A lot of factors can cause a drop in an asset or property’s value.
One might encounter economic obsolescence in financial report adjustments or use it in bankruptcy filing. Economic obsolescence adds complexity to valuation as this stems beyond the control of a business or homeowner.
What is economic obsolescence and how does it affect businesses and real estate? Well, friends…
Physical, Functional, and Economic Obsolescence
If one looks up at the definition of obsolescence in the dictionary, it simply means the process of becoming no longer useful or needed.
There are three main types that would indicate signs of obsolescence and affect an asset’s value:
Physical obsolescence is the most common and it refers to the wear and tear that is evident in a tangible asset, like a machine or equipment. Over time, physical deterioration becomes visible after much use.
Meanwhile, functional obsolescence occurs when an asset’s usefulness is decreased as the design or materials used no longer meets the demands or needs of its users and become obsolete.
In contrast to replacing a piece of item when physical deterioration is evident, functional obsolescence is more complex as updating or fixing the design is not usually a feasible or a practical option.
When builders do not meet the standards of the neighborhood or the original design of the property, the building utility decreases which is another form of depreciation. Modifying any part of the building would add cost and is considered impractical.
Take for example a home with a large master bedroom disproportionate to the size of the whole house.
Not only does it occupy space that can be converted to another purpose but doing so would incur cost and damage the house.
As the final design of the property reduces its functionality, the appraised value also decreases. This exhibits functional obsolescence.
The third form of depreciation is economic obsolescence. By definition, economic obsolescence refers to the reduction or loss of value due to external factors or outside forces. This is why it’s also commonly known as external obsolescence.
Some examples of economic obsolescence indicators are increased competition, legislative changes, reduced profit margin or lower operating margin, recession, reduced market demand, or economic depression.
How Can Economic Obsolescence Occur in Properties and Real Estate?
Economic obsolescence affects the decisions of people when buying or selling homes.
These factors tremendously affect the value of a property or a neighborhood. As value loss stems from outside issues, home design features and property qualities come second to people when these external factors come into play.
Different types, examples, and manifestations are listed below.
Some examples of economic obsolescence are new government mandates, changes in zoning laws, rising crime rates, even the construction of a national highway or an airport could make the area less desirable.
A home close to a highway would increase traffic and the airport would cause a lot of noise throughout the day.
Locational obsolescence falls under economic obsolescence. For example, a neighborhood or property value deteriorates as people would prefer to transfer or live in bustling or thriving cities.
This situation takes place in what is commonly referred to as “housing crash” or “economic downturn.” As there would be a reduced demand for the neighborhood, property value loss will follow.
Another example would be environmental obsolescence. Changes in the activity of a nearby volcano would tremendously affect the appeal of properties in that area.
A particular example would be the construction of nuclear power plants within proximity. No one would be comfortable in a home that poses environmental risks.
External obsolescence is considered incurable or irreparable. These economic factors are detrimental to the value of properties. Thus, economic obsolescence should be carefully considered in dealing with real estate.
Economic Obsolescence in Real Estate and Your Home
Determining economic obsolescence in assets, such as land and machines, would differ slightly from real estate.
For real estate and subject property appraisal, it would depend primarily on the desirability of where a property is located. There is a lot to factor in when it comes to homes, such as the crime rate in the area, noise levels, and safety from environmental dangers.
Meanwhile, asset values are computed based on comparable sales.
Economic Obsolescence in Valuation of Fixed Assets
It is important to note that the value given to fixed assets is computed with an in-use premise.
After taking into account the depreciation caused by physical and functional obsolescence, the asset’s utility is compared vis-a-vis the asset’s productive capacity in full operation at that given point.
For example, the peak operation of an asset would have a range of 85%-95%, giving consideration to the downtime required to maintain the machine or equipment.
An adjustment is required if a particular asset is deemed to be in good condition or if it’s not fully utilized to make sure it is valued fairly.
Establishment of Floor Value
Determining an asset’s floor value is crucial as it could help minimize value overestimation caused by economic obsolescence.
Generally, floor values can be established in two ways: salvage value or net orderly liquidation value – the net monetary value attributed to things or assets which must be sold as the seller is compelled to sell it.
Normally, fair values after economic obsolescence are likely to fall in between the asset’s in-use value and its net orderly liquidation value.
However, in instances wherein economic obsolescence is significant, the forced liquidation value is taken into account to support the determination of floor value.
If fixed assets face economic obsolescence, there will be a decrease in value due to business or economic factors, the floor value of these assets must be established.
The same is true when the obsolescence is caused by its purchase price; it refers to the enterprise value, or monetary value given by the buyer company to acquire the business.
After determining the unit value of a group or all affected fixed assets, next is to compute for the collective value of all identified assets.
The gap between the enterprise value and collective value assets might be attributable to economic obsolescence.
A purchase price lower or equal to the collective value of its assets plus working capital indicate that it has been valued fairly.
Meanwhile, a valuation of collective assets higher than purchase price might need to be reviewed to have a more accurate picture of the impact of economic obsolescence in the business.
Intangible Assets: Valuation and Implications
In terms of asset valuation of intangibles, it is also important to know how these things are evaluated.
Customer relationships, rights reserved obtained, patented technology, intellectual property rights, trade names are some examples of intangible assets.
Although these may hold positive value in the market, oftentimes these are given minimal or no value. Subjectivity plays a part in the value assessment of these intangibles and can tilt the magnitude of economic obsolescence present in the business.
A rule of thumb when determining the value of intangibles would be assessing these from a market participant perspective. This would result in a fairer valuation of intangible assets.
Economic Obsolescence adds complexities to the valuation of properties and assets.
These are often unforeseeable and can occur at any point in an asset’s life. Several calculations and factors are needed in calculating economic obsolescence and measuring its degree of impact – whether it be a home, personal property, real estate, or an entire business.
Therefore…it is important to seek advice from valuation experts to determine and come up with justifiable and sound values.