Remsha - Identifying Economic Obsolescence (NEW FILE)
Remsha - Identifying Economic Obsolescence (NEW FILE)
Remsha - Identifying Economic Obsolescence (NEW FILE)
Introduction
Economic obsolescence: You can’t see it, you can’t touch it, and you can’t smell it (at
least most of the time), so how are appraisers supposed to quantify it? No one ever said
being an appraiser was easy. It takes years of training, experience, and hard work to be
able to investigate an industry, analyze market data, and derive factors such as economic
obsolescence (“EO”).
This paper will discuss a number of procedures that can be used to identify and quantify EO.
The appraiser must study the subject property and its industry, as appropriate, to determine
if EO exists, and if it does, how to measure and apply it. These procedures may not apply
to every property or industry, and may not be appropriate in the case of certain U.S. Federal
Tax or financial reporting matters where other perspectives may apply.
even global economy. Major properties that typically include real estate and significant
other capital assets, and going concern influences (business values such as tangible
and intangible assets and working capital) can be affected by local economic factors,
but usually are more significantly affected by industry-wide economic conditions.
Industry economic conditions affect all aspects of a business, and commonly, entire
businesses are appraised, not just real estate or just machinery and equipment. Some
typical properties that would be appraised as a business include cement plants, steel mills,
paper mills, petrochemical and chemical plants, and other processing plants; oil and gas
production, mining, and other facilities in the extractive industries; and any other assemblies
of assets that compete in a specific industry. Typical sources of data that can be used to
review the economics of an industry include annual stockholder reports of companies in
the industry, 10K reports to the Securities and Exchange Commission, industry publications
discussing product and raw material price changes, investment banking and brokerage
reports, and government studies. By using such data, the appraiser can determine if the
earnings in the industry – and hence, of the subject property – have been, are currently, or
will be affected by some outside economic influence that will reduce earnings and, therefore,
the value of the business and its assets.
Of course, if certain assets in the plant or in the industry are generic such that they could
be used by other industries, the EO of the current user may not be appropriate for that
specific asset. For example, EO in the typewriter industry may be significant, but the real
estate associated with a typewriter plant could be used by many different users. Therefore,
it would be appropriate to apply the EO penalty to the machinery and equipment used
to manufacture typewriters, but not to the buildings. The appraiser must practice careful
analysis.
Quantification
Overview
To quantify EO, an appraiser must first investigate the existence of economic conditions that
may reduce the value of a business and, hence, its assets. Then, the EO must be quantified
in an objective manner. EO may exist in any industry or property where the following
attributes are found:
EO is present when better economic opportunities exist for an investment. The economic
principles of supply and demand, and competition drive the loss of value associated with
EO. Typically, EO cannot be reduced by capital investments, but it can change and even
decline to zero through changing industry conditions.
EO can be quantified using many different methods, including the following:
• Market-Derived Approach
• Income Approach
• Utilization Analysis
• Return-on-Capital Analysis
• Equity-to-Book Ratio Analysis
• Gross Margin Analysis
• Government Regulations Analysis
• Income Shortfall Analysis
• Best of the Best Technique
Every method may not be applicable in every valuation problem. Determination of the
appropriate method will depend on the availability of data for review and the type of asset
being valued. The following sections discuss each method in greater detail.
Market-Derived Approach
A very simple and direct approach is to derive EO from the market by reviewing sales
of similar properties. This is especially useful for real estate where similar properties are
available in the local or regional market and sufficient information is available on properties
that have sold. In this approach, the following steps are applied:
Step 1 Deduct land value from the sale price of the property that sold;
the result is the value of only non-land assets. Because EO is an
attribute of the cost approach and land is typically valued using the
sales comparison approach, the land value is removed from the
analysis.
Step 3 Calculate all depreciation and obsolescence, except EO, and deduct
it from the current cost new of non-land assets.
Step 4 Deduct the adjusted sale price (Step 1) from the current cost new
less depreciation and obsolescence (Step 3).
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CORLD $1,000,000
Less Functional Obsolescence 0
Indicated EO $200,000
Hence, based on the above, EO is $200,000, or 13% of the COR, or 20% of the CORLD.
The dollar amount of EO is the same, but the percent will vary depending on how it is
measured and how it is to be used.
Income Approach
A common valuation technique used by the financial community is simply to develop
the income approach to indicate the value of the property being appraised. The income
approach quantifies all forms of depreciation and obsolescence - physical, functional, and
economic. However, when quantifying depreciation and obsolescence through use of
the income approach, EO cannot be separately delineated in the analysis without relying
on the cost approach. A modification of this approach is to develop all aspects of the
cost approach, with the exception of EO, as in the market-derived approach previously
discussed, then subtract the income approach indication of value from the partially
completed cost approach; the difference is EO. The primary problem with this approach is
that the result really relies on just one approach to value, the income approach. As a general
rule, using this technique, the result of the cost approach to value will always equal the result
of the income approach to value. Although EO has been developed, it is totally dependent
on the basic assumptions of the income approach. An example, based on the previous
example used in the Market-Derived Approach section, follows:
EO in this example is therefore $100,000. If the income approach indication of value were
to change based on a different set of projections or even a different discount rate, the dollar
amount of EO also would change.
Utilization Analysis
Other totally independent procedures are available to quantify the effects of EO. One simple
approach is to review the asset’s utilization. If the asset is being utilized at less than 100%
or whatever is the norm for the industry, then EO exists because demand in the industry is
substantially less than the available supply. Mathematically, this is based on the relationship
whereby EO equals actual utilized capacity (demand) divided by maximum capacity (supply)
with the result taken to an exponent (scale factor), subtracted from 1. The scale factor is a
relationship of cost to capacity, which reflects the concept that as capacity increases, the
cost of construction increases at a different rate, typically a slower rate. Typical scale factors
are 0.6 to 0.7, based on data published in engineering and construction texts.
The typewriter industry circa 1999 will be used as an example of this type of calculation.
Because of the use of personal computers, demand for typewriters has been greatly
reduced. While the manufacturing supply potential is still in place, the demand is not. Let’s
say the machinery and equipment at a certain plant has the capacity (supply) to manufacture
100,000 units per year, but demand is for only 1,000 units per year. The magnitude of EO in
the industry and in the assets located at the plant is calculated as follows:
EO = 1 - (Demand/Capacity)0.7
= 1 - (1,000/100,000)0.7
= 1 - 0.010.7
= 96%
Note that to convert the 96% figure into a dollar amount, one can multiply it by the CRN,
COR, or CORLD. Percentage deductions are always deducted before dollar deductions.
The order of the mathematical calculation is not important; the result will be the same (the
associative principle of algebra).
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The subject company in our example has some income from production of the product,
but the machinery and equipment is severely underutilized and, hence, exhibits a high level
of EO, 96%. The market for typewriters has been replaced due to a new form of office
equipment, personal computers.
Some unenlightened practitioners may argue that EO cannot exist if capacity at the subject
or in the industry is nearly or fully used. This is not always true. It can be true only if
earnings in the industry can support the capital investment at a market-based rate of return.
If utilization is at 100%, but the industry (including the subject) is only breaking even or losing
money, then EO is strongly indicated. Utilization can be at what is considered the norm in
the industry because of economic influences outside the property, such as high consumer
demand, and yet the company may have low levels of profitability because of competition
or some other outside influence on the subject property. An example would be any U.S.
company competing with companies located in foreign countries where raw materials
or operating expenses are less than in the United States. A U.S. plant with a maximum
capacity of 100,000 units per year and high demand for its products may have an output of
100,000 units per year. But because of imports from overseas, the price (i.e., value) received
for the products produced may just cover expenses; therefore, earnings are low or negative,
and the return on the investments in the business are reduced. The magnitude of EO in the
industry, based on utilization only (that is, with a blindfold on), is “calculated” to be zero. Of
course, this is incorrect.
As can be seen in the example above, a company may have low or negative earnings
from the manufacture of a product, yet the equipment may still be utilized at 100%. The
plant is likely experiencing financial difficulties because of reduced earnings caused by
competition; hence, EO exists and must be quantified using an earnings-related approach.
The practitioner can’t just plug numbers into formulas to calculate a result and call it
EO. Thoughtful, reasoned analysis is required. Several questions must be investigated
and answered: Are expected earnings reasonable for the subject property? How do the
property’s earnings compare to the industry? How do the property’s and industry’s earnings
compare to those in alternative investments?
If a plant is new and “state-of-the-art,” it still can exhibit EO. For example, if a plant was
built to manufacture a product, and because of changes in government regulations or
consumer preferences, the demand for the product or maybe even the primary raw material
disappears, EO for the plant and the industry could suddenly be 100%, and the plant would
shut down. This could happen today (2001) in the MTBE industry if the U.S. government
follows the lead of California and bans the use of MTBE (a blendstock used in reformulated
gasoline) in the entire country. The MTBE plants would have the option of shutting down or
maybe, if even possible, spending capital to modify the facilities to produce another product.
EO can be sudden and significant, especially if a government body is involved.
Return-on-Capital Analysis
Another approach to quantifying EO is a return-on-capital (or investment) analysis. In such
an analysis, the relationship of earnings is compared to the magnitude of investment used
to generate those earnings. A simple and direct approach to apply the return-on-capital
analysis is to review the relationships of publicly traded companies in the same or a similar
line of business as the subject property as of the appraisal date to a benchmark to determine
if EO exists and at what level. One method is to compare the percent earned on total capital
(return on capital) for the year prior to the appraisal date with the percent earned on total
capital during a time frame when it was higher (that is, the good old days of more reasonable
returns; the time frame may be one year or over several years).
A convenient publication to utilize in this analysis is Value Line Investment Survey (“Value
Line”). Value Line publishes a significant amount of current and historical financial data on
thousands of publicly traded stocks on a continuous basis. One of the components of a
Value Line analysis is percent earned on total capital.
Value Line defines percent earned on total capital as “a company’s return on its
stockholders’ equity and long-term debt obligations.” As defined in the financial community,
the summation of long-term debt and stockholders’ equity represents the total invested
capital of a business or the business enterprise. When the economics of the industry are
good, the return on capital will be high; when poor, low. Hence, a return-on-capital analysis
is a meaningful indicator of economic obsolescence.
To develop an example analysis, returns for a typical industry were reviewed based on
data published in Value Line. A review follows, showing Value Line-type data for a sample
industry:
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Therefore, using the data presented above, EO in this example can be calculated as follows:
Accordingly, based on the return-on-capital analysis, the economic penalty, or EO, on assets
in the sample industry is 18%.
This is a meaningful indicator of EO when the practitioner can identify companies followed by
Value Line that are in an industry similar to the subject property and have a minimal amount
of diversification. For example, if the subject property were an oil refinery, several companies
followed by Value Line would be considered good comparables because they are primarily
oil refining companies with few other assets in other sectors of the oil and gas industry, or
other industries. In other words, the economics of the subject property would be influenced
by the same or similar factors as the economics of the comparable companies. If the
subject property were a single tissue (paper) mill, this approach may not be as meaningful
because Value Line does not track any companies that own just tissue mills. All the paper
industry companies followed are diversified and, hence, may experience different economic
factors than the subject.
After finding the comparable companies, the second step is to study the history of the
industry to find a period of time when the return on capital was good (that is, again, what
industry insiders would call “the good old days”). For the oil refining industry, this can be
identified as the late 1970s, and 1988, the years before supply and demand disruptions and
expensive government regulations.
The practitioner must study the subject property’s economics and locate companies to
be used as comparables that are as similar as possible to the subject. Of course, no
comparable will be perfect. The goal is to locate comparables that are in a similar economic
environment.
From a legal perspective, stockholders own the firm in which they have invested. From an
investor’s viewpoint, stock ownership is considered to represent a net ownership position
in the firm’s assets. At any point in time, if the total value of all assets is considered and all
liabilities are deducted, the net amount is representative of the total value of the common
stock or the value of the common equity in the firm. Thus, an investor purchasing shares of
common stock is making a decision on the value of the total assets.
The book value of common stocks of publicly held companies is calculated with reasonable
consistency for most publicly traded companies due to accounting regulations. The
regulations involve not only the general methodology used in the calculations, but also the
type of data available to investors. Because of the consistency of reporting, book values are
useful as a benchmark for certain types of measurements. However, book values will not
specifically represent fair market value of the assets, primarily because they are based on
historical costs.
Stock Prices
888 821
High
709 652
Low
799 737
Mean
Therefore, using the data presented above, EO in this example is calculated as follows:
This relationship is indicative of investors’ relative valuation of the sample industry assets
when compared with general industrial stocks. Owners of general industrial stocks appear
willing to pay about 27% more for such stocks than they would pay for stock in the sample
industry, based on the equity-to-book-value ratio. By this method, EO of 27% is indicated.
To the extent that EO exists in the general industrial companies used in this analysis, the EO
conclusion for the sample industry is somewhat understated.
EO = 13% - 10% = 3%
= 23%
13% 13%
This means, because of regulatory lag (bureaucracy), the utility in our example is not able
to earn at market rates, and therefore, the owners of the utility must accept a lower level of
earnings. This loss of earnings is a form of EO that reduces the value of the utility’s property.
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Again, because of local government controls, EO exists, and the value of the property is
reduced.
Consider the position of a potential buyer. If a potential buyer knows that the earnings
will be reduced by local government rent controls, will a purchase offer be based on the
property’s earnings limited by local regulations, or on current market rental rates that do not
apply to the property? Of course, the prudent investor will base the offer to purchase on
the property’s permitted earnings, not on market earnings that do not apply. Rent controls
reduce the value of a property because earnings are controlled, reduced. That’s economic
obsolescence.
15% - 10% 5%
EO = = = 33%
15% 15%
Another way to calculate the EO caused by an income shortfall is to calculate the differential
in earnings. This can be determined by the following formula:
Current Income
Calculated Return = = 10%
Current Investment
Projected Income
Projected Return = = 7%
Projected Investment
10% - 7%
EO = = 30%
10%
This income shortfall calculation of EO is very similar to the first calculation, in which the
required and current returns were known. In this example, the returns are calculated
based on the investment in the property and the return received or projected after a new
investment is made that provided no additional income. The result is similar: EO exists and
is significant.
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Step 2 Compare the subject property’s indicators against the best indicators
in the market to obtain a relationship to the standard, or Best of the
Best.
The above method was commonly used in the valuation of railroads for property tax
purposes. A simple example follows:
Rate of Return 6 10 60
Net Margin 2 3 67
Utilization 75 90 83
Average 70
Using the 70% indication of the subject’s relationship to the Best of the Best results in an EO
indication of 30% (1 - 70%). This method could be applied to any subject, or in any industry,
where reliable economic performance data are available for similar properties. The primary
problem with this method is obtaining reliable economic performance data.
Summary
The choice of which method to use depends on the availability of data to utilize and the type
of property being valued.
Entrepreneurial Profit
Entrepreneurial profit is the anticipated profit an investor requires to construct and sell a
property. It is a reward to the entrepreneur for the inherent risks of investing time and money
in the construction of a property.
Entrepreneurial profit must be market based; it is not automatic. The market will not
automatically reward an entrepreneur for hard work and risky investments. Most likely,
this type of profit will exist in generic industrial, commercial, and residual properties in an
expanding market where demand is greater than supply. It will not exist in unique or special-
purpose properties that are built by users and are not for sale in the general marketplace. Of
course, if EO exists, entrepreneurial profit is negative. Both cannot exist at the same time
(that is, both cannot be positive or negative).
A lack of new construction is generally an indicator that EO may exist. However, EO can
exist in the presence of new construction, as well. Sometimes, a large corporation will
replace an old functionally obsolete plant with a new, modern, state-of-the-art plant to
reduce operating costs and create a stronger presence in the industry. While EO still exists
in the industry, which reduces the earnings of the company, the reduced operating expenses
resulting from a new plant will make it a stronger participant in the industry and potentially
even help to drive out the competition. This may reduce and even eliminate some of the
competition and, also, reduce or eliminate EO.
Conclusion
Economic obsolescence is present when better economic opportunities exist for an
investment. When a government entity steps in and attempts to control the market through
regulations, EO is created externally and reduces the value of assets. The loss of value
associated with EO also is caused by the economic principles of supply and demand, and
competition. EO typically cannot be reduced by capital investments, but it can change, and
even decline to zero through changing industry conditions.
An enlightened appraiser will investigate the existence of EO and quantify it based on market
indicators. Ideally, more than one method will be utilized and the results correlated to
conclude the magnitude of the EO.
This text has covered a number of procedures that can be used to quantify the effects of EO.
These procedures will not apply to every property or industry, and other more appropriate
indicators may apply. The appraiser must study the subject property and its industry, as
appropriate, to determine if EO exists, and if it does, how to measure it. Careful analysis
and study are required, and the process described herein may not be appropriate for matters
pertaining to certain U.S. Federal Tax or financial reporting.
You can’t see it, you can’t touch it, and you can’t smell it, but you can measure it using the
appraiser’s proper valuation tools. It’s in the market, and if an informed appraiser is alert, it
will be heard. When the market speaks, appraisers listen.
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Bibliography
Hartman, Donald and Michael Shapiro. 1983. Depreciation: Incurable Functional
Obsolescence and Sequence of Deductions, The Appraisal Journal, July.
Kinnard, William, and Gail Beron. 1984. Quantification and Measurement of Economic
Obsolescence. Paper presented at the Real Estate Valuation Symposium, November 14.
Institute of Property Taxation.
Landretti, Greg. 1986. Annual Economic Adjustments and the Special Purpose Industrial
Property, Assessment Digest, International Association of Assessing Officers, September/
October, Volume 8, Number 5.
Miles, Les. 1993. Economic Obsolescence, The M/TV Journal, American Society of
Appraisers, Fall, Volume 10, Number 2.
Rhodes, Lester. 2001. External Obsolescence and Complex Properties. Paper presented
at the 25th Annual Conference, June 2001. Institute for Professionals in Taxation.
Thatcher, Lionel, and Richard Dubielzig. 1967. Obsolescence in Railroad Ad Valorem Tax
Assessments, Wisconsin Commerce Reports, The University of Wisconsin, May, Volume VIII,
No. 2.
Leading / Thinking / Performing®
This paper is based on a presentation given at the 2001 Property Tax Symposium in La
Jolla, California, sponsored by the Institute for Professionals in Taxation; the presentation
was based on an article published in the Machinery and Technical Specialties Journal of
the American Society of Appraisers, Volume 16, Number 1, 2000.
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