External depreciation

[Austin]

I got my class manual out on Economic obsolescence that I got when I took the class from Dr. William Kinnard about 12 years ago. The last time I posted above on this subject this book was at the office, so I took it home to use, now I am at the office.
He said a number of things that may be of interest on this subject, but he said that location was a form of external obsolescence as some one above stated. I beg to differ on the following grounds: When you say there is external obsolescence in a residential property due to location, here is what you run into. Lets say there are three subdivisions. A is one mile from the Mall, B is 5 miles from the Mall, and C is 10 miles from the Mall. All subdivisions are identical in quality, design, and appeal. Lets say it can be shown that there is a $5,000 average price difference between each subdivision depending on distance from the Mall. Lets say we are appraising a house in subdivision C. We do the cost approach and extract all depreciation elements from the subject subdivision C as well as site value. In this case, there is no locational obsolescence included because all of the data was from the same subdivision.
Now we perform the sales comparison approach and used sales from subdivisions A & B with the subject in C. Now we have location adjustments of $5,000 and $10,000. If the houses were identical it would appear that the locational obsolescence is in the land. If I remember correctly, Kinnard said external obsolescence was always in the improvements. That being the case, locational differences are not forms of obsolescence but differences in time-distance relationships and totally a different factor. You can’t build locational obsolescence into the house but if it exist, it musts be in the site value. If locational obsolescence exists at all, then what is the bench market against which it is measured?
In summary, if we say that locational obsolescence exists in the subject property, then what is the benchmark against which you are making the measurement and is it attributal to the land or building?

 

[Farm Gal]

Dear Austin:
When I stirred up this can of worms, I was responding to a plea for a 'real example' of External Depreciation....

If you follow the above thread: I indicated that in my very specific example, the lot value is currently somewhere around $500 or maybe a thousand dollars 'as vacant', as indicated by the market.... We then apply your example of having again 'found in the market' $5,000 or $10,000 value difference between the fairly proximate subdivisions, which subdivisions have otherwise reasonably similar access to all usual amenities an no specific 'cause' for the value difference other than buyer perception, and find that unless you apportion the negative influence to the improvement in the cost approach, you would have a "negative site value" ... Since the negative site value is disproved in the market, you CANNOT subtract that $10,000 from a site already valued at $500.
THUS IN MY OPINION
you must put the observed value difference somewhere, and for reasons sporadiccly indicated through out this thread, I elect to call it External Depreciation.

Koert: The horse still whinneys (or wheezes)

In some areas where the land values are higher and you must first determine the site value 'as vacant' and then work throught he cost approach with a different view and a tad more value in the site, I agree that you might be able to 'sort of' 'kind of' call the thing Functionally Obsolete, or Superadequate, HOWEVER by reading the above definitions and applying them to my very specific example, I beleive that you CANNOT call the aged but well maintained improvement itself superadequate. Again the proof of the improvements value TO THE LAND is that if you lift it off the site, it has more value than on the site, and the site does not in and of itself possess a negative value.

You must explain the existance of a difference between what is indicated in the market for the subject and similar homes in the immediate vicinity and the homes in similar but less proximate areas subject to all other external environmental influences, except the specific subdivision where they sit.

This slight muddying of the water between the cost approach and the market approach gave me FITS when I was taking my initial appraisal classes, as it is specifically contradictory to what you THOUGHT you were doing: two entirely separate approaches to value. They aren't entirely pure!

 

[KD247]

Austin,

Sounds like you and I are on the same wavelength. I still haven't seen an example of External Obsolescence that doesn't require the arbitrary benchmark you describe. Every example so far seems to require that the subject property is viewed relative to another area or another time period.

At what point is external obsolescence differentiated from all other locational attributes? At the moment, I'm appraising a high-value sale that is across the street from a public park, which is often crowded and noisy. Is this property worth significantly less than a similar property without the park influence? Sure.

But, for this property, there are probably five or six important value determinants that are due to the property's location. Some are positive influences, some are negative. If the park's presence has a negative impact on the value of the improvements, wouldn't it be consistent to say that the proximity of the beach has a positive impact on the value of the improvements? I don't think so. I think they are all wrapped up in the land value.

I'm still willing to offer my wife's dog as a prize to the first person to provide an example of external obsolescence that impacts the improvements. At the moment, she's outside barking at the mailman and doing her best to completely destroy the image I try to create over the phone. Meanwhile, my dog is sitting by my side trying to make up for the other dog's behavior.

 

[KD247]

Lee Ann,

You're making your point well, and I think that your example is the best one possible.

But, if your subject site was vacant, what could you economically build on it?

If the answer is "nothing", then the site's highest and best use is vacant and it truly has no value as a residential site (although it still might have some sort of speculative market value).

If the financially maximal structure is anything less than the existing improvements, the difference in construction costs can be attributed to functional obsolescence.

Your improvements add some value to the property, but the market doesn't return the full depreciated cost of the improvements. That sounds like Functional Obsolescence to me.

 

[Tom Hildebrandt]

Koert

Thought I had already won the dog!.

Several of the posts are saying the same thing, but mixing terms.

Externalities would include factors that usually impact both land and improvements. They must be derived by factors originating outside the subject property. They could be economic (plant closings or condemnation blight), they could be physical (the construction of a new industrial plant in a neighborhood) or they could be social or governmental (rezoning or historic overlay districts or wetlands designations). Sometimes, more often than not, they are rather temporary in nature. Generally, they are not cureable. To determine allocation between land and improvements, some pretty esoteric assumptions are made, usually involving some sort of residual techniques.

However, most assignments do not require this kind of allocation breakout. You can just derive a value unimpaired (reconciling normal data) and then apply the total externality to the unimpaired value giving the impaired value.

External obscolescence is depeciation caused by externalities and it is defined as the amount of deprecition left over after physical and functional obscolescence are removed. Since this is depreciation, it is applied in the cost approach to the improvements. If an adjustment is required in the land values, it is treated as a separate adjustment under an appropriate adjustment heading. The combined value of the two would then equal the entire loss due to the externality.

In the sales approach, you could apply the entire adjustment for the externality under one heading or also break it out. Your choice so long as it is explained.

How you do it is pretty well explained in the AI The Appraisal of Real Estate 11th edition in Chapter 17. Unless you do this kind of detailed analysis regularly, you need to sit down and read the whole concept of depreciation, externalities, and think through the whole problem before you really get going because you will only confuse yourself otherwise.

About a year ago I had such an issue, after pondering these imponderables for about 4 hours on my own I got hopelessly confused as to the methodology and the reasonableness of my results. I then went to several other appraisers and after keeping them from doing their paying work for about an hour and a half we came to a consensus as to what was a reasonable and appropriate solution.

You are right that the sales approach and the cost approach provide circular logic in these cases because our methodology often relies on the one approach providing the answer for the second approach. But that is the nature of our business, lots of opinions with not such great techniques to try to explain what is sometimes irrational behavior.

Say, is a dead horse an externality or a form of functional obsolescence?

Regards

Tom Hildebrandt GAA

 

[Farm Gal]

Functional obsolescence.

Dead horse's ability to provide value is strictly limited to salvage return, and it is no longer returning value according to the design features inherent in the 'normal protype (live horse).

It is only an externality if it croaks on your neighbors front porch and is left there over the summer.

 

[Austin]

Koert and others: Some times when I have a difficult problem, I sit down to the computer and start writing and somewhere in the process the spirit guides me in the right direction, so here goes. I hope the spirit is present tonight. I think this all has to do with highest and best, and land to building ratios. For example, in any market a particular dwelling, in order to maximize profit (maximumly feasible) has to have the correct balance between building and site value resulting in the land to value ratio that maximizes profit. Theoretically, the cost of the improvement should be the same on any lot, but profit is maximized at some land to value ratio for each dwelling style or type. If the land component ratio is too high, that indicates a different highest and best use trend and the same for a low land to improvement ratio. If the average price for a particular type dwelling is represented by a trend line for that type property, then any deviation from the land to value ratio in either direction, must be reflected in the improvements because highest and best use is changing at each different site value. This is the benchmark we have been searching for.
Location is thus a different ball of wax, because location affects highest and best use. The land to value ratio that maximizes profit in one location can be different from another location. This implies different market characteristics, which indicates higher or lower demand intensity in one location versus another. In summary, when me make location adjustments, we are comparing market demand factors and not properties. For example, if you took a dwelling with so called locational obsolescence in the dwelling, and moved it to an area with a superior location, the obsolescence would be removed. That being the case, how can the obsolescence be in the improvement? It must be in the old location with its land to value ratio relationship to highest and best use.
If you take a particular style dwelling in a market and graph the profit on the Y-axis and land to value ratio on the X-axis, then each style/size dwelling’s price graph should be a bell curve with the peak at the point of maximum profit margin. Again, move away from the land to value ratio that maximizes profit and the highest and best use changes for the site. That is the source of obsolescence and that indicates to me that the external obsolescence due to location actually is a highest and best use factor and the location factor comes into play due to different highest best uses dictated by the market forces deriving from the different market influences in the different locations. I was taught that location related to time-distance to most traveled places. That appears to be true, but it is not driving time that causes the difference, it is the different chemistry of supply and demand of the two competing locations.
The type or name we give certain forms of obsolescence, economic or functional, appears to me to also relate to the land to value ratio/highest and best use conceps. For example, if a single-family neighborhood is in transition to multi-family, the land value raises, the value of the single-family residential houses drops, so there is functional obsolescence in the dwelling. If an industrial park moves close to a residential neighborhood and average dwelling prices drop, then the allocation of economic obsolescence would be in the dwelling if site values rise or fall because one way or the other, highest and best use is changing due to the land to value ratio. When the site value exceeds the value as improved, the dwelling is fully depreciated regardless of the form of external obsolescence.
Koert wanted an example of external obsolescence allocated only to the dwelling, and in my opinion ever instance is attributable to the dwelling.
Put that in your pipe and smoke it for a while, then see what the spirit tells you.

 

[Lee SW IL]

MAN, OH MAN. This thread is a keeper, I have printed all for future use. What GREAT replys. THANK YOU, THANK YOU, THANK YOU TO ALL.

I really think we should get some continuing ed for being members of this forum. I have learned a tremendous amount from this forum.


Thanks again.

Lee SW IL

 

[KD247]

Lee,
Please don't use this thread against me in court someday! I can practically hear the opposing council saying "Sir, is it true that you don't believe in the commonly accepted concept of external obsolescence as a form of depreciation?"

I get a laugh out of the fact that this was posted in the Urgent forum. Good thing we're not emergency room doctors debating different treatments!

Austin,
Keep talking like that, and people are going to get the impression that appraising isn't an exact science!

I thought we were seeing the issue from the same perspective when you earlier said "...if it (locational obsolescence) exists, it musts be in the site value." Now I'm not so sure.

The spirit is telling me to go to bed... oh wait, that's my wife.
Koert

 

[Austin]

Koert: My book on economic obsolescence and I finally caught up. I am quoting from a course manual titled “The Challenge of Measuring Economic Obsolescence” by Dr. William N. Kinnard, Jr,, and Gail L. Beron MAI.
I don’t have time to go into detail but here are some interesting quotes from their definitions.:
“Accrued Depreciation (diminished utility): Total depreciation from all sources, measured as the difference between reproduction cost new of the improvements and the present worth of those improvements as of the date of appraisal.”
Comment: Notice the use of the “reproduction” cost, and also notice that he never mentions site value. He goes on to give definitions of external, location, and economic obsolescence, and in each it is “diminished utility from cost new of a structure” with never a mention of site value.
Then he goes on to say some very significant things under his definition of replacement cost new: “The use of the replacement cost concept presumably eliminates virtually all functional obsolescence, and the only significant depreciation to be measured is physical deterioration and external obsolescence. (Replacement of space, capacity.)” My comment on that is that if replacement cost new can remove all forms of functional obsolescence, isn’t he saying the same thing I said above. Replacement cost versus reproduction costs reflects a new highest and best use and although the capacity is the same, the functional utility is different using replacement costs. Even in buildings with the same capacity/design/style, if the site value goes up or down, the highest and best use changes to reflect quality of construction if nothing else to maintain the land to building ratio at the point of maximum profit.
PS: Koert: Locational obsolescence is in the site, but it apparently manifest its presence by changing the highest and best use which is reflected in the diminished building value. Or so it would seem.
I will read the book tonight when I have time and see what else I can glean to add to this discussion.