Functional Or External Obsolescence?

[Ken B]

Land is always valued at it's highest and best use. While the allocation method is a recognized method of estimating land value, it is often an arbitrary allocation, as appeared to be recognized in the preceding post. Given adequate land comparable land sales, in any reconciliation between the value indicated by allocation method and comparable sales approach, most consideration should be given the sales comparison approach.

If it is asserted that land value is substantially adversely affected by on-site conditions, specifically, an existing building, the adverse factor is located on-site. If correcting the adverse on-site condition (razing the improvements) corrects any adverse affect on the land value, that is not an externality.

 

[leasedfee]

Ken,
We agree with the first part. My original comment.

The land is valued at its H&BU in the cost approach.

It needn't be a residual approach. A sales comparison approach of the value attributable to the non-H&BU (in my example an office land comps). ((For descriptive purposes I like to use the language of residual as it attempts to explain that when I tenant pays their rent some is going towards the land and some is going towards the improvement.)) The challenge of course is that sometimes you won't find land sales of your non-H&BU in the subject neighborhood. Unless you feel comfortable expanding your search, you can look at it from both perspectives sales comparison or residual -- get's to the same place. The non-H&BU can only afford to pay for its use at its competitive rate so the residual will be the same or similar to where it is the H&BU.

Here is where we disagree. The diminution is external obsolescence and it predominately hits the land. The land's current useage is sub-optimal here, not the improvement. External obs can be temporary or permanent, or both. By saying that it is functional, you're saying that the building is flawed. It's not. We can see countless examples of smaller buildings that are in a dead-race against the H&BU. Theoretically they should be torn down in downtown cores or in the central/midtown sectors, but aren't. This can go on for a long time. The owners are squeezing out rents that are not H&BU waiting for the right timing, or for the right party with deeper pockets, or for the spread b/w non-H&BU and H&BU to be sufficient to take the risk of razing a known value (rent paying building) for a riskier value (H&BU land) that may not pay off immediately. Anyway, to cure the external obs, raze it. Here's the The Appraisal of Real Estate with my emphasis:

"Use That Is Not The Highest and Best Use:" "For certain sites the general category of highest and best use may have changed -- e.g., from apartment to industrial use or from one-unit residential to commercial use. If the improvements on these sites existed prior to the change in the market area, they from external obsolescence and are likely to have less value than similar improvements on more appropriate sites. . . . . Similarly, comparable rental properties ought to reflect or be adjusted to reflect similar deficiencies in location. The cost approach value indication would also be affected by external obsolescence" (TARE, 13th Ed., p. 293).​

 

[leasedfee]

Ken,
We agree with the first part. My original comment.

The land is valued at its H&BU in the cost approach.

Here's the The Appraisal of Real Estate with my emphasis:

"Use That Is Not The Highest and Best Use:" "For certain sites the general category of highest and best use may have changed -- e.g., from apartment to industrial use or from one-unit residential to commercial use. If the improvements on these sites existed prior to the change in the market area, they from external obsolescence and are likely to have less value than similar improvements on more appropriate sites. . . . . Similarly, comparable rental properties ought to reflect or be adjusted to reflect similar deficiencies in location. The cost approach value indication would also be affected by external obsolescence" (TARE, 13th Ed., p. 293).
​

To determine the non-H&BU land value, it needn't be a residual approach. A sales comparison approach of the value attributable to the non-H&BU (in my example an office land comps). ((For descriptive purposes I like to use the language of residual as it attempts to explain that when I tenant pays their rent some is going towards the land and some is going towards the improvement.)) The challenge of course is that sometimes you won't find land sales of your non-H&BU in the subject neighborhood so you have to feel comfortable expanding your search geography. You can look at it from both perspectives of the sales comparison or the residual -- get's to the same place if done correctly. The non-H&BU can only afford to pay for its use at its competitive rate so the residual will be the same or similar to where it is the H&BU.

The diminution is external obsolescence and it predominately hits the land. External obs can be temporary or permanent, or both. The land's current useage is sub-optimal here, not the improvement. Some small building improvements can actually be relocated to a more optimal site, because they retain value, so it is the site that is being changed, not the improvement.

By saying that it is functional, you're saying that the building is flawed. It's not. We can see countless examples of smaller buildings that are in a dead-race against the H&BU. Theoretically they should be torn down in downtown cores or in the central/midtown sectors, but aren't. This can go on for a long time. The owners are squeezing out rents that are not H&BU waiting for the right timing, or for the right party with deeper pockets, or for the spread b/w non-H&BU and H&BU to be sufficient to take the risk of razing a known value (rent paying building) for a riskier value (H&BU land) that may not pay off immediately. Anyway, to cure the external obs, raze it.

 

[Ken B]

My hard copy 13th Edition is at work. However, I have the 14th Edition in searchable PDF format on my computer. I can't find the language quoted as being on page 293 anywhere within the 14th Edition. However, I think the following extracts from the 14th Edition are pertinent:

The principle of consistent use holds that land cannot be valued based on one use while improvements are valued based on another. An improved site is always valued as though vacant and available for its highest and best use. Existing improvements that do not conform with the ideal improvement may be an interim use (i.e., not the highest and best use) that contributes some value or no value or even reduces value if the costs to remove the improvements are substantial. p.345

An interim use may or may not contribute to value until the highest and best use of the property can be achieved. If an old building or other use cannot produce gross revenues that exceed reasonable operating
expenses, it does not contribute to property value. Many outmoded improvements clearly do not resemble the ideal improvement, but they do create increments of value over the value of the vacant land. If the net return of the property as improved is less than the amount that could be earned by the vacant land, the improvements do not have contributory value (although some property owners may understandably prefer to retain the structure—e.g., a single-family dwelling on commercial land in transition—rather than leave the land vacant). Indeed, the value of an improved property may be less than the value of the land as though vacant when demolition costs and real estate taxes are considered. The market value of the land is based entirely on its highest and best use. At the same time, the interim use may have value to the property user to the extent that the income generated by the improvements defrays the costs of carrying the property and the cost of demolishing the improvements. p. 345

The principle of balance also holds that both the relationship between land and improvements and the relationship between a property and its environment must be in balance for a property to achieve its
optimum market value. For example, a property that has too much land in relation to its improvements (known as an underimprovement) or too many expensive amenities for its location (known as an overimprovement)
is out of balance. Appraisers must watch for imbalances in the market and within specific properties because those imbalances can cause the market to ascribe different prices to otherwise comparable
properties. Overimprovements and underimprovements can lead to functional obsolescence that may need to be accounted for in sales comparison, income capitalization, and cost approach analyses, but
differently in each approach. p. 379

In the application of the cost approach, the amount each component contributes to the value of the property as a whole is measured in relation to the highest and best use of the property. For example, if the highest and best use of the property is for the conversion of the existing improvements to an alternative use, items that must be changed for the property to achieve its highest and best use would suffer from some form of depreciation. In the cost approach, the effect on value of a deficiency or superadequacy is addressed in the estimate of a form of depreciation known as functional obsolescence. The deficiency or superadequacy can be
identified by comparing the existing improvements with the ideal improvement and then treated by making a deduction from the cost of the improvements. As the improvements depreciate, the site often contributes
a higher percentage of total property value. As the ratio of land value to total property value approaches 100%, the likelihood that the improvements will be demolished or remodeled and that the property will be redeveloped to a new highest and best use increases. p. 564 - 565

Gains or losses in value caused by externalities may accrue to the land, the site, the building, or the property as a whole. Rising construction costs can significantly affect the market value of new construction and, in turn, the demand for and market value of older, substitute properties. In the cost approach, a loss in building value due to external causes is attributed to external obsolescence, which is covered in detail in Chapter 29. Externalities can be temporary and may work in positive and negative directions over the life of a building improvement. p. 565

Depreciation in an improvement can result from three major causes operating separately or in combination:
• wear and tear from regular use, the impact of the elements, or damage, which is known as physical deterioration and may be curable or incurable
• a flaw in the structure, materials, or design that diminishes the function, utility, and value of the improvement, which is known as functional obsolescence and again may be curable or incurable
• a temporary or permanent impairment of the utility or salability of an improvement or property due to negative influences outside the property, which is known as external obsolescence and is incurable p. 576

The test of curability is a straightforward comparison:
• Items of physical deterioration or functional obsolescence are economically feasible to cure if the cost to
cure is equal to or less than the anticipated increase in the value of the property.
• If the cost to cure is more than the anticipated increase in value, the item is incurable. p.599

Functional obsolescence is caused by a flaw in the structure, materials, or design of an improvement when the improvement is compared with the highest and best use p. 623

Functional obsolescence is attributable to defects within the property lines, in contrast to external obsolescence, which involves conditions outside the property lines and therefore outside the control of the
owner and occupants. p. 623

Types of Functional Obsolescence: A curable deficiency requiring substitution or modernization is caused by something substitution or modernization that is present in the subject property but is either substandard compared to other properties on the market or is defective and thereby prevents some other component or system in the property from working properly. The measure is the excess cost to cure. In addition, the depreciated or remaining cost of the existing item, which is now worthless, must be deducted. p. 624

External obsolescence is a loss in value caused by negative externalities, i.e., factors outside a property. It is almost always incurable...External obsolescence usually has a marketwide effect and influences a whole class of properties, rather than just a single property. However, external obsolescence may affect only one property when its cause is location—e.g., proximity to negative environmental factors or the absence of zoning and land use controls. In fact, the causes of external obsolescence can be broadly characterized as either market obsolescence or locational obsolescence. p. 632 - 633

The effect of external factors on the current land value is not external obsolescence in the strictest sense but
rather simply the operation of market forces on the value of the land. External obsolescence, therefore, is specifically the loss in value attributed to external influences allocated to the building improvements. p. 633

Figure 29.7 illustrates various ways in which loss in value due to external influences on a property could be allocated between the land and building components. p. 633

In Column C, the value is still $80, but the land value increases from $30 to $50. In this case, the building is worth $30, i.e., the loss to the building is $40, which is more than the $20 loss in value to the property as a whole. This sort of loss is often an indication of a change in highest and best use, with part of the $40 loss in building value being additional functional obsolescence. Column C could represent the change in value
of a single property over time (with the land value rising as building value drops), or it could represent a comparison between one property with no value loss due to external factors and a comparable property
with a higher land value but some other external issue causing depreciation of the building improvements. P. 633 - 634



In the above chart, it should be understood that what is being demonstrated is how externalities affect either/or land and building. In Column C, land value is increasing, which is acknowledged to be an indication of a change in highest and best use. Although there is some factor other than the change in highest and best use at work, it is acknowledged that part of the loss in building value is attributable to additional functional obsolescence. The loss from functional obsolescence is attributable to a building design which no longer represents a design consistent with the perfect improvement. The existing design may be perfect for some use. But the test of functionality is not that the building may be perfectly designed to perform some use, but that the building is perfectly designed to support the highest and best use of the property.

A building could be brand new and perfectly designed to perform some use. But if that use does not represent the highest and best use, the defect is in the building and the defect is functional.

 

[Terrel L. Shields]

Land is always valued at it's highest and best use

Not by the assessor and many appraisers... I was looking at a small older community and the land value by the assessor depended upon the age of the dwelling and whether it was a manufactured home, small older house, or a newer house... With that hat trick you never have to deal with functional obsolescence

 

[George Hatch]

The problem is that the existing improvements - on that site - have exceeded their economic lifespan. There may *also* be some obsolescence in the design or configuration and there may also be some physical depreciation, but (IMO) if those improvements would be functional most anywhere else then (IMO) it comes back to the economics of effect on that site.


When they level a 5000 room hotel on the Las Vegas Strip that's only 15 years old in favor of redeveloping the site with a 15,000 room hotel that's not the result of a design problem with the original structure; it's a result of the external economic conditions changing.

 

[Ken B]

The problem is that the existing improvements - on that site - have exceeded their economic lifespan. There may *also* be some obsolescence in the design or configuration and there may also be some physical depreciation, but (IMO) if those improvements would be functional most anywhere else then (IMO) it comes back to the economics of effect on that site.


When they level a 5000 room hotel on the Las Vegas Strip that's only 15 years old in favor of redeveloping the site with a 15,000 room hotel that's not the result of a design problem with the original structure; it's a result of the external economic conditions changing.

The highest and best use of a property may change due changes inarket conditions or demands, but the defect is on site. If the cost to correct the defect involves demolition of an existing structure, that is something an owner can do within the boundaries of the property. If the roof of a warehouse needs to be raised due to changing market requirements, that is something an owner can do on site. Highest and best use regards the use of the property. An owner has total control of the property with regard to a property's existing use compared to its highest and best use.

 

[Gobears81]

The highest and best use of a property may change due changes inarket conditions or demands, but the defect is on site. If the cost to correct the defect involves demolition of an existing structure, that is something an owner can do within the boundaries of the property. If the roof of a warehouse needs to be raised due to changing market requirements, that is something an owner can do on site. Highest and best use regards the use of the property. An owner has total control of the property with regard to a property's existing use compared to its highest and best use.

I know this has been centered on the market being so great, but what is the primary difference between that and locational obsolescence in your opinion. An example I was given of locational obsolescence is living next to a garbage dump. Assuming that there are other viable uses for that site, the highest and best use as vacant is different than the current use, so the defect is also on the site. What's the difference between that and say a retail property that is on an interior street (which could be a functionally deficient site for the use and probably treated as functional obsolescence)?

Just a disclaimer that I was taught that your example is a pretty textbook method of functional obsolescence, but I appreciate the arguments for external obsolescence.

 

[Ken B]

In the general context of the discussion, I think the primary consideration is whether or not changes in highest and best use result in an over improvement or underimprovement of an existing improvements compared to the perfect improvement.

 

[Gobears81]

I don't disagree with that, but whether or not the highest and best use was ever consistent with the current use isn't entirely relevant to the future. In my example, maybe a garbage dump came in after the adjoining property was already constructed, or maybe the adjoining property owner made a bad decision to go there. In this case, assuming another use is viable, you could look at it as functional, due to the current improvement not being consistent with the highest and best use, or you could look at it as locational obsolescence, due to the adjoining garbage dump resulting in value declines.