Table of Contents
- Common Causes of Economic Obsolescence
a. Examples of Economic Obsolescence
- Economic Obsolescence versus Functional Obsolescence
Economic Obsolescence, in the context of real estate, is the depreciation in the value of a property due to external factors that are outside the control of the owner. As such, economic obsolescence is usually considered irreparable, as the owner has little to no influence over these external factors. Economic obsolescence is otherwise known as external obsolescence.
Common Causes of Economic Obsolescence
External factors such as an increase in crime rate in the neighbourhood, economic downturn, unfavourable environmental changes such as the construction of sewer plants or landfills in the vicinity of the property can negatively impact the appeal of the property and hence lower its value.
Examples of Economic Obsolescence
You own a residential property with a high occupancy rate. However, the government has constructed a highway near the property, resulting in increased traffic congestion in the neighbourhood and excessive noise pollution. As a consequence, your tenants have chosen to move out and you encounter challenges in sourcing for new tenants, as they find the excessive traffic unfavourable and the noise levels less conducive. In such an instance, you have no say in the construction of the highway and are made to suffer the consequence. Faced with a vacant property, you have no choice but to reduce your rent to incentivise prospective tenants to consider renting the property despite the noise. Not only the income generated by the property would be reduced, but its value would also be impaired. In severe circumstances, the value of the property might decline to a point where it might be considered economically unviable as an investment.
Economic obsolescence can occur if the crime rate increases within the neighbourhood of the property. Tenants may not feel safe and you are forced to reduce your rent to incentivise new tenants to move in. Furthermore, a high crime rate could also mean an increased risk of damage to the property, which would incur additional costs to the owner and in the long term, a reduction in the value of the property.
Economic obsolescence could also occur during an economic downturn where people lose their jobs and have lower incomes. As a result, many may be unable to afford the monthly rent. Rental properties would then face a reduction in occupancy rates, driving the value of the property lower. Furthermore, properties may also go into foreclosure as borrowers are unable to service their mortgage payments, so lenders attempt to recover the balance of the loan by selling the property, which is collateral for the loan. If there are enough vacant properties in a certain area, the value of the properties there could plunge, even if they are occupied and well-maintained. As a homeowner or a landlord, these factors are outside of your control.
A good example of economic obsolescence is when the economy of a town heavily supported by a factory suffers a major hit when the business corporation that owns the factory decides to shut it down in a major restructuring move. Workers at the factory will be laid off and many of them will migrate to other cities to find work, resulting in housing demand in the city to plummet.
Economic Obsolescence versus Functional Obsolescence
Economic obsolescence may be confused with functional obsolescence, as both economic and functional obsolescence result in a loss of value, arising from factors which are beyond the owner’s control.
Functional obsolescence refers to the loss of utility or functionality that is attached to a property due to changes in market standards, which ultimately results in a loss of value. This could be due to outdated design, equipment and technology that are unable to satisfy the needs of tenants. For example, if a property is unable to provide internet and cellular services while other similar properties are able to do so, it could be considered functionally obsolete as it cannot meet the expected needs of tenants.
Although the change in market standards for properties to have internet and cellular services is not within the control of the landlord, it is considered functional obsolescence as the issues are internal to the property. Furthermore, the owner has the potential to resolve the issue of functional obsolescence, as long as the cost to rectify the issue is less than the benefit provided by the improvement. The owner can simply set up the internet and cellular services within the property, at a relatively low price.
However, for economic obsolescence, the issues are external to the property and the owner has no influence over it. An example would be if the local government decides to build a power plant in the vicinity of the property, the owner of the property has no way to resolve the issue.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.