Types of Obsolescence in Real Estate
When valuing real estate using the replacement cost approach, one important step includes deducting any depreciation. This includes physical deterioration, function obsolescence, locational obsolescence, and economic obsolescence.
Physical deterioration is related to the building’s age and occurs as a result of normal wear and tear over time. Real estate investors consider both the effective age and the economic life of a building.
On this page, we discuss the different types of obsolescence in real estate in more detail. In particular, we discuss functional obsolescence, locational obsolescence, and economic obsolescence.
Functional obsolescence
Functional obsolescence is the loss in value resulting from defects in design that impairs a building’s utility. For example, a building might have a bad floor plan. As a result of functional obsolescence, net operating income (NOI) is usually lower than it otherwise would be because of lower rent or higher operating expenses. Functional obsolescence can be estimated by capitalizing the decline in NOI.
Locational obsolescence
Locational obsolescence occurs when the location is no longer optimal. For example, five years after a luxury apartment complex is completed, a refugee center is built down the street making the location of the apartment complex less desirable. As a result, lower rental rates will decrease the value of the complex. Care must be taken in deducting the loss in value because part of the loss is likely reflected in the market value of the land.
Economic obsolescence
The third kind of obsolescence is economic obsolescence. It occurs when new construction is not feasible under current economic conditions. This can occur when rental rates are not sufficient to support the property. Consequently, the replacement cost of the subject property exceeds the value of a new building if it was developed.
Summary
We discussed three types of obsolescence in real estate that investors should take into account when trying to estimate the value of a real estate property using the replacement cost approach.