Functional & External Obsolesence in the Cost Approach

Step 3 of the cost approach to valuation is to estimate the structure's accumulated depreciation. There are five forms of depreciation and value adjustments that should be considered.  Three of these adjustments involve functional and external obsolescence related to the subject property.

 

Curable Functional Obsolescence: Essentially this value adjustment acknowledges that design defects or obsolete components can create a loss of value.  For example, materials once considered acceptable when the structure was built may be considered sub-standard today.  The cost of bringing the obsolete components up to current standards should be calculated and subtracted from the building's replacement cost.  The follwoing example of adding an elevator to a building is instructive:

 

Cost of Widening Halls:                                     $15,000

Cost of Elevator:

             To install Today               $50,000

             To install at orig constr    $30,000

             Value Loss                                           $20,000

 

Total Curable Functional Obsolescence:         $35,000

 

 

Incurable Functional Obsolescence: Assume that a property needs a parking lot to compete in its marketplace.  If that property does not have the physical space to build a parking lot, obviously the condition cannot be cured. The resulting loss in value counts as incurable functional obsolescence.  To value incurable functional obsolescence, estimate the loss of net operating income (NOI) from the lack of the parking lot and divide the estimated NOI by properties capitalization rate to obtain lost value.

 

 

External Obsolescence: This value impairment is a function of forces beyond the property owner's control. For example, if an entire area where the subject property is located deteriorates due to lack of maintenance of common areas and roads, that is external obsolescence.  Likewise, if a new mall is built near a property and traffic congestion significantly increases to the point of impairing access to the property, this obsolescence is external to the property.  Any loss in value from external obsolescence is divided proportionally between the land and the improvements because both are affected by the outside influence.