Acknowledging Functional Obsolescence in Multifamily Real Estate
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One of my biggest pet peeves is when a real estate investor evaluates a property with zero regard for unattractive, impossible-to-fix attributes. To the untrained eye, these blemishes may go unnoticed. However, as a sophisticated property owner, you need to understand that if the physical attributes of your property negatively affect renter desirability, your property valuation will likely take a hit, too.
Contents
Obsolescence Definition
To understand obsolescence, you need to first look through the lens of a commercial real estate appraiser. They usually utilize three methods of valuing real estate investments:
The Sales Method
The Income Method
The Cost Approach
The sales method will look at recent sales data from comparable properties in the direct vicinity and benchmark the subject property against the comp set.
The income method examines the property’s operations, precisely the net operating income (NOI), and capitalizes that income stream with the prevailing market cap rate.
The cost approach looks at the land value plus the structure in terms of replacement cost while adjusting for blemishes. These blemishes are referred to in the appraisal community as depreciation. Let’s discuss the cost approach and how depreciation affects the property.
Note: While I am taking the time to detail more technical definitions from the appraisal community, the article intends to tackle functional obsolescence from an investor’s perspective. I think the appraisal lens is powerful and will help build a framework when evaluating investments. These insights could help avoid costly oversights.
We’ll get to real-life examples of functional obsolescence shortly.
Depreciation
Forms of depreciation (or reduction in market value) can come from:
Physical Deterioration
External Obsolescence
Functional Obsolescence
Physical Deterioration
Physical deterioration is commonly the wear and tear a property experiences over time. Competent management will take care of maintenance issues and implement preventative measures to keep the property in good condition and avoid incurable decay.
Mismanagement that allows minor issues to linger and compound could lead to major structural problems and eventual physical obsolescence, meaning the cost to remedy major issues outweighs the utility of the repairs.
An example could be defunct gutters that don’t correctly carry rainwater and snowmelt away from the building. Eventually, runoff water erodes the soil around the premises and deteriorates the foundation. What started as a water mitigation issue evolved into a structural problem over a prolonged period.
External Obsolescence
External obsolescence is almost always incurable, meaning that the property owner has no control over external factors affecting the property. External factors could be a change in zoning, noise pollution from a nearby factory, or a closure of a busy road that affects traffic patterns and ultimately reduces the traffic count and occupancy potential.
External changes negatively impacting a property could eventually lead to economic obsolescence and diminishing property value.
Functional Obsolescence
The final category of obsolescence is where the rest of the article will cover in great depth with examples. Over time, the market tastes and preferences change, adversely impacting commercial properties. Forms of functional obsolescence are classified as curable or incurable:
Curable = Fixable
Incurable = Unfixable
Curable Functional Obsolescence
You can easily handle curable obsolescence, and improvements will likely increase the value of a property. Think of cosmetic attributes like:
Flooring
Countertops
Cabinets/surfaces
Siding
Plumbing fixtures (toilets, vanities,
Light fixtures
You can even knock down a non-load-bearing wall to open the living room or add technology (thermostats, security, lighting) compatible with smartphones. Undesirable attributes that are curable aren’t a significant hindrance. These design features are easily swapped out as preferences change over the decades through a value-add business plan.
Incurable Functional Obsolescence
Earlier, I desired insurance attributes to be “unfixable.” Technically, everything is potentially fixable, but it could be too cost-prohibitive to proceed with such lofty improvements. I’ve commonly seen incurable types of functional obsolescence in the apartment investment world.
Two-Bedroom/One Bath Units
Nothing irks me more than when an investor plans a value-add on a Class C garden-style building and forecasts to rent out the 2BR/1BA at rent levels comparable to 2BR/2BA units in the market. Having one less bathroom is a massive deficiency and should be accounted for.
Adding a bathroom is not feasible in many instances. Thinking a prospective renter would pay the same for one bathroom as two bathrooms is a flawed thought process. These defective units should always be rented for less than their 2BR/2BA counterparts.
Ceiling Height
The difference between an eight-foot and nine-foot ceiling is astonishing. A nine-foot ceiling can open up the room and give the illusion of a much bigger unit. Most buildings constructed in the 1960s and 1970s possess eight-foot ceilings. Comping these units to Class A units with nine-foot ceilings is a mistake.
Ceiling Texture
Everybody hates popcorn ceilings, and I’ve heard it rarely makes sense to get rid of it. The cost is too burdensome in most instances to justify removal.
Windows
On the same wavelength as ceiling height and texture, windows can make a massive difference in the aesthetic of an apartment unit. Today, the development trend is incorporating “floor-to-ceiling” windows. Will knocking out a window and enlarging it be cost-effective for vintage projects? I’d argue no, and you rarely do this renovation in older buildings.
Note: I lived in a 1960s building with enlarged windows. While they were a nice feature and brightened up the unit, I still question how they made financial sense for the ownership group. I’d argue that this apartment complex was on the spectrum of “super adequacy” or over-renovated for its asking rents.
Parking
Underground, secured, heated parking is a relished amenity, even with a monthly cost. Properties with detached garages, surface parking, or no parking will always be disadvantaged. A portion of the renter pool will place tremendous value on the option of having secured parking on site. For obvious reasons, underground parking is likely too burdensome to add to a structure if it wasn’t there originally.
Washer/Dryers
Another massive perk is the ability to do laundry in the unit. For many renters, communal laundry is a non-starter and will automatically disqualify a property from consideration. Unfortunately, retrofitting a unit for washer and dryer hookups and venting can be cost-prohibitive and, in some instances, impossible. Feasibility will be highly dependent on the architectural design.
I’ve commonly witnessed older properties add washer-dryer units to conveniently located units where it could be done cost-effectively and forgo the retrofitting on units where venting and water hookups would be too costly. Units dependent on communal laundry facilities will always be less valuable than units that can add laundry facilities.
Floorplans/Layout
Some floorplans of past eras are awkward and not functional in the present day. Outdated designs, tiny cl sets, inefficient layouts, and claustrophobic living spaces make renting units harder. Moving walls around (or eliminating) means shifting plumbing or adding additional support, so the renovation will not likely make financial sense. It’s best to leave the unit and discount those inefficiencies with the comp set.
Other Impairments
Many other examples of obsolescence exist, including heating/cooling systems (such as a boiler in an older complex) or lack of utility metering infrastructure. Some could even consider the oldest property on a “newer” block obsolete (as only a complete teardown could remedy the age).
Using a platform like HelloData is paramount in seamlessly comparing properties and understanding the curable and incurable components of the subject property and comps.
Summarizing Functional Obsolescence in Real Estate
Functional obsolescence isn’t necessarily a bad thing. Even the most luxurious properties built within the last year will exhibit features deemed obsolescent and out of style by future generations. It’s all part of the natural real estate market life cycle.
The vital takeaway is to be able to:
Spot the functionally obsolescent features
Discount those features appropriately
In rental projections
In valuing the asset
As long as you acknowledge the less desirable characteristics and are thoughtful about their limitations on rental rates and future investors’ perceptions, you’ll still be able to find solid investments at prudent prices.
