Economic obsolescence is when an asset depreciates in value due to external factors. In real estate, it refers to an asset losing value due to factors such as changes in zoning, transportation patterns, nearby development, or even increased crime rates. Although future economic obsolescence can be hard to spot, investors can pay attention to certain changes in order to mitigate risk.
No one wants to be obsolete! For those in the workforce where new technologies are constantly disrupting the environment, becoming obsolete is a fear that lives in the back of our minds. Economic obsolescence can conjure the same fears but for an entirely different reason. Economic obsolescence refers to assets losing value for reasons such as industrial or economic factors that are outside of the asset holder’s direct control. If you are either holding real estate or looking at buying real estate, pay attention. Avoiding situations in which your property succumbs to the effects of economic obsolescence can save you a world of hurt down the line.
What is economic obsolescence?
Economic obsolescence refers to when an asset loses value for reasons outside of the owner’s control. Economic obsolescence is due exclusively to external factors, such as location and environment or government regulation changes. Businesses and investors will use this term to determine if buying and holding an asset is viable now and in the future.
Economic obsolescence as an economic concept
Economic obsolescence is most commonly associated with real estate, but as an economic concept, it can be related to appropriate fixed assets. Economic obsolescence is a concept in economics that occurs when an asset or product is no longer viable due to forces outside of its control. It affects a company or asset’s “enterprise value,” which can make it difficult to generate future cash flow. Economic obsolescence also affects the fixed assets subject to the area in which the obsolescence occurs.
When looking at how quickly an asset can be sold, economists will use the term “net orderly liquidation value,” which represents the estimated amount that an asset will sell for, given a reasonable period of time. This stands in contrast to “forced liquidation value,” which is how much you can sell an asset for (unit value) in an unreasonable or very short amount of time.
Functional obsolescence vs. economic obsolescence in real estate
In the world of investing, the word obsolescence comes with a few different connotations. In fact, depending on who you talk to, there are four subsets of obsolescence:
- physical obsolescence
- functional obsolescence
- locational obsolescence
- economic obsolescence
However, as economic obsolescence encompasses most of what physical and locational do, we will use that as an umbrella term for all three (it is commonly used that way).
Functional obsolescence, in short, means that with some improvement, you can turn the obsolescence around and make the asset viable again. The asset is functionally obsolete and can be fixed to make it fully functional again. For instance, you might have a property with an outdated kitchen or system that can be improved. Once this has been completed, the asset’s value should be more in line with the market.
Economic obsolescence in real estate refers to things that, in the majority of cases, cannot be fixed and are completely outside the control of the owner of the asset. In some cases, they are not related to anything in the physical world, such as government regulation and zoning. In other cases, the movement of an airport or train station nearby might change the value. The most important difference to note is that, unlike functional obsolescence, economic obsolescence is due to EXTERNAL factors outside the control of the owner.
Bad news for real estate agents
This can be a real estate agent’s worst nightmare! You have a bunch of listings in an area, and forces outside of your control bring down the value. Elizabeth Alligood, a real estate professional, has experienced this. “Various social, economic, and local factors can exert a substantial influence on real estate values,” she says. “Examples include zoning regulations, tax policies, legislative changes, inflation, and specific bills or laws, such as the ULA tax, which affects residential and commercial properties, and proposed bills that could impact short-term investment properties, such as Airbnb and VRBO.”
How economic obsolescence affects real estate
Although economic obsolescence can be applied to virtually any asset including intangible assets, it is most commonly used in the real estate industry.
Changes in surrounding infrastructure
Changes in surrounding infrastructure can have an effect on values that result in a significant drop in the value of an asset. For instance, many commercial real estate assets, such as rest stops, are valued because of their proximity to major infrastructure such as a highway.
If a new highway was to be built that directs traffic in a different direction, this could cause a drop in values across the board for all property near the old highway. On the flip side, a new highway right next to a residential property development could increase noise and congestion. This could then have a negative effect on the property values of the surrounding areas.
Changes in zoning
Zoning is an extremely powerful tool for governments to sculpt different areas in a certain way. For instance, say that a property only had one type of zone, agricultural, and a home buyer was able to get a zoning exception to build the only rudimental property for miles around. If the zoning was then changed to residential, there could be many more residential developments springing up, thus increasing supply and potentially dropping values.
Changes in tax and regulation
Changes in tax and or regulation can also have an effect on property values that are outside of the owner’s control. For instance, after the financial crisis, many real estate developments were granted “tax abatement” status, in which the buyer was exempt from property tax for a period of time, sometimes up to 10 years. If you bought a condo in a building where everyone also bought with a 10-year tax abatement, and then in the future it expired, that could have a negative effect on prices.
Some of the most inexpensive properties in the United States can be found in the industrial Midwest and the surrounding towns. This is due to the phasing out of on-short manufacturing and heavy industry on domestic soil for cheaper and less intrusive options overseas. If a town or city is tied to one industry, and that industry moves away, this can result in economic obsolescence affecting all of the properties located nearby.
Some areas can even be hit by popular restaurants and venues closing down or moving. For instance, Tacos Perla is a popular restaurant chain in Southern California. Tacos Perla’s homemade Mexican menu, which keeps customers lining up, has an impact on the property values in the area. When a successful business like this leaves, so will foot traffic and the desire to live in the area.
Change in climate or natural disasters
Our physical world can change in an instant or over a longer period of time, which can affect property values. For example, properties that are nestled next to ski resorts in places like New Mexico might be affected by higher temperatures and a shorter ski season. This would, of course, result in less ski traffic which could result in a drop in values. Another example of naturally related economic obsolescence could be a property in Florida, which is susceptible to floods and hurricanes.
Change in transportation access
Go to any major city in the world, and the distance to a subway or train station directly correlates to property values. The same goes for real estate that is near water ports or airports. If a new train station comes in that is more convenient than the existing train station near a property, this could affect property values. Likewise, if a new airport is put right beside a condominium complex, those condominiums risk losing value because of noise pollution due to the planes flying above.
On the reverse end, does gentrification have its downsides?
Gentrification can sometimes have downsides for an area, says David Cheatham, founder of ReGrow. “While these new opportunities can be appealing, they can be troubling for current residents and legacy business owners,” he says. “Not only can the cost of living increase, but it can also affect local business owners who not only have established a physical presence and comfort for the community — but a lasting sentiment for what has either been passed on or acquired through hard work and dedication. For those working-class residents hoping to buy a home, they find themselves being priced out of what was once an affordable neighborhood.”
How to avoid economic obsolescence
- Know your county or municipality’s plans.
- Know the economic environment of the surrounding area.
- Continue to keep in touch with real estate agents.
What are the signs of economic obsolescence?
There can be a number of different signs. Local properties might be unable to be sold for fair market value or businesses in the area could start closing. Economic obsolescence occurs when an area is on the decline for various reasons, or something better comes up which makes the existing area obsolete.
- Economic obsolescence is when asset values depreciate due to external factors.
- Economic obsolescence in real estate is when real estate values start declining due to forces outside the owner’s control or external obsolescence.
- Changes in surrounding infrastructure, changes in industry, and changes in climate/natural disasters are some of the causes of economic obsolescence.
- No one can predict the future 100%, but you can watch out for warning signs of economic obsolescence. Check your municipal government’s plans or talk to local agents and business owners.
View Article Sources
- Economic Obsolescence (Real Estate) – Corporate Finance Institute
- Curable / Incurable Depreciation & Rates – Santa Cruz County Arizona
- Enterprise Value: A Comprehensive Measure of a Company’s Worth – SuperMoney
- How to Invest in Real Estate: An Expert Guide for Beginners – SuperMoney
- Tangible vs Intangible Assets: Here Are The Differences – SuperMoney
- What is a Tax Abatement and How Does It Work? – SuperMoney