Economic obsolescence

[SANDY]

Wow, that is an incredible piece of writing! Thanks very much for steering me to that. I'd encourage every appraiser here to read (and comprehend) his concepts line by line, word by word.

Quite a while ago we had a long discussion about external obsolescence as it relates to the Cost Approach on the URAR. I still stand by my opinion that the form is not fully thought out and that there is occasion when an amount for external obsolescence is appropriate on the form. (I think Özdilek, the author of the article, would probably agree.)

My reasoning is that external obsolescence is a comparative measure that only exists when explaining the difference between values at different times or in different locations. The URAR Cost Approach is "static" and describes the value of a single property at a precise point in time, not over a time interval. At a static point in time, any external obsolescence will be entirely incorporated into the lot value, with no remaining external obsolescence left to be deducted from the cost of the improvements.

Think it through. Take a typical site and another that is less desirable because of traffic noise. They obviously have different market values. What would ever be the justification for using the same lot value for both sites in the Cost Approach of each appraisal? And, when using the value of the sites as if vacant, what would be the justification for attributing any portion of the difference in site values to the improvements?

Same for economic obsolescence over time. In terms of the site value at the exact moment of the appraisal, what possible relevance does a changing market have? Change doesn't exist at one point in time, it's only perceivable when comparing historic prices or future values. Maybe not. Economic obsolescence due to a general economic downturn like we just experienced likely has different value effects for different neighborhoods/marketing areas although it likely permeates throughout all properties. In my opinion, a cyclical (widespread)related economic obsolesence factor is different from an economic obsolescence factor related to a specific marketing area or neighborhood due for instance to a plant closing. By the way which external ob. is a plant closing- locational or economic or both?

That said, external obsolescence is a crucial factor when explaining price or value differences between different properties or over time. (But as the article alludes to, not when explaining cost, which occurs at a single point in time.)

The biggest mistake I see with the Cost Approach is when appraisers imply an unrealistic degree of precision. (Yeah, that again.) It's not uncommon to see costs calculated to the penny in areas that have normal cost variances that can be 40-50% or higher. But, even in areas where costs vary significantly, there are limited land sales, and where few buyers even consider building as an option, the Cost Approach is a valuable test of an appraisal's reasonableness. Bingo!!! If EO is calculated by the remaining difference after all other factors are considered and let's say the remainder is $50,000, how does one know that the EO actually only accounts for $40,000 due to inaccuracies in other parts of the CA?

Same with the Income Approach. Even in areas where few property's are held as investments, a comparison between the buyer's option to either purchase or rent can be a real eye-opener. I've always wondered if consistent and appropriate use of the Cost Approach might have headed off the real estate bubble.

Now we are getting into the nuances and weaknesses of the CA and some recognition of the differences between theory and the application of that theory.

 

[J Grant]

Interesting article. The article actually does not make a persuasive case for the CA, as it states the best application is to unique buildings such as a church. He does a good job of interlating time and the concepts of cost, price and value. The uses can be misapplied , such as when appraisers deduct cost to cure in the sales comparison approach and turn it into a defacto value adjustment.

There is a simple aspect to the IA that adresses the present time problem Terrel mentioned, the income and expense statement. The IE statement shows today's income and expenses, and if mortgage payments are factored in, some properties would be upside down in cash flow. There could be a way to develop ec obsolesence from it ...but as a stand alone the IE statement shows a if the property throws off positive, neutral, or negative cash flow today.

Though ec obs can be extracted, the weakness of CA is that is not even relevant as a choice for most res buyers. To build new, a wait of 8 to 12 months to occupy, typically buyers need or want to move in right away. There is no vacant land in most built up res areas, so what "choice" is there to build new in those areas? One could buy new, but in a very different location and price range.

New home buyers are a niche market and the CA has more relevance, as these buyers already made the choice to buy new. The diff between resales a year old in development and new home sales prices would show the economic obs, but how many appraisers would apply that, when they can choose to apply, instead, EI/ profit incentive? ( applying one or the other would result in a different value on the CA of a new development house)

I agree KD that an IA would have helped in the boom ....but, imo, the income approach is more relevant as a value check on res appraisals as the information is actual fact of proven market rents, not a theoretical model . Rents are paid in cash , not financed money the way mortgages are, thus, rents have a direct relation to earnings and income and don't fluctuate as much as prices.

 

[Terrel L. Shields]

appraisers imply an unrealistic degree of precision

The scary part is that the users of appraisals expect a much higher degree of precision than our data can support.

To build new, a wait of 8 to 12 months to occupy, typically buyers need or want to move in right away. There is no vacant land in most built up res areas, so what "choice" is there to build new in those areas? One could buy new, but in a very different location and price range.

About 2 million annually exercised that option in the years 2000- 2012. There is no mention in the Cost Approach that the owner is expected to wait weeks to move in. That's just a red herring. Why? It is as of the date of appraisal. The land is already there, like the SA and IA, the APPROACH is a hypothetical. And if you don't capture the actual land residual value of the property, then the CA will be wrong...just as if you have two identical houses, one on a ¼ acre lot and the other on a 40 acre lot...the underlying value of the land is what it is. Land is valued "AS IF vacant and available for its highest and best use." Nothing in that implies that vacant land has to be available.

New home buyers are a niche market

That's a very big "niche". In fact, new construction is driven by demand not custom orders. Some people want to build their dream home, but for most it is simply an option to buy a house with a warranty that is new and therefore should have a minimum of problems. And they are moving in today. These are spec homes built for market. Problems most folks don't want to deal with, like replacing the hot water heater 2 months after you move in.

 

[J Grant]

Terell, my point was, that in the overall housing market, new homes are a small percent of sales overall. It is an option for some people, not for most, for a number of reasons inlcuding the fact that most newer construction is in outlying areas, as most in town or beach side or other desireable areas are already built out.

The wait to move in has nothing to do with the cost approach, it is one of the reasons people opt not to build new or contract for a new construction home. For those who choose to buy new, the CA makes more sense in an appraisal.

 

[Meandering]

The wait to move in has nothing to do with the cost approach, it is one of the reasons people opt not to build new or contract for a new construction home. For those who choose to buy new, the CA makes more sense in an appraisal.

I'll argue this point. The wait, is accountable for custom built, not spec home, because there is the additional risk that is allotted to time.

Spec homes are already built, so there is no or very little option for customization.

Custom built is a different animal.

Here is an example and I'm sure there are thousands across the country in a similar situation.

New custom built construction started lot clearing in the middle of an old subdivision, an old vacant lot, March 2008. Owner wants it built on that particular lot as owner's adult children live nearby and wants the grand kids to be able to walk across the street and visit grandma and grandpa. (Remember this is a custom build)

Home is a bi-level, mid range for new bi-levels outside of new developments on one acre with well and septic, estimated value was $170k, under the HC of completed as of the day.

Cherry cabinets, laminated back splash, 2 car built in garage, well, septic, one acre, 3 beds up, 2 baths up, finished partial basement.

Around the 4th construction draw, market crashed and bank pulls the loan.

Buyer is out. The builder uses it as fill in work over the course of 2009 completing it about September and puts it on the market as a spec house for $165k.

New buyer tax credits are in place, but it fails to attract a buyer.

The following year drops the list price to $140k. There is heavy competition from REO bi-levels in the neighborhood, most that are much larger even though they are more than 10 years older, or are in better neighborhoods.

It sits on the market until about May 2012, when the builder pulls the listing and installs a renter for $1,200 a month.

This is how time has impacted the custom built home value.

Developing the Cost Approach would have changed over any point in this short life to account for economic obsolescence.

The costs of a sheet of plywood at the time of lot clearing was $X and was $X+ by May 2012. The cost of labor did not drop as much as the cost of the plywood increased, but the demand (Economic Obsolescence) dropped substantially.

The problem with custom built is to decide if, what is going to be built to the specifications of one owner will be acceptable as "typical" within the wider market, and frankly, the placement of, or the location of, this particular home, had no appeal to a "typical" buyer for this type of property as demonstrated by it's failure to sell over the several years since completion. So it has an additional functional obsolescence to consider, which was not provable at the time of lot clearing, as there was not market data to support it, but 4 years later, there is market data to support a functional obsolescence due to it's location, to be considered along with the economic obsolescence.


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[23Degrees]

Without the COST of construction plus the cost of the land, then the SA has no link with the real world.

There we have it. The one sentence that is the best argument for across the board use of the cost approach. Perhaps even in cases not qualified by the posted article (unique, churches, etc.). Having been publicly scolded in print for suggesting that appraisal practice should consider providing standardized metrics as to the "reasonableness" of opined market value I can understand your point - even though that scolding was arguably deserved. In my view, and apparently it is only my view, the cost approach and better yet the income approach (but at least one or the other) were urgently needed as a means to do just that over the last decade. But not as they are currently utilized - towards development of an opinion of market value. Towards that end the income approach too easily becomes a self fulfilling prophesy and the cost approach is more often than not filled with inter-reliant fudge factors and contrived "judgments" based on ethereal or non-existent data as I indicated before. And perhaps this is a problem limited to populated areas of CA and FL but I would think it applies to many areas where the subjects are 20-30 years old or more and there has not been a vacant land sale since Papa Bush was in office.

Using these other two approaches as a means to develop a value that stands in contrast to market value, by (at least in the case of the cost approach) removing easily manipulated supposed inputs and outputs makes far more sense in my opinion (and after five years I'll admit - only my opinion).

As to the initial argument of economic obsolescence - here where I work I can virtually guarantee you that the vast majority questioned regarding that particular piece of (missing??) information would likely argue that said obsolescence, when present, is accounted for within the opined land value - and without any recent land sales to prove that directly I guess we should open a state sponsored case to professionally assassinate them over that aspect of their appraisal with lender mandated cost approach included.

 

[SANDY]

There we have it. The one sentence that is the best argument for across the board use of the cost approach. Perhaps even in cases not qualified by the posted article (unique, churches, etc.). Having been publicly scolded in print for suggesting that appraisal practice should consider providing standardized metrics as to the "reasonableness" of opined market value I can understand your point - even though that scolding was arguably deserved. In my view, and apparently it is only my view, the cost approach and better yet the income approach (but at least one or the other) were urgently needed as a means to do just that over the last decade. But not as they are currently utilized - towards development of an opinion of market value. Towards that end the income approach too easily becomes a self fulfilling prophesy and the cost approach is more often than not filled with inter-reliant fudge factors and contrived "judgments" based on ethereal or non-existent data as I indicated before. And perhaps this is a problem limited to populated areas of CA and FL but I would think it applies to many areas where the subjects are 20-30 years old or more and there has not been a vacant land sale since Papa Bush was in office.

Using these other two approaches as a means to develop a value that stands in contrast to market value, by (at least in the case of the cost approach) removing easily manipulated supposed inputs and outputs makes far more sense in my opinion (and after five years I'll admit - only my opinion).

As to the initial argument of economic obsolescence - here where I work I can virtually guarantee you that the vast majority questioned regarding that particular piece of (missing??) information would likely argue that said obsolescence, when present, is accounted for within the opined land value - and without any recent land sales to prove that directly I guess we should open a state sponsored case to professionally assassinate them over that aspect of their appraisal with lender mandated cost approach included.

Not necessarily can it all be accounted for within the land value-I know because I just finished one where the land did not account for all of it. How did I know that? I know how to calculate it using direct market data and not by inference.

 

[CANative]

When necessary for credible results, such as is the case with new construction,

A cost approach for a new or proposed construction SFR is not NECESSARY as long as there are adequate sales in the market.

Economic obsolesence for residential property is caused by supply and demand factors. It's probably more useful to use the terms "economic obsolesence" for commercial property where external factors include local, national and international market conditions.

 

[CANative]

Not necessarily can it all be accounted for within the land value-I know because I just finished one where the land did not account for all of it. How did I know that? I know how to calculate it using direct market data and not by inference.

Depreciation caused by externalities (external obsolesence) can be attributed to the land, or improvements, or the land AND the improvements.

 

[Meandering]

Not necessarily can it all be accounted for within the land value-I know because I just finished one where the land did not account for all of it. How did I know that? I know how to calculate it using direct market data and not by inference.

And so how did that work for you?

Was there EO that was separate from FO, like a 3,500 sf home where the market now prefers 1,600 sf homes? The "white elephant" concept is attributable to FO.

Can it be that similar lots are selling for more when they are in different areas showing a preference for new homes than areas that do not show a preference for new homes?

So what part of the building was the victim of EO if your "analysis" found that EO was attributable to more than just the land?

This ought to be good.


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