential for accurate valuation, identifying and quantifying economic obsolescence presents several challenges and criticisms:

• Subjectivity: Measuring economic obsolescence often involves a degree of subjectivity. It requires appraisers to interpret market data and forecasts, which can lead to inconsistencies compared to more tangible forms of depreciation like physical deterioration.²⁵, ²⁶
• Difficulty in Quantification: Precisely isolating the value loss solely attributable to external factors can be complex. It can be challenging to differentiate between the impact of economic obsolescence on the improvements versus a reduction in the value of the underlying land, leading to potential "double counting" of value loss if not carefully managed within the cost approach.²³, ²⁴
• Lack of Control: By its nature, economic obsolescence is due to factors outside the owner's control, such as a major employer leaving the area or new zoning laws. This "incurable" aspect means the owner cannot directly invest in the property to mitigate this specific form of depreciation.²¹, ²²
• Market Data Reliability: Accurate assessment relies heavily on reliable market data and comparable sales, which may be scarce in rapidly declining or niche markets.²⁰
• Temporary vs. Permanent: Sometimes, external factors causing economic obsolescence, like a temporary economic downturn, may reverse over time. This makes it difficult to ascertain whether the obsolescence is a short-term blip or a long-term shift in the highest and best use of the property value.¹⁹ For example, a temporary dip in net operating income due to a recession might not warrant the same level of economic obsolescence as a permanent shift in industry demand.¹⁸

Economic Obsolescence vs. Functional Obsolescence

Economic obsolescence and functional obsolescence are both forms of depreciation that reduce an asset's value, but they stem from fundamentally different causes. The key distinction lies in their origin: economic obsolescence arises from factors external to the property, while functional obsolescence originates from internal factors.¹⁶, ¹⁷

Functional obsolescence occurs when a property loses value because its design, layout, or features are outdated, inefficient, or no longer align with current market preferences or utility standards. Examples include a house with only one bathroom for multiple bedrooms, an outdated kitchen, an inefficient floor plan, or a commercial building lacking modern technological infrastructure like high-speed internet. These issues are inherent to the property itself and can often be "curable" through renovations or upgrades, provided the cost of the improvement justifies the increase in value.¹⁴, ¹⁵

Conversely, economic obsolescence (also known as external obsolescence) results from adverse conditions outside the property lines and beyond the owner's control. These include broader economic downturns, increased crime rates in the neighborhood, changes in zoning laws, the construction of undesirable nearby developments (like a landfill), or a shift in the local market approach or industry. This type of obsolescence is typically "incurable" by the property owner, as they cannot remedy the external cause.¹¹, ¹², ¹³ While both lead to a reduction in property value, functional obsolescence is a property-specific flaw, whereas economic obsolescence is a consequence of the property's external environment.

FAQs

What are common causes of economic obsolescence?

Common causes of economic obsolescence include declining local economies, loss of major employers, increased crime rates in the area, changes in zoning or environmental regulations, shifts in consumer demand that affect a specific property type, or the construction of undesirable facilities (like a busy highway or landfill) nearby.⁸, ⁹, ¹⁰

Is economic obsolescence curable?

Economic obsolescence is generally considered "incurable" because the factors causing the loss of value are external to the property and beyond the individual owner's ability to fix. For example, a homeowner cannot reverse a regional economic recession or move a newly built highway.⁶, ⁷

How does economic obsolescence impact property valuation?

Economic obsolescence directly reduces a property's fair market value by diminishing its desirability, utility, or income-generating potential due to external forces. Appraisers account for this loss to arrive at an accurate valuation that reflects the property's true worth in its current external environment.⁴, ⁵ This is particularly relevant when using the capitalization rate for income-producing properties.³

Can economic obsolescence be temporary?

While often long-lasting, some forms of economic obsolescence can be temporary, such as those caused by short-term economic downturns or specific market fluctuations that eventually rebound. However, many external factors, like the permanent closure of a major industry or a significant demographic shift, can lead to more persistent or irreversible value loss.¹, ²