What is Economic Obsolescence or Benefit?
Say what? I’m sure that will be the response of some reading the term ‘Economic Obsolescence’ for the first time. Just stay calm a second and I’ll explain. Basically, obsolescence is a word that describes the state or process of something becoming obsolete. Think eight track tape players or rotary phones. When something loses its utility in the eyes of prospective purchasers, it becomes obsolete – it loses value and it is no longer profitable to manufacture or build. The item under consideration may still be in perfect condition but the public perceives it as less valuable. So the source of the loss in value is not the physical condition of the item itself but from external conditions.
The same principle applies to real estate. As with any other commodity, an oversupply results in diminished value. Your home or commercial building may be in perfect condition but if there are 50 other homes or small commercial buildings in perfect condition for sale in your neighborhood, there is likely an oversupply. Welcome to the world of economic obsolescence. By the same token, a major retailer may have selected a site near your business and the value of your property skyrockets. Nothing has changed about the condition of your property but forces that are external have had a major impact. This would be an economic benefit.
How to Quantify Economic Obsolescence or Benefit
Fortunately for commercial appraisers, there is a simple method to quantify the effect. Actually, there are a few methods but I’m only here to discuss one. In my estimation, this is the easiest method to understand and explain. Unlike a single family home, whose value is often derived from sources that are difficult to quantify, what makes many types of commercial real estate valuable is the capacity of the improvements to generate income. When the current supply begins to exceed demand, construction is no longer profitable. When absorption pressures prices upwards, building becomes profitable again, attracting developers and new construction. The key to quantifying economic obsolescence (or benefit) is to measure the deviation of current rent levels from economically feasible rent levels and evaluate the impact on value to potential purchasers.
For example, suppose that $18.00 per square foot annually is the rent level at which new construction becomes economically feasible for office buildings in your market. Now suppose that a local manufacturing company closes resulting loss employment and an oversupply of office space. Current rent levels have dropped to $10.00 per square foot on an annual basis. Part of my job, as an appraiser, is to evaluate the impact of the $8.00 per square foot rent loss. This loss in value is called economic obsolescence. Conversely, a major retailer may have selected a nearby site for development, resulting in an increased demand in your neighborhood and resulting in rent levels that exceed economically feasible rent levels. Now rent levels have increased to $21.00 per square foot. The impact of the $3.00 deviation from financially feasible rent results in a benefit. This is known as economic benefit, the inverse of economic obsolescence. How can we measure the impact?
Well, the first step is to evaluate the rent levels at which development is financially feasible. And that will be the topic for my next post.