The Journal of the International Machinery & Technical Specialties Committee of the American Society of Appraisers Publishes External Obsolescence and Complex Property Article Part 2

Table 1. Inutility Model - Temporary External Obsolescence

Table 2 shows the components of the inutility model for measuring permanent external obsolescence. Table 2 is identical to Table 1 until Line 9. In this model, the purpose of the inutility factor is to balance, or "right size" the plant to match utility. A scale factor or size exponent is necessary because the capital cost of facilities of different capacities varies exponentially rather than linearly due to economies of scale. In other words, as capacity increases, cost also increases but at a different rate.⁸ Note that the difference between the measure of temporary and permanent external obsolescence by the inutility method relates to the contributory value of the excess capacity. In addition, the inutility factor only provides an adjustment for the degree of use, and other external factors such as reduced product price or higher feed stock prices, must be considered in addition to inutility. When reduced capacity utilization is permanent, the appraiser may choose to adjust the replacement cost new estimate to reflect the probable capacity of the replacement facility and measure as excess operating cost the cost of maintaining the excess capacity.

Income Valuation Techniques
When appropriate income data can be assembled, the income approach to value techniques provide an accurate and defensible measure of external obsolescence. When obsolescence exists, however, it is often in several forms and insolating income loss associated with each occurrence becomes very difficult. For this reason, external obsolescence may be measured individually or collectively, or both.

Because external obsolescence usually results in increased costs, the loss in value can be measured by capitalization of excess operating costs.

Table 3 measures loss in value due to the increased transportation cost of raw materials. In this example, domestic feed shortages have dwindled and must be purchased overseas and shipped to US ports. An inland shipping premium of $40 per ton represents excess operating costs incurred by the operation. This condition is expected to be permanent and continue throughout the remaining life of the plant. Line 6 contains the total annual excess cost, the result of multiplying Line 4 and Line 5. Adjusted for taxes, the net annual excess cost is $780,000 (Line 8). The present value of the excess operating cost, and the estimated loss in value, is $4,318,416 (Line10). If each item of external obsolescence can be identified and income loss isolated, this model presents the most defensible method of measuring external obsolescence.

Value loss due to obsolescence can also be estimated utilizing conventional discounted cash flow techniques. The plant is considered obsolete to the degree income fails to satisfy current investment requirements. Comparing the present value of projected income from plant operations with the present value of an income stream generated at a market rate of return provides the measure of external obsolescence.

In Table 4, the replacement cost new less depreciation (RCNLD) is $50.0 million. Since projected cash flow (CF) is less than market cash flow (MCF)¹ , the income deficiency (CF-MCF) should be discounted to present value at an appropriate discount rate. In this example, the discounting of the income shortfall provides a measure of external obsolescence of approximately $11.5 million.

Rates of Return and Valuation Ratio Comparisons
External obsolescence may also be estimated though an analysis of relative change in various macroeconomic factors. Some appraisal practitioners argue that this method is too simplistic and generalized, and that other forms of depreciation may be "double counted." There is also, however, considerable support for including the comparative analysis of rates of return and valuation ratios in the estimation of external obsolescence. According to the text, Valuing Machinery and Equipment:

It should be noted that other measures of economic obsolescence can be developed based on analyses of industry returns, supply/demand relationships, margin analysis, product or raw material price changes, stock prices, the relationship between replacement cost new and cash flows the hypothetical replacement facility is capable of generating, and other economic evidence indicating that the value of the subject property has been reduced by external factors.⁹

In Robert Reilly's widely published article on economic obsolescence, he states that "a current and sustained reduction in the level of investor returns, compared to historical industry averages, also indicated economic obsolescence on an industry-wide basis. Appropriate measures of investor returns would include return on net assets, return on total assets, return on investment, return on equity, and return on tangible assets."¹⁰

Table 5 provides historical rate of return data for the basic material sector. This sector has been particularly affected by increasing environmental legislation and other government regulations, foreign competition, and worldwide economic events. The table presents a 5-year average rate of return and the trailing twelve months (TTM) rate of return on assets (ROA) and on investment (ROI). Obsolescence Factor 1 may provide an estimate of external obsolescence resulting from industry wide factors, such as changes in product price, raw material costs, etc. The measure compares current industry returns (TTM) to 5-year average industry returns. When certain types of external obsolescence affect particular industries or sectors, and the impact has been long term, comparisons outside the specific industry may be more appropriate. For example, in order to gauge the impact of environmental regulations on a particular industry, it may be necessary to make a comparison to industry in general. Obsolescence factor 2 compares returns in the subject industries to returns in the S&P 500. The S&P 500 Index is widely regarded as the standard for measuring large-cap U. S. stock market performance and contains a representative sample of leading companies in leading industries. Other index measures of general industrial performance that can be used for benchmarking rates of return include the S&P 100, 400, and 600.

¹Compares trailing twelve month (TTM) return with 5-year average return.
²Compares industry 5-year average return to S&P 500 5-year average return. 

Summary
Complex properties and external obsolescence present unique valuation challenges. The problem is both in identifying the external causes of obsolescence and measuring the loss in value. When income loss can be reasonably determined, the various income capitalization and discounting techniques provide an acceptable means of translating income loss into a capital sum, and therefore a loss in value estimate. When the use of income valuation techniques is impractical, the inutility model should be developed.

The traditional inutility model, the extent of which involved the application of a scale factor to throughput, is overly simplistic and unenthusiastically received by assessors as a measure of value loss. The addition of operating leverage in the formulation dramatically improves the accuracy, and the acceptance, of the inutility measure. The operating profit and cost ratios must, however, be in proper balance with the practical capacity estimate.

Still, the problem of valuing the excess capacity in the inutility model was obviously missing. When the cause of the external obsolescence is temporary, the unused capacity will likely add value in the future as growth consumes capacity. The model deficiency can be resolved by adding a simple present value calculation to the inutility model. If you assume that absorption of excess capacity is linear, then the only input variable required is absorption period and discount rate. The overall inutility factor is now the sum of the factors for both utilized capacity and unutilized capacity.

While not all causes of external obsolescence have been identified and not all methods of measuring external obsolescence have been covered in this paper, it should be clear that external forces exert powerful positive and negative pressures on complex property value. External obsolescence is not just "the cost of doing business", as one assessor argued, but a tangible and measurable loss in value.

¹ Market cash flow in this case is the income generated from a $50.0 million investment at a market rate of return.

¹ Appraisal Institute. The Dictionary of Real Estate Appraisal, 3^rd ed. Chicago: Appraisal Institute, 1993. 128.

² American Society of Appraisers. Valuing Machinery and Equipment, Washington: American Society of Appraisers, 2000. 99.

³ Industrial Property Appraisal, Course 207. Chicago: International Association of Assessing Officers. 1997. 1-6.

⁴ Appraisal Institute. The Appraisal of Real Estate, 11^th ed. Chicago: Appraisal Institute, 1996: 316.

⁵ American Society of Appraisers. 2.

⁶ Robert Crawford, PhD and Gary Cornia, PhD. "The Problem of Appraising Specialized Assets." Appraisal Journal Jan. 1994: 75-85.

⁷ Belverd Needles, Henry Anderson, and James Caldwell. Principals of Accounting, 5^th ed. Boston: Houghton Mifflin Company, 1993: 844.

⁸ American Society of Appraisers. 101.

⁹ American Society of Appraisers. 104,105.

¹⁰ Robert Reilly. "Identification and Quantification of Economic Obsolescence." Journal of Property Taxation 1.1 (1988): 45-62.