Deterioration and Obsolescence
To arrive at an estimate of fair value by cost approach, the cost new (CRN/ COR) is adjusted for physical deterioration, functional obsolescence and economic obsolescence as and where applicable.
Physical deterioration is a form of depreciation and is the loss in value resulting from wear and tear over time and any lack of maintenance.
Physical deterioration adjustments are calculated using the physical age-life method because my analysis revealed reliable data on the fixed assets‟ actual physical ages, remaining lives as well as overhaul and other related repair history which would affect the assets remaining lives.
In estimating the physical deterioration of an asset its actual physical age and remaining life are considered to be of primary importance as they provide a basis for calculation of total useful life and thus arriving at a physical deterioration adjustment as a ratio of the actual age to total useful life in line with the following formula:
PD = PA / TL,
Where: PD is Physical Depreciation, PA is physical age, TL is total useful life (physical
age+ remaining useful life)
The physical age of an asset reflects its actual condition and represents the total time that an asset has been operational. It is based on the difference between the valuation date and the date of commissioning.
Remaining useful Life is expected useful life of an asset till its decommissioning period during which the asset is expected to contribute to the value of products manufactured or services provided. There remaining useful life of an asset is estimated based on the Company’s plans regarding the asset replacement (decommissioning) or (if no such plans are made availa le by the Company) is calculated as a difference between its normal useful life and actual life based on the assumption that it was operated in line with technical conditions prescribed by the manufacturer during its actual life, i.e. from the date of its production (construction) till the valuation date. As provided by the company, dates in the fixed assets register for the subject fixed assets generally reflect actual dates of their construction/ production or acquisition.
The remaining useful life of the selected fixed assets was estimated based on the Company’s plans about the subject fixed asset replacement (decommissioning), considering the opinion of the Company’s technical specialists about probable technically possible life.
Functional or technical obsolescence is a form of depreciation resulting in a loss in value
caused by advances in technology that create new assets capable of more efficient delivery
of goods and services. The appraised assets should be reviewed for their optimum operating capacity and adjustments should be made for functional obsolescence accordingly.
Functional Obsolescence and Real Estate
In real estate, functional obsolescence usually leads to lower appraisal values. Real estate can exhibit functional obsolescence if its design features are outdated, not useful, or not aligned with market tastes and standards, such as when an old house is located within a neighborhood of new homes.
While functional obsolescence is generally associated with rundown structures or dilapidated neighbourhoods, it can also occur in the opposite case. For example, a home may have “over-improvements” when a homeowner renovates and includes features within their home that might not be necessary.
While various efforts have been made over the years to objectively quantify the effect of functional obsolescence in real estate, assessment or appraisal of functional obsolescence is mostly subjective. The subjectivity occurs because various factors go into making decisions about the price of a home. In the case of real estate, some features can potentially be renovated to overcome functional obsolescence.
Examples of Functional Obsolescence
Consider a 1950s house with three bedrooms and one bathroom located in a gated subdivision filled with two-story houses containing five bedrooms and four bathrooms. Because the old house does not have the capacity that buyers in this market want, it is said to be functionally obsolete even if it is still in good condition and is perfectly livable.
Economic obsolescence is the loss in value caused by adverse conditions external to the
assets, such as poor market demand for the product or service, industrial reorientation,
unavailability of transportation, and governmental regulation.
Economic Obsolescence (“EO”) is the loss in value caused by adverse conditions external to the assets, such as poor market demand for the product or service, industrial reorientation, unavailability of transportation, and governmental regulation. A situation where operating EV is less than value of operating fixed assets indicates economic obsolescence in assets of that plant.
As per International Valuation Standards, to estimate the fair value of fixed assets, it is mandatory to check the existence of economic obsolescence (EO), and suitably adjust the
estimated Depreciated Replacement Cost (DRC) of the fixed assets with applicable EO (if any) to arrive at the fair value.
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 neighbourhood. 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.
A valuer is required to measure the residual value of an asset as the amount it estimates it would receive at the end of its useful life. It is also called salvage value.
Residual value is generally the range of 0% – 40 % of estimated CRN/ COR depending upon the type and class of fixed assets valued.