External depreciation

[bradellis]

OK folks,

Now you got me REAL concerned. I am a certified instructor in this, so I'm hoping this helps- I DO think I know what I am talking about.

External obsolescence comes in two forms: ECONOMIC and LOCATIONAL. Both can exist in a single property. Loss from environmental impact is just another form of locational loss. Remember that this obsolescence is depreciation. Depreciation is a loss from the upper limit of value from all causes.

Economic has to do with purchasing power. Remember your basic principles courses. Locational has to do with specific location of the subject and what is around it.

External obsolescence is ALWAYS attributed to the IMPROVEMENTS- not to the site value. Land does not depreciate, but the improvements thereon can and do. Now for EXAMPLES:

1. Peoria, IL has 2 major employers- John Deere and Harvester. Every few years the work force of one or the other goes on strike. Property values decline- why? Purchasing power. You cannot pay a mortgage if you cannot earn a living- unless you are already rich. The typical buyer is not. So this is ECONOMIC obsolescence. When the stirke ends, values tend to recover quickly. Anybody still questioning why clients want to know about economic conditions in a market?

Economic forces can be national as well. Today, high value properties in many, if not most, areas are declining. Why? Folks are losing jobs (although this trend may be over now). Irf you live in the Silicon Valley of CA you have seen you may well have seen your property go down substantially. What changed? Dot com bankruptcies and the general economy.

2. House sits right next to a commuter RR station. It sells for less than other similar ones due to the noise. LOCATIONAL obsolescence- outside the property lines and not under control of the owner. Site is zoned for multifamily but SFR is allowed.

If the home were torn down and a 24 unit building were erected, there may not be any loss at all. The proximity to the RR station could be a plus. THAT is why the loss is attributable to the improvements only.

Now, PLEASE do not get me going on whether land can or cannot depreciate. I'm giving you the current theory as taught by all the major schools and associations. I happen to think that there is a legitimate debate that could be had- but CURRENT theory says land does not depreciate- so don't tilt at windmills.

So, pull out your text books and read them again.

Brad

 

[KD247]

Brad,

Thanks for the well-written summary of external obsolescence theory. It’s too bad nobody’s compiling replies like this into a FAQ. (No, I’m not volunteering!)

Your examples illustrate external obsolescence exactly as I learned it. But, I’ve always been confused as to how external factors can influence anything but the site value.

In my day-to-day business, if I were completing the Cost Approach section of the URAR for either of your examples, I would usually know the subject’s estimated value. My next step would be to calculate the cost of the improvements (including physical depreciation), which is a fairly reliable number. Next, I would subtract the improvement costs from the estimated value to derive the site value.

This is a reliable way to estimate site value because it imitates the way that a builder would calculate site value when purchasing lots.

So, where does external depreciation of the improvements come into this equation?

(I realize that there are cases where site value approaches zero and/or there is extreme functional obsolescence due to lack of market demand for the improvements, but I would probably consider these cases in terms of highest-and-best use or functional obsolescence. If highest-and-best use is as a multi-unit building, why is the SFR’s loss of value attributed to the location and not to functional obsolescence due to the “incorrect” improvements?)

Sure, there are times when these calculations are approached from different directions, like when there are recent sales of comparable vacant sites, but I think the principal remains the same – that external forces primarily affect site value and rarely have an influence on the value of materials or labor that are brought onto the site.

Koert

 

[bradellis]

Koert,

Well thought out and presented. Remember that I said that there is a case to be made for land depreciating and that this is another topic. Perhaps there should be a new string. Unfortunately, we would have to rewrite all the texts on this (OK by me, but not likely to happen).

I guess that prevailing wisdom can be summed up like this: Take your subdivision example. The one home that sides to the main highway sells for less, but the improvements are a model match for other sales. So using paired sales, you calculate the loss from the noise generated from the main highway. You also note that this lot carried no premium- yes the builder understood that this site was inferior.

The value of the site is different from the others because of location- but it is not depreciation. It simply sold for less BECAUSE of the use it was being put to. Had the builder erected a clubhouse, strip mall, or something else, the lot may be worth more than the residential sites (subject of course to zoning, etc). THAT is why the loss is attributed to the improvements.

Does this defy logic? Sure. Should we, as a profession, be engaged in discussions on whether or not land depreciates? Sure. Frankly, I could make the case both ways in certain situations.

My info was primarily intended to point out what I believe to be proper terminology and technique- based upon current procedures.

I've had some fun over the years in court with this. Many appraisers do not understand it (for good reason).

I was most concerned with those who want to use the term "environmental" instead of "locational". Having been on the lending side, I can tell you that when that word appears- other than in a disclaimer- all the flags go up, all the whistles blow, and everyone runs around like the world was ending. For good reason.

If the lender has any reason at all to suspect an environmental problem on th site, they are forced to do due diligence- meaning a full blown phase one and perhaps a phase two. If they do not, and end up owning the property throught foreclosure, they are considered to be PRPs (perps)- potentially responsible parties- and may have to cover the cost or remediation all by themselves! Not an appetizing prospect when you are making all of $3K on a deal.

Brad

 

[KD247]

Brad,

Most examples of external depreciation seem to include a change in the property over time, an inefficient use of the site, or a bulk purchase of sites at the same price. This topic seems to involve a "Which came first, the chiken or the egg?" issue.

Given my conditions - that site value is what remains after costs are deducted from market value - external obsolescence would (almost) never be attributed to the improvements.

Given conditions where the appraiser feels that the site value is known, depreciation for location might be the only explanation. However, in this case, one could make the argument that the site value was not fully developed if a locational factor was not considered.

The best working explanation I can come up with (without discarding the whole notion of external depreciation) is that it's the part of functional obsolescence attributed to the negative influence of a tangible external feature (like being downwind to a chicken ranch) or the negative influence of a local economic situation. But, I would only include external depreciation in the cost approach in a case where the improvements do not represent the highest-and-best use of the site.

I can practically hear the instructor saying "Well, I wish we had more time to discuss this. Now, moving along to Neighborhood Boundaries...".

Have a good week,
Koert

 

[Farm Gal]

Brad:

I appreciate you clarifying external depreciation issues as regards the rest of the country, but cannot apply this to my area.

I would like some feedback from someone who has professional testimony experience on this issue, as I strongly suspect that there maybe litigation pending with regard to red-lining and fair housing issues in our area. The fact remains that in my professional capacity I MUST report the values I find in the market, and if the market indicates value explicable only by the words 'external depreciation' I must so report!

I did read my textbooks and study carefully, but had to throw the 'land does not depreciate' theory you describe out the door due to inapplicability in our area. Physical/functional depreciation alone cannot explain area values! And the lots original sales prices is not what they sell for now, if land vcalues can appreciate, why can they not then depreciate? I do however, have a problem with the concept of negative lot value.

I NEVER use the 'E' (environmental) word for exactly the reasons you describe. Whenever I can accurately quantify the reason for external depreciation I do so: excessive rental units in a SF housing area, visible defferred maintainence in the area, in one or two areas school specific or otherwise quantifiable factors.

However, given that the MLS zones in our area are tied to the Census tract lines, it is quite easy to do some in depth analysis: when the results of that analysis conbined with all available data on safety issues (police logs) demographics, etc are combined there is no single specific (or for that matter cumulative) reason why a house of a certain size, age, quality etc. should sell for more 'here' than the four to eight block away "there" other than buyer perception. I cannot describe that difference in any other way than external depreciation, unless someone can point me to a reference.

There are not sufficent lot values to explain the difference, area lots are typically valued as low as $1,500 (one thousand five hundred- sometimes even $500 or zero). As per my earlier post, we either have negative lot value or external depreciation (type unspecified).

This cannot be described as economic depreciation, as the people living in these homes have equal access to the same employment as the individuals living 8 blocks away. The subject and nearby improvements can be in average or very good condition with little or no deferred maintainance, and no functional differences from the 'better area' fairly proximate homes.

There IS no highest and best use problem, the H&BU is 'as improved': the area is zoned residential and there is no current ecomomic reason to bulldoze the homes for alternate development. Sufficient nearby vacant ground appropraitely zoned exists for development.

So how SHOULD I describe this issue in the cost approach?

Regards,
Lee Ann

 

[KD247]

Lee Ann,

Here's my take on your situation:

Sales Comparison Analysis
Locational differences can't always be explained in politically correct terms. The best solution is to use only sales from the subject's immediate area (i.e. sales with the same market appeal as the subject).

With our recent spike in local property prices, we've seen completely illogical values when the market thinks one area is particularly "hot", even though there's no logical explanation for it. Sometimes the "hot" area is across the street from an area buyers aren't very interested in. In other markets the reverse situation can occur.

However, our job is to be analysts, not referees. If the data indicates the market prefers one area over another, our job is to record that, not to demonstrate why the market is "incorrect".

Highest and Best Use
There are two ways of analyzing highest-and-best use: 1) as if the site were vacant or 2) as the site is presently improved.

If the cost approach yields a zero or negative site value, the highest-and-best use may be as a vacant lot. However, the highest-and-best "as-improved" is probably the current use. Now that a home is built on the property, it usually wouldn't be economically efficient to remove the home to have a vacant lot.

Cost Approach
From your description, it sounds like the Cost Approach will not be heavily relied on in estimating the subject's value. You just want it to be consistent with the Sales Comparison Analysis.

Estimated-value minus physically-depreciated construction cost equals site value. If you come out with a zero or negative site value, I would look at other vacant land in the area. If owners of vacant lots are paying taxes on the lots, they must be worth "something". Make your best estimate, based on any listings, sales of tear-down houses, whatever's available.

After you've estimated the site value, any remaining discrepancy could be attributed to the improvements as Functional Obsolescence due to over-improvement.



So, here's what I would put in the report:

Neighborhood section
"The subject directly competes with homes only within its small neighborhood. Sales data shows that market response varies dramatically in nearby areas." (You don't have to mention that homes in the subject's immediate area have cars parked on the lawn and laundry hanging on the fence.)

Highest and Best Use As Improved
X Present Use
(I don't know if there's any obligation to report the highest-and-best use, as if vacant.)

Cost Approach (plug in your numbers):
Total Estimated Cost New $75,000
Physical Depreciation $35,000
Functional Obsolescence $20,000
Site Value $1,000
Indicated Value $21,000

"The market in this area will not return the full depreciated cost of the improvements, the difference attributed to Functional Obsolescence."


Thanks for the interesting problem - hope I've been clear in showing my approach. I'd be very interested in other approaches to this situation.

Koert

 

[Farm Gal]

Brad and Koert-
This thread seems to be attracting a lot of attention.

I agree that 'negative site value' (absent environmental or significant physical cleanup situations) is unlikely. Most vacant sites will eventualy be purchased by someone if only for a dollar at tax sale!

I will admit is has been many a year since my initial Appraisal Institute education in these basics, but despite every effort to continue that good start on my education I have never seen a really good answer for this problem. I do recall being taught that the methods I use today are acceptable.

I find the following definitions in my admittedly dated Dictionary of Real Estate Terms 1993, Appraisal Institute:

External Obsolescense (def.) "An element of accrued depreciation; a defect, usually incureable, caused by negative influences outside a site, and generally incureable on the part of the owner, landlord or tenant."
[Dictionary of Real Estate Terms 1993, Appraisal Institute]
While this can affect site values one has normally performed that portion of the calculation in H&BU processing. I agree that sometimes the best way to back into a site value if subtractive, but sometimes that doesn't work as in my example!

Externalities (def.)
" 1. The principle that economies outside a property have a positive effect on it's value while diseconomies outside a property have a negative effect upon it's value.
2. Costs or benefits accrueing to a property for which compensation or renumeration cannot be handled through normal contractual proceedures."
[Dictionary of Real Estate Terms 1993, Appriasal Institute]
This does apply, howver the residential reporting FORM doesn't let us use this exactly...

Functional Obsolescence (def.) "An element of accrued depreciation resulting from deficiencies or superadequacies in the structure' see also cureable functional obsolescense; incureable functional obsolescense.
[Dictionary of Real Estate Terms 1993, Appraisal Institute]

Somehow this does not clearly convey to me, the reader, that the negative value problem I have identified lies inside the boundaries of the lot, neither does it convey the idea that the site is responsible.

If you took that same improvement and physically removed it less than 1/4 mile away, it's value may double, without any further modification (possibly without painting the cracks from the move....)

Now when studying the above, along with the description of physical depreciation from that same source, I find no reason to place this 'significant negative impact on value due to location' found in certain sub-markets into either a 'negative' site value or into physical depreciation.

Perhaps in commercial application this might hold true and works according to theory along with sufficient supporting verbage, but I am a residential appraiser, and spend some time and effort in attempting to 'correctly' fill out the URAR, in which we get 3 itty bitty boxes, box #1 gets filled in based on effective life (or however else you chose to apply normal physical depreciation), box #2 is Functional, which can include 'physical cureable or physical incureable', and box #3 is External.

Barring external events such as nuclear waste, identified superfund sites, or visible evidence of problems I see no reason not to place an identified source of detriment to value into the 'external' box, Folks IT IS A FORM: supporting verbage needs to be put some place else than the 5 numerical slot available for this purpose.

I would be quite willing to review any identified relaible sources which point me in another direction, but would much prefer that the suggestion to seek those sources be placed with reasonable respect for my past effort and future intent to remain educated in my field.

Thank you,
Lee Ann

 

[KD247]

Lee Ann,

I sure like your passion and desire to do the job correctly! But, I don't think I've ever seen this issue thoroughly addressed by an expert. The problem of reconciling External Obsolescence is either a case where the philosophy isn't well thought out and no one is commenting on it (the emperor has no clothes), or else I am missing a major conceptual point. Pragmatically, the topic is of minor importance, so not many people care.

We do agree that the appraiser should note all the important value determinants. The problem is that the bundle of factors that make up a valuation problem doesn't always neatly "unbundle" into the spaces on the form. And it's worse for properties with personality.

I've reviewed many appraisals with e.g. "$10,000 for External Obsolescence due to proximity of freeway". I understand the point the appraiser is making, but I don't think that it's logically consistent through the Cost Approach. I've been asked by reviewers to include External Obsolescence for negative factors, but when I tell them that it's already considered in the site value, they're never quite sure how to handle it without misleading the reader regarding the contribution of the site.

Sometimes a look at an exaggerated example helps me to see through a problem: My house is located about six lots away from properties with similar improvements, except that those homes are worth about $500,000 more than mine because they are on the beach. In comparing them, exactly how much of the difference is attributable to each of the location, site, and view adjustments? Is any of the difference due to a negative aspect of my location because I'm closer to traffic noise? There's got to be more than one correct answer, but the important thing is that the problem is expressed in terms the reader is familiar with, and in terms that make logical sense.

In your case, I think Functional Obsolescence completes the puzzle. If the site's worth $1,000 and a new home sells for $50,000 then no builder is going to put up $75,000 in improvements. And if the market doesn't return the cost of the improvements, isn't that attributable to Functional Obsolescence? Maybe the economically optimal combination is a $20,000 modular home on that site, which would sell for $21,000. Anything more could be considered an over-improvement.

I just don't see anything in your example that doesn't fit into the Site Value and Functional Obsolescence boxes. Outside of the Sales Comparison Analysis, what difference does it make if homes are selling for more or less in a different part of town?

However, that External Depreciation box on the form does worry me a bit. I can't help but think that maybe I am missing something that can be explained by another appraiser. If someone can enlighten me, I'm all ears.

(And no, I don't make a fuss of this when I'm reviewing someone elses work!)

Koert

 

[bradellis]

Lee Ann,

Let's see if I can help. Please note that I am not only an instructor of this but also a fair housing advocate. Most recently I served on the Mortgage Credit Access Partnership in Chicago convened under the auspices of the Federal Reserve Bank of Chicago. These were also convened in Cleveland, Boston San Fran, and I believe St. Louis. I served on the steering committee, chaired their education committee, and am an instructor of Fair Lending for NAIFA.

By the way, I believe, but cannot prove it, that the change in the Competency Rule as regards geographic knowledge resulted, at least in part, from a request made by the Boston MCAP to have SPECIFIC LICENSING for inner city appraisers! When that got to Chicago, I screamed. I personally wrote the the ASB asking them to NOT do this. However, there is nothing wrong with requiring that the appraiser know his/her area- that part is inherent in competency. Hence, the change in the rule.

Now on to your dilemma. First, YES- using comps from the area will help you avoid a fair housing problem. It is not up to you to decide what buyers will pay and sellers will accept. It is your job to report and analyze their actions. Period. So, using comps from the immediate neighborhood will negate the need for a discussion on external obsolescence.

You seem to be concerned about the fact that land values are lower in these areas. I call them LMI areas (low and moderate income- since that is how the fair housing folks refer to them). But, this is not a problem.

While land does not depreciate (again, under current theory), this does not mean that land values cannot or do not vary from area to area- regardless of use. The LMI lot may be worth only $1000 while one on the city's "gold coast" may be worth half a million. Same size and style of home. So, if you choose your comps carefully- and from the immediate market area- you avoid the discussion altogether.

Brad Ellis, IFA

 

[Farm Gal]

Koert:

Yup passion and opinions - I got lots.... I am probably continueing to beat a very dead horse, but here goes:

Now with regard to your point that the 'value problem to be solved' can fit not so neatly into different spaces "on the FORM", we are in agreement.
(I am not sure that the emporor is wearing undies, and really should take a bit more care of those undergarmets, they are pretty ratty...) again we agree that it is the accompanying explanation which does not mislead the reader...

I am still of the opinion that those attributes which (key concept) exist outside the site effecting value are more appropriately placed into that box labled "external" ...

I agree that you can extract a site value, particularly in your market example, however in as much as possible I think one should label those factors which cause the value difference.... If one house has a partial view and the other has no access and if if if... an appraisal is a reporting of a value OPINION! How we report is a business decision based on cleint need: summarize or explain at great length. We get into the same issues on our rural properties where proximity to paved road, site topography, view, amenity etc are all part of the site value puzzle. Lenders really scream about smaller sites being given greater value as they call before they read the explanation....

A negative site valuein instances where the adjoining sites have demonstable positive (albeit nominal) value is certainly improper use of extraction. Similarly I find it more inappropriate to define the mentioned value loss as Functional Obsolescence: Superadequacy.

If the improvement can be physically moved such a short distance and regain the 'missing/lost' value, then the location in a sub-sub-area where externalities exist is the primary issue! Since the lot does not have a negative value (as demonstrated in the market), and the improvement does not have a huge issue, then I prefer to label the missing puzzle piece as external.

A wise mentor of mine used to say "You can't buy used paint". In the instance of repairs changes to a property's physical condition, if you are going to call for a fix to one small portion of a wall, or a broken tile (color obsolete) you have to do the whole job. Parting it out results in a glaring new spot amongst the old which made the entire 'fix' inappropriate and potentially of less value than it was 'as damaged'. I think that when you have an immaculate house surrounded by junk shacks, you have identifiable superadequacy. However, when you have a well maintained home, surrounded by equally, or at least 'average for the larger marketing area' well-maintained homes, and when finally, there is no other identifiable 'defect' you have external depreciation.

Anyone possssing other opinions please jump in as I am truely interested!