This article was originally published in Volume 18, Issue 1, The Journal of the International Machinery & Technical Specialties Committee of the American Society of Appraisers, February, 2001, and is republished on our web site by permission of the American Society of Appraisers. The article was authored by Lester Rhodes, Senior Manager of Valuation Services at Ryan & Company. Mr. Rhodes is an Accredited Senior Appraiser with the American Society of Appraisers, and a State Certified General Real Estate Appraiser in Texas.
Measuring external obsolescence is a central issue in valuing complex property for ad valorem taxation. Because specialized complex properties are particularly sensitive to external conditions, accurate measure of external obsolescence is critical to achieving a fair property tax valuation. In terms of contentious issues, it may very well rate above intangible property taxation and value in use versus value in exchange. In appraisal theory, there are several ways to measure external obsolescence using cost, direct sales comparison, and income valuation techniques.
The cost approach to value, where accurate measure of external obsolescence is critical, is generally considered the most appropriate, and certainly the most widely employed method of estimating the value of complex properties. Measuring the full extent of external obsolescence, however, is a major weakness of the cost approach. External obsolescence is difficult to isolate and measure and many assessors and tax appraisers omit this measure due to constraints of budget, time, and information.
The income and sales comparison methods of estimating the value of complex property are problematic. Although all value loss, including external obsolescence, is incorporated in value estimates derived from these approaches to value, the characteristics of complex properties often render these methods incalculable. Complex properties are often a unit in a vertically integrated business operation or the major tangible asset of a business enterprise. Complete financial data are generally unavailable for an individual property unit and, when available, often reflect income allocation methods and operating synergies rather than an appropriate market income. Sales data, when available, often reflect the value of the business enterprise thus allocation to each of the operating units is impractical. In addition, intangible and tangible asset value is intrinsic in the income and comparable sales data, creating isolation difficulties where intangible property is exempt from taxation.
The Dictionary of Real Estate Appraisal defines external obsolescence as "An element of accrued depreciation; a defect caused by negative influences outside a site and generally incurable on the part of the owner, landlord, or tenant."1 Economic/external obsolescence is also defined as the loss in value or usefulness of a property caused by factors external to the property, such as increased cost of raw materials, labor, or utilities (without an offsetting increase in product price); reduced demand for the product; increased competition; environmental or other regulations; inflation or high interest rates; or similar factors.2
Characteristics of Complex Properties
Complex properties are typically industrial in nature and are usually larger than commercial property in area, volume, and land occupancy. Function in complex property is more important than aesthetics. Location with accessibility to resources, utilities, and markets for finished goods is critical for operating efficiency and competitive production cost. Complex property requires large investments with the investment in machinery and equipment often exceeding that of land and improvements. In addition the property is highly non-liquid, with even less liquidity as specialization of the property increases to maximize productivity. Because of the degree of specialization, complex property is highly susceptible to technological and economic obsolescence.
Complex property is often referred to as special-purpose or single-purpose property. Special purpose property is usually limited to specific uses within a given sector of manufacturing, for example food processing and consumer good manufacturing. While special purpose property may be converted to similar alternative uses within the industry sector, single purpose property is limited to a single industrial use and not adaptable for any occupancy other than as constructed.3 Examples of single purpose property include power plants, refineries, cement plants, and grain elevators. The Appraisal Institute text, The Appraisal of Real Estate, addresses the highest and best use of complex properties as follows.
Because special-purpose properties are appropriate for only one use or for a very limited number of uses, appraisers may encounter practical problems in specifying their highest and best uses. The highest and best use of a special-purpose property as improved is probably the continuation of its current use, if that use remains viable. For example, the highest and best use of a plant now used for heavy manufacturing is probably continued use for heavy manufacturing, and the highest and best use for a grain elevator is probably continued use as a grain elevator. If the current use of a special-purpose property is physically or functionally obsolete and no alternative uses are feasible, the highest and best use of the property as improved may be realized by demolishing the structure and selling the remains for their scrap value or salvage value.4
Because machinery and equipment, the primary components of complex property can be moved, it is necessary for the appraiser to recognize different value premises as well as different markets. According to the American Society of Appraiser text Valuing Machinery and Equipment, "the market value premises are broadly classified into three categories, distinguished mainly by an asset's anticipated use."5 The premises of value are continued use, installed, and removal. This paper addresses the measurement of external obsolescence in the context of market value in continued use. The fair market value in continued use premise presupposes the continued utilization of the facility. This premise is applicable when the facility is functionally adequate and economically viable and the present use is likely to continue. The buyer would likely be an end user who would acquire the assets for continued use.
Categories and Causes of External Obsolescence
External obsolescence is usually incurable as the events, be they temporary or permanent, causing the loss in value are outside of the control of the property owner. If the conditions are temporary, the predicted length of time the external impairment will affect the subject property should be considered in the measurement of value loss.
External obsolescence is commonly categorized as being locational, or non-systematic and economic, or systematic. Economic factors can be either industry wide or market wide. Locational causes include zoning changes, changes in highest and best use, incompatible development of adjacent land, increased taxation, change in location and sources of supply, and increased cost of raw materials, labor or utilities. Industry wide economic factors include reduced product demand, increased competition, increased foreign imports, environmental or other government regulations, changes in product prices and profitability, and decreased rates of return. Market wide conditions can be national or international and include increased import duties and tariffs, inflation, economic recession, high cost of capital, and government regulations.
Measuring External Obsolescence
The consequence of most external obsolescence is a reduction in operating income and profit. Some locational external obsolescence can be measured by sales comparison, however, this method is rare in complex property valuation due to a lack of usable sales data. Estimates of value loss, therefore, are often calculated using various income valuation techniques. As data are available, incidences of external obsolescence can be measured individually or collectively, using income valuation methods. Individual measurement involves isolating each occurrence of external obsolescence and capitalizing income loss attributable to each cause. Collective measurement is accomplished by capitalization of overall annual income loss, or by the discounting of a periodic, measured income deficiency. A determination of "inutility" can also form the basis of a value loss estimate employed in the cost approach to value. Typically, estimates of value loss are expressed in whole dollars, percentages, or mathematical factors. A common formulation of the cost approach is as follows.
MV = RCN * PDF * FOF * EOF Where, MV = Market Value Estimate RCN = Replacement Cost New = Physical Depreciation Factor FOF = Functional Obsolescence Factor EOF = External Obsolescence Factor
Expressing value loss in the form of multipliers, or percent good factors, facilitates allocation of value to various categories, units, or individual items of property. For purposes of this paper, each measure of external obsolescence is expressed as a factor to be applied to replacement cost new less physical depreciation and functional obsolescence.
Inutility exists when the operating level of a property is significantly less than practical capacity. Lower capacity utilization translates to lower property value. Depending on the level of fixed cost, inutility accelerates reduction in profit. The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage". The greater the use of operating leverage, the larger the increase in profits as sales rise and the larger the increase in losses as sales fall. The Crawford and Cornia paper "The Problem of Appraising Specialized Assets" discusses the use of operating leverage in the standard inutility model, describing the problems of estimating specialized-asset obsolescence by emphasizing the relationship of fixed and variable costs to the measure of obsolescence.6
The inutility models presented in Table 1 and 2 depend on an accurate and standard method of capacity determination and representative variable cost, fixed cost, and operating profit at the determined practical capacity level. The following capacity definitions are provided in order to provide a clear understanding of various capacity terminologies. Theoretical capacity is the maximum productive output for a given period assuming all machinery and equipment are operating at optimum speed without interruption. Practical capacity is theoretical capacity reduced by normal and expected work stoppages. Normal capacity is the average annual level of operating capacity needed to meet expected sales demand.7Excess capacity is the difference between either theoretical or practical capacity, and normal capacity (actual production).
The U.S. Department of Commerce survey of plant capacity utilization provides a standard for determining practical capacity. The survey requests the maximum level of production that an establishment could reasonably expect to attain under normal and realistic operating conditions, assuming:
- The machinery and equipment in place and ready to operate will be utilized.
- Normal downtime, maintenance, repair and cleanup.
- Number of shifts, hours of plant operations, and overtime pay that can be sustained under normal conditions and a realistic work schedule.
- Availability of labor, materials, and utilities are not limiting factors.
- A product mix that was typical or representative of production during the year.
The inutility model shown in Table 1 serves to measure ss in value due to external factors affecting production and, therefore, operating profit. In this example, domestic raw material shortages have reduced production. The condition is considered temporary and full practical capacity is expected to return, in a linear pattern, over the next five years. Lines 1 - 3 contrasts practical capacity and actual production. Lines 4 - 7 delineate fixed and variable operating costs and profit in relationship to total revenue. Line 5 shows the change in variable cost due to the decline in production and the resulting impact on operating profit in Line 7. The utilized capacity factor in Line 8 reflects the change in operating profit and Line 9 is the excess or unused capacity factor. Lines 10-12 contain the components for calculating the present value of the excess capacity. The sum of the utilized capacity factor in Line 8, and the present value of the excess capacity in Line 12 provide the total value impact of inutility, expressed as a factor to replacement cost new less physical and functional depreciation.
When the external condition causing reduced capacity utilization is permanent, a different measure of inutility is necessary because the value of excess capacity is very likely no more than its scrap, or salvage value.