Functional Or External Obsolescence

[NachoPerito]

"External obsolescence - A temporary or permanent impairment of the utility or salability of an improvement or property due to negative influences outside the property (External obsolescence may result fro adverse market conditions. Because of its fixed location, real estate is subject to external influences that usually cannot be controlled by the property owner, landlord, or tenant)" - The Appraisal of Real Estate 13th Ed.

I modify my previous statement, Pretty clear that this is considered external obsolescence.

 

[Lucidity]

most importantly that it is feasible to construct a sixplex in the market. If it is in fact feasible, the site is now super-adequate for the use, which is a functional issue.

I don't think our answers contradict the other but I do think we are looking at it from different perspectives, have semantic differences and are re-arranging the timeline.

My understanding is that the pivot difference is what came first the chicken or the egg, or rather were the improvements in line with the highest and best use of the site at the time of construction and than the dynamic changed or were they constructed on a site that should have been developed to a use that was more productive/maximally productive. The former is external and the latter is functional.

It might be feasible, but not maximally productive and suffers the opportunity cost, which is synonymous with the obsolescence.

I hesitate to give an example because then there will be plenty of what if's, but look at it for it's point.

apartment across town produces $100 income covering all operating cost (for land and building) of which $15 is attributable to the land rent.

Apartment in situation similar to mine also produces $100 in income covering all operating cost (for land and building), still feasible. But if the site was developed to it's highest and best use, it should be credited or rather should rent for $50/land rent in income. The building therefore only contributes the equivalent value to $50 in income as opposed to $85.

I liken these situations to an acre of land with oil underneath it. If it has the potential to produce 100 gallons but you put a pump on it that pulls 50 gallons, where is the fault? It is the improvement that didn't maximize the potential of the site, and therefore in this situation a function issue.

 

[Michigan CG]

The current improvements aren't maximally productive so I am on the functional side of the argument.

 

[hastalavista]

Why? Take an opposite situation than what this case sounds like and say that someone made a bad decision of constructing something several years ago, yet for whatever reason, something has changed which results in this somehow becoming an ideal improvement on the site. In that example, what does it matter that it was a bad decision before? Should we allow that to change how we analyze the property with a current effective date?

In the above example, there is no obsolescence present. That isn't the same as the OP where there is obsolescence present.
Since in the OP's scenario, there is obsolescence present, the question is, is it external or functional?
To determine if it is functional, one has to determine if the obsolescence is related to what is happening at the property. Was it built as something it shouldn't have been, or what exists is correct but the market expectations of that improvement have changed?
To determine if it is external, one has to determine if the obsolescence is related to what is happening outside of the property. It was built correctly at the time and remains correct for that initial use, but conditions external to the property have changed.

And, it is possible to have both external and functional obsolescence; it was and continues to be the wrong improvement (should have been a warehouse) and now the external conditions have changed (now it should be retail).

If the question is about identifying what type of obsolescence exists, then one must test for each type of obsolescence to identify the obsolescence, no?

The OP correctly (IMO) determined the obsolescence is external. And to support that conclusion, the OP determined that H&BU in the beginning and up to the new freeway link was as-improved. Since the freeway link, the H&BU has changed due to the externality.
Both types of obsolescence were tested and the one that passed the test is the one that is identified.

I think your point (which I don't disagree with) is, "Is such testing really necessary?" Many times, no. Sometimes, yes.

 

[Gobears81]

In the above example, there is no obsolescence present. That isn't the same as the OP where there is obsolescence present.
Since in the OP's scenario, there is obsolescence present, the question is, is it external or functional?
To determine if it is functional, one has to determine if the obsolescence is related to what is happening at the property. Was it built as something it shouldn't have been, or what exists is correct but the market expectations of that improvement have changed?
To determine if it is external, one has to determine if the obsolescence is related to what is happening outside of the property. It was built correctly at the time and remains correct for that initial use, but conditions external to the property have changed.

And, it is possible to have both external and functional obsolescence; it was and continues to be the wrong improvement (should have been a warehouse) and now the external conditions have changed (now it should be retail).

If the question is about identifying what type of obsolescence exists, then one must test for each type of obsolescence to identify the obsolescence, no?

The OP correctly (IMO) determined the obsolescence is external. And to support that conclusion, the OP determined that H&BU in the beginning and up to the new freeway link was as-improved. Since the freeway link, the H&BU has changed due to the externality.
Both types of obsolescence were tested and the one that passed the test is the one that is identified.

I think your point (which I don't disagree with) is, "Is such testing really necessary?" Many times, no. Sometimes, yes.

So what would happen if the developer made a poor choice to build apartments on this site today? Would that be regarded as functional, due to a poor builder's decision? I don't want to put words in your mouth, especially since we don't agree on this issue, but past changes are not a litmus test for economic obs. vs functional. It sounds like this property is fairly new, but what about older properties where there have been all kinds of externalities and shifts in HBU taking place? Your assertion that there could be functional and economic in those cases would probably be relevant in the aforementioned question, but I think that where we differ is based on knowing the back story. My opinion is that:
Functional: Multi-family is feasible for development in this market (with the delineated market area having some bearing here, of course), so moving one site over from Primo Road A to the interior street results in feasibility for development. Site specific problem.
Economic: Multi-family is not feasible for this market. If you build on the interior street, it isn't feasible, which results in a market-specific deficiency. Move back from the interior street to Primo Road A and then you have economic AND functional obsolescence, due to it not only being a market-specific issue but a site-specific issue. If in this example, you do a depreciated cost analysis on the two sites, the one with the higher land value also has the higher obsolescence. But why would economic obsolescence that is externalities have a higher obsolescence for the property with the higher land value if that doesn't increase the overall value?

In either test shown above, you do not need to know the thought process of the developer, the feasibility at the time of development, or what the highest and best use was 10-years ago or 100-years ago.

 

[hastalavista]

So what would happen if the developer made a poor choice to build apartments on this site today? Would that be regarded as functional, due to a poor builder's decision?

Yes, it would be considered functional if the H&BU were retail/commercial.

I don't want to put words in your mouth, especially since we don't agree on this issue, but past changes are not a litmus test for economic obs. vs functional. It sounds like this property is fairly new, but what about older properties where there have been all kinds of externalities and shifts in HBU taking place? Your assertion that there could be functional and economic in those cases would probably be relevant in the aforementioned question, but I think that where we differ is based on knowing the back story.

Let's put it this way; assume that improvement was built 6 months before the freeway extension was announced and at that time, its H&BU was multifamily. It takes 3 years to build out the freeway offramp. It takes another 2 years for the land use to change to a H&BU of commercial/retail.
Our hypothetical subject is 5.5 years old.
Is the obsolescence external or functional? I say it is external because an external factor changed the H&BU and therefore created obsolescence.

I said-

I think your point (which I don't disagree with) is, "Is such testing really necessary?" Many times, no. Sometimes, yes.

In my above 5.5 year lifespan of the multifamily building, if one didn't look to see what the H&BU was at the time of the improvement's development, one cannot determine if the obsolescence is functional or external; ergo, the bolded part in my self-quote.

 

[Gobears81]

Yes, it would be considered functional if the H&BU were retail/commercial.

And I agree with that. But if I understand your thought process correctly, a problem is longer passages of time. 5.5-years is new enough to understand the back story, but 100-years is not. Using a 100-year-old building as an example would understandably invoke eye rolls, but longer passages of time are a limitation of this thought process.

What are your thoughts on the example I gave of the two sites and market-based economic obsolescence? The total value would be the same on both, yet obsolescence on the site placed on the higher-traffic thoroughfare would be higher than the identical property one site over on the interior street? We could have a property with identical utility for much cheaper, yet both are not feasible, so that suggests economic and functional to me. For that example, I would probably analyze obsolescence in the following manner:

Economic: Some variant of a capitalized or discounted deficit NOI derived from the equilibrium NOI (ie feasible at $10,000 NOI per unit, market is $8,000 NOI per unit, thus capitalize/discount $2,000 NOI/ unit)
Functional: Difference in land values between current land value on Road A and land value on interior street

Thus, if multi-family is feasible in this market, regardless of the feasibility at the time of development or the thought process of the developer, I will still treat that difference in land values for the site on Road A vs the adjoining site on the interior street as functional, only economic obsolescence would go away

 

[hastalavista]

A 100-year retrospective H&BU analysis wouldn't be practical or necessary; so I agree with you there.
To be clear, my point is that if there is a question between identifying obsolescence as functional or external, then both conditions need to be tested. The reason why it would be important to do so is to ensure that if the obsolescence needs to be accounted for in one of the approaches (SCA, for example) then it should be allocated to the correct element of comparison. If the question is important and affects how the property is valued/analyzed, then it takes on significance. As Terrel likes to point out (correctly) the USPAP doesn't require depreciation to be separated and identified; it just requires that all forms be considered when part of the analysis-process (it uses the term "accrued appreciation").

Functional: Multi-family is feasible for development in this market (with the delineated market area having some bearing here, of course), so moving one site over from Primo Road A to the interior street results in feasibility for development. Site specific problem.
Economic: Multi-family is not feasible for this market. If you build on the interior street, it isn't feasible, which results in a market-specific deficiency. Move back from the interior street to Primo Road A and then you have economic AND functional obsolescence, due to it not only being a market-specific issue but a site-specific issue. If in this example, you do a depreciated cost analysis on the two sites, the one with the higher land value also has the higher obsolescence. But why would economic obsolescence that is externalities have a higher obsolescence for the property with the higher land value if that doesn't increase the overall value?

I'm having difficulty following the example.
We are building the same apartment, so costs to construct (all-in costs) are the same.
But Primo Rd A is more valuable than Interior Rd (right?).
Primo Rd A, to be more valuable for a multifamily use, must generate more income; otherwise, it wouldn't be more valuable than Interior Rd.

(What am I missing?)

 

[Gobears81]

I'm having difficulty following the example.
We are building the same apartment, so costs to construct (all-in costs) are the same.
But Primo Rd A is more valuable than Interior Rd (right?).
Primo Rd A, to be more valuable for a multifamily use, must generate more income; otherwise, it wouldn't be more valuable than Interior Rd.

(What am I missing?)

I had a feeling that my example wasn't overly clear, so I'll give some numbers. But, my bold is exactly what makes this case functional IMO. Here goes with numbers:

6-unit Property #1 located on Interior Road:
Cost to construct (as of today): $600,000
Land value: $100,000
Physical depreciation: 10%

Identical 6-unit Property #2 located one site over on Primo Road A:
Cost to construct (as of today): $600,000
Land value: $300,000
Physical depreciation: 10%

Now, let's say that NOI per unit for both properties is $6,000, with a cap rate of 7%. This indicates that the value is $514,286 before rounding (for both properties). This indicates that Property #1 on Interior Road has economic obsolescence somewhere in the vicinity of $125,714.
Property #2...is the market or economic conditions any worse than Property #1? No, but there is more depreciation that I think we both agree is site-specific. I still recognize $125,714 for economic obsolescence to Property #2. But, I also recognize the difference of $200,000 as functional obsolescence, due to the value not being any higher for either property.
If the market changes overnight and it suddenly becomes feasible to construct MF again, the value of both properties is $640,000. Since Property #2 has the wrong use for the site, which is again, site specific, and there is nothing wrong with the market, $200,000 would still be recognized as functional obsolescence for this property.

I actually feel that this case is more cut and dry than Terrel's example where it was feasible to build a higher priced house a mere 20-miles away...but I have a feeling that we are respectfully coming to an armistice

 

[Lucidity]

But why would economic obsolescence that is externalities have a higher obsolescence for the property with the higher land value if that doesn't increase the overall value?

If I'm following your point correctly let me break it down this way. I'll expand on a previous point. Income equals value, cap rate 100%. Values is in gallons of oil.
Issue=imbalance between the land and impr H&B Use.

You have a site that has 1,000 gallons under the surface and you develop it with an oil pump that has the capacity to extract 500 gallons. Your improvements have a functional issue and the origin of the issue was the functionality starting with the design and construction of the improvements.

Now you have another site that has 500 gallons of oil under the surface and you develop it with an oil pump that can extract 500 gallons. But months after this oil pump is constructed and oil is about to start extracting oil an earthquake with an epicenter 100 yards west happens, creates fissure that allows 500 more gallons of oil to flow into the space below this site. Yes, the existing pump now has a functional issue, but was that caused by design at the time of construction or was that caused by an external factor?

Aren't we getting lost in semantics? In the example above, what would be different in the math and the subsequent result between categorization as either functional and external?

Think through the distinguishing cause and effects. Your example of the lots, one on the main road and one off of the main road, what is the origin of the issue, it was when you develop the same improvements on both, so yes, your example speaks to functional issues.

Pivot point in simple form, was the issue caused before/at the time of improvement construction or was it created after, in relationship to the influence of external forces, and assuming no shift in market preference of improvement design?