When appraising an asset, there are three types of depreciation to be considered, physical depreciation, functional obsolescence, and economic (external) obsolescence.
Physical depreciation is exactly what it sounds like. It is a decrease in property value due to physical wear and tear, deterioration, exposure to various elements, physical stress, the passage of time, and similar factors. Depending on the cost to cure, physical depreciation can be curable or incurable. Normally, physical deterioration is considered first.
Functional obsolescence is a decrease in value due to the equipment’s inability to provide the benefit or perform the task at a level of safety, efficiency, or product quality or capability that a new version would provide (i.e., passenger vehicles). The intended function of the equipment or the products produced may have become obsolete or have reduced demand (i.e., newspaper presses). Functional obsolescence can be curable or incurable depending on the cost to cure the inefficiencies. There are several things to consider when determining the amount of functional obsolescence, including excess operating or maintenance costs, or structural or capacity deficiencies. In real estate, functional obsolescence can be the result of outdated design features, or lack of features typical to the market.
External or economic obsolescence (EO) is a form of depreciation caused by influencing factors that are independent of the property. More specifically, it is the loss in value caused by those outside factors. The outside factors can originate locally, regionally, nationally, or even internationally, depending on the industry and the asset affected.
Some factors causing EO include:
- Location – a neighborhood experiencing a rise in crime or an increase in operating cost;
- The economy – reduced demand for a company’s product, overcapacity in the industry, depletion of or increased costs of raw materials, labor, utilities, and/or transportation, or environmental consideration; or
- The government – a change to the local zoning code, or the prohibition or restriction of the product or process the equipment is used for (i.e., freon manufacture).
EO may also occur due to an economic recession or depression. What we are experiencing currently with the COVID-19 pandemic and Stay-at-Home orders may affect the value of businesses and other assets in the coming months or possibly years. The full economic implications of the pandemic and new government regulations have yet to be realized, and in many cases may affect all aspects of the business, not just assets such as real estate and tangible property.
For example, restaurants are typically appraised as a Going Concern, meaning that the value includes the real property, the furniture, fixtures, and equipment, and the business itself. The pandemic and Stay-at-Home Order has caused most restaurants to experience decreased earnings, which reduces the value of the business and its assets. In addition, if a large number of restaurants go out of business, the market will be flooded with used restaurant equipment driving down the value of that equipment.
Physical and functional depreciation can typically be quantified, but because economic obsolescence is a function of outside influences that affect a portion of, or an entire business, it can be difficult to measure. A market-derived approach can be utilized but may be difficult until the markets correct themselves due to current circumstances. If an income stream can be attributed to real or a specific asset, EO can also be measured using the income approach. Other methods include Utilization Analysis, Return-On-Capital Analysis, Gross Margins Analysis, Government Regulations Analysis, Income Shortfall Analysis, and the Best of the Best Technique. The method applied is dependent on the asset being appraised and the data available.
The concept of economic obsolescence is especially important right now for individuals and businesses who pay real property taxes and/or personal property taxes. Local assessments are conducted annually at best, and up to every ten years in some parts of the country, meaning that the most recent assessment does not consider the effect of this pandemic on taxable property. Speak to your attorney or financial professional to determine if an updated appraisal may be advisable to provide you or your company with a defensible fair market value determination for your assets.
Allyson O’Malley, Sobel EAC Valuations
Allyson.OMalley@SobelCoLLC.com
