Calculating Economically Feasible Rent Levels
In my previous post, I discussed the task of quantifying economic obsolescence or benefit that affects real estate. As I noted, the first step to evaluate the impact is to calculate the level of rent at which development of specific property types is financially feasible. Doing this requires knowing certain variables such as land value, projected construction costs, projected expenses, entrepreneurial incentive, current capitalization rates, etc. Armed with this information, the chart below demonstrates the method for calculating a financially feasible rent level for a hypothetical 10,000 square foot office building:
As calculated in this chart, the rent level at which hypothetical office building is $18.00 per square foot. Now suppose that the office building being appraised has the following cash flows:
With this information, the total depreciation affecting the subject property may be calculated by capitalizing the difference in the feasible rent level and the actual rent for the subject property as follows:
Now that we have a figure for the total depreciation affecting the subject property, the economic obsolescence may be calculated by inference. Using the Breakdown Method of depreciation in the cost approach, other forms of depreciation are accounted for separately. These include deferred maintenance, short-lived depreciation, long-lived depreciation, and functional obsolescence. And here’s the key to using this method to calculate economic obsolescence. Once other forms of depreciation are accounted for, the difference may be attributed to economic obsolescence, or benefit. This is, in my opinion, the best method to reconcile differences between the cost and income approaches. The final calculation for economic obsolescence is presented in the chart below which utilizes the breakdown method for estimating accrued depreciation. Here are the calculations.
As you can see in the calculations, the amount of total depreciation not accounted for by deferred maintenance, short-lived depreciation, or long-lived depreciation is attributed to economic obsolescence. As I understand appraisal theory, this is an absolutely sound method for calculating economic obsolescence. But here’s the problem. Using this method perfectly reconciles the income approach with the cost approach.
See how both the cost and income approaches result in a value estimate of $650,000? Odd as it may sound, this process or method for calculating economic obsolescence is too perfect. This, in spite of the fact that every calculation, as far as I can tell, is based on sound appraisal theory. In today’s world, arriving at the same value conclusion for two different approaches based on sound appraisal theory is simply intolerable. If there is some flaw in my logic, please, point it out. I welcome your comments. Otherwise, let’s try to come to grips with the fact that appraisal theory, if applied correctly, can really reconcile two separate methods for estimating value.