Printer Friendly

Supply-saturation - induced external obsolescence: two techniques for quantifying value loss.

During the 1980s, the United States experienced an unparalleled development frenzy. Stimulated by abundant financing, fee-driven developers and financiers, and an expanding economy, the supply of commercial real estate nearly doubled over this decade. Now that the development party is over, the nation is grappling with supply hangover symptoms including a national office vacancy rate of 20%, devastated banking and savings and loan industries, increased government regulation, unfulfilled expectations, and severe capital illiquidity. All this is occurring in the midst of an economic recession ironically caused in part by decreased development. Indeed, the costs of the real estate recovery will affect U.S. taxpayers, investors, lenders, and borrowers throughout the 1990s.

In depressed markets, a popular unit of comparison is replacement cost to value. Enhanced regulation and review of appraisals has increased the need to quantify supply-saturation--induced external obsolescence. This article introduces two techniques--comparison of replacement cost to values derived under sales comparison (sales/cost technique) and comparison of replacement cost to values derived under income analyses (income/cost technique)--which are applied to Dallas/Fort Worth apartment properties over the peak and valley of the recession and the initial stages of the recovery period, or from 1985 to 1990. The results of the two techniques are compared and the reliability of each is explored relative to market conditions.

Real estate markets in Texas were the first to experience the development boom of the 1980s and the subsequent decline created by oversupply, and also appear to be leading the nation in recovery. Accordingly, in this article valuation issues emanating from the most recent cycle are examined, under the premise that behavior in Texas markets provides a case history for analysts in markets just entering the supply-saturation quagmire. Specifically, the focus of this study is external obsolescence for multifamily properties in the Dallas/Fort Worth area. Garden-apartment properties are good indicators of market conditions because the absence of long-term leases subjects property owners to prevailing market trends. Further, these properties are actively conveyed, increasing data for analysis.


Under the sales/cost technique, replacement cost (less physical depreciation and plus site value) is compared to the sale price of a comparable transaction. If replacement cost exceeds sale price, the difference is obsolescence; if price exceeds cost, excess entrepreneurial profit is implied. For this analysis, entrepreneurial profit is included; however, as demonstrated in the following sections, the analysis is also valid if profit is excluded. Inclusion of profit depends on an analyst's preference; some appraisers believe it is appropriate to exclude profit from the cost in markets where feasibility clearly has not been attained.

In 1983, 1984, and 1985, developers added 85,610 units to the Dallas apartment market; units built in these three years comprised 45% of the total market at the end of 1985. This newest class of properties is also the clearest indicator of tumultuous market conditions because a typical chain of ownership includes a developer or partnership, a lender (or its successor) through foreclosure or deed-back, and subsequently an investor. Further, physical depreciation is typically minimal for newer properties, implying that value loss derived is attributable to external obsolescence. Therefore, this research focused on conveyances of newer apartment properties, usually located in growth suburbs and containing 200 to 350 units. Properties with known functional issues were excluded, with emphasis on all-cash conveyances with no unusual conditions of sale. As a result of this research, seven multifamily sales were selected for each of the six years of analysis.

As noted earlier, the sale price of each comparable was compared with estimated replacement cost (including site value with a deduction for physical depreciation) to derive an estimate of profit or loss (i.e., obsolescence). This technique is illustrated with and without entrepreneurial profit for those who do not use profit in a market where development is not feasible. Replacement cost for each year of analysis was estimated via the Marshall & Swift Cost Service; the properties were compared to class D--above average/average construction. Physical depreciation for each sale was based on the age/life method; effective ages for the properties were considered equivalent to chronological age, with economic lives estimated at 35 years, based on averages in Marshall & Swift Cost Service. Land values were estimated after review of multifamily-zoned land conveyances in each year. Because of a dearth of sales in some years the estimates were augmented by a survey of prominent apartment brokers and investors. Profit was estimated at 12% for each year of analysis based on the authors' survey of the market and the yields available on alternative investment. Assumptions regarding replacement cost and land values are summarized in Figure 1.

Once depreciated replacement cost (including profit and land) is estimated, comparison to the sale price of the property allows an estimate of external obsolescence to be derived. Moreover, two units of comparison can be extracted: external obsolescence per square foot and external obsolescence as a percentage of replacement cost. An example of the application of this technique is illustrated in Figure 2.
FIGURE 1 Assumptions: Dallas/Fort Worth Apartment Market
Replacement Cost and Land Value

 Replacement Cost
 New (RCN(1)) RCN(1)
Year Without Profit With Profit Site Value(1)

1985 $39.71 $44.48 $12.51
1986 $38.05 $42.61 $10.01
1987 $37.86 $42.40 $ 5.63
1988 $38.58 $43.21 $ 5.00
1989 $40.00 $44.80 $ 6.26
1990 $40.36 $45.21 $ 6.89

1 Per square foot of building area. Replacement cost estimates
include hard and soft costs. An allocation of 12% of cost is
used for entrepreneurial profit to illustrate that the
mechanics of the procedure do not materially change if profit
is considered.


For this study, the quantity of data analyzed mandated the use of averages: in practice appraisers can refine inputs after inspection and analysis of data compiled for the appraisal at hand. Thus, although the conclusions from this analysis were based on the use of broad averages, application in an actual appraisal should result in more accurate indicators of external obsolescence.

The results of the comparative analyses for the seven sales in each year are shown in Figure 3.

The standard deviation was included to assist in analyzing central tendency; theoretically, if the standard deviation is lower, the correlation of the data is closer. In 1985, the data indicated an average external obsolescence indicator of 0.11% including a 12% factor for profit; this documents the hyperactive market of the time as well as the effect of tax benefits. Abolition of tax advantages coupled with oversupply caused values to plummet in 1986, and the sales indicate average external obsolescence of 49.6% and $21.14 per square foot; in other words, values were at half of replacement costs. Declining cash flows in turn stimulated mortgage defaults, and in 1986 there were 84 TABULAR DATA OMITTED apartment foreclosures compared with 66 the previous year and two in 1984. Increased foreclosures foreshadowed market events of the late 1980s: lenders became owners (and grantors) when the market recovery commenced. The number of multifamily conveyances also declined in 1986 (from 334 to 280) as buyers and sellers grew further apart in value expectations.

In 1987, rents and occupancy declined, foreclosures more than doubled, and the number of conveyances declined; these statistics portended market decline. Despite this, the average external obsolescence extracted from the sales declined to 36.7% and $15.55 per square foot, implying that investors anticipated market improvement. Use of the sales/cost technique for this year proved challenging because of the dearth of sales for analysis; in 1987 only 236 apartment properties were conveyed, the lowest sales volume for any year of analysis.

In 1988, market occupancy improved 3%, although rents were level. Market turmoil continued as the number of foreclosures increased 44.6% to 269; this year proved to be the apex of foreclosure activity. Concurrently, the number of sales increased 10.6% as contrarian investors recognized improving occupancy, depressed values, and lenders motivated to dispose of foreclosed property. The sales/cost analysis indicated average external obsolescence of 27.6% and $11.92 per square foot for this year, showing a slight improvement over the previous year.

Occupancy improvement continued in 1989 and also eased rental rates upward by $0.01 per square foot. Foreclosures declined slightly, while the number of sales increased 47.5% (approximately 385 properties were conveyed). Market improvement is noted in external obsolescence indicators derived from the sales: 27.34% and $12.25 per square foot. The data from this year, however, reflected the second highest standard deviation, indicating a wider dispersion in the data.

Despite strong sale activity, declining foreclosures, and enhanced occupancy and rental rates, (all factors that portend diminution in external obsolescence), the data exhibited higher obsolescence of 35.29% and $15.96 per square foot for 1990. As discussed later in this article, this is attributed to a decline in the average quality of the sales and reflected in a higher standard deviation (the third highest among the six years analyzed).

One inherent weakness of the data is that during the years of greatest market decline (1986 and 1987) few sales occurred; thus the application of this technique during these years was more difficult because of the more limited body of conveyances. In addition, once the recovery commenced, investors sought the highest quality properties first, with subsequent acquisitions reflecting declining quality. This is shown in the average sale price per square foot for the sales considered: after remaining basically static in 1987 and 1988, the average price per square foot increased slightly in 1989, then declined in 1990. The decline in average sale price in 1990 in particular reflects a lower average quality, because several new apartment projects were started in this year, which implies that feasibility had been attained in premier submarkets. In addition, investors who acquired apartments in 1987 or 1988 enjoyed 8% to 10% rent increases and thus few were willing to sell, precluding period sales analyses.

Another interesting aspect of the data is that in 1985, five of the seven sales indicated negative external obsolescence, better described as excess entrepreneurial profit. The rapid growth of Dallas and resultant upward pressure on real estate values had created a hyperactive investment environment, which was exacerbated by tax incentives and the deregulation of the savings and loan industry. In 1986, slowed population growth and diminished tax advantages combined to depress Dallas apartment values: The data analyzed implied a 43.6% decline in average sale price per square foot. Tax incentives and competition among buyers had created an artificial value above replacement cost and thus the severe decline in 1986 truly embodies the concept that excess profits breed ruinous competition.


This type of analysis measures external obsolescence in the cost approach compared to income inputs. An indicated value on a per-square-foot basis via a direct capitalization approach is compared to a value computed with the same cost figures used in the prior technique. The resulting difference between the two values is the indicated external obsolescence if the cost analysis exceeds the calculated income value. As with the sales/cost technique, entrepreneurial profit is implied if the income value exceeds cost; if profit has been included in the cost estimate, above-normal profit is indicated.

For this method, broad average parameters from the Dallas apartment market were input, and the resulting external obsolescence was calculated for each year. On the income side, market rent, occupancy, and expenses were obtained from leading secondary sources, while overall rates were derived from comparable sales, published investor surveys and a consensus of Dallas area apartment specialists. As indicated previously, the cost figures are from the Marshall & Swift Cost Service and replicate the estimates used in the sales/cost technique. The site value was converted to a value per square foot for ease of addition. As with the sales/cost technique, the results of this method are exhibited with and without entrepreneurial profit. For purposes of this article, the discussion focuses on the results with profit. The relationship between the various years remains the same, however, whether an analysis is performed with or without profit. The comparative analysis with profit is shown in Figure 4, while the analysis that excludes profit is presented in Figure 5.

The resulting indicated external obsolescence figures are quite revealing. In 1985, the acknowledged peak of the Dallas real estate cycle, external factors (e.g., overbuilding) had influenced income and occupancy levels to the point where, on an overall average basis, new construction should not have been considered economically sound. The external obsolescence for this year was 35.4% and $18.83 per square foot, indicating over a one-third loss from replacement cost. While many real estate experts continued to be bullish on Dallas in 1985, this analysis could have indicated to appraisers the pending supply saturation.

The external-obsolescence gap grew TABULAR DATA OMITTED to 42.4% and $20.25 per square foot in 1986, in what proved to be the culmination of many people's fears: the market was oversaturated and expenses continued to rise even as revenues declined dramatically. Apartment developers were not able to respond quickly enough, however, as over 22,000 new units were added to the existing inventory. This represented about a 10% increase in the total supply.

An interesting phenomenon appears to have occurred in 1987. In reaction to the misfortunes of the previous year and the realization that a correction was necessary, apartment owners were able to drastically reduce operating expenses in the wake of revenues that continued to slide. This "bunker mentality" led to a one-year blip on the external-obsolescence curve, as average values rose slightly and the calculated external obsolescence fell to 33% and TABULAR DATA OMITTED $13.85 per square foot. Investor return requirements remained low, however, with expectations of increasing rents and potential appreciation still uncertain. The obsolescence decrease was also aided by the fact that competition caused by a lower volume of construction reduced building costs. The building pipeline was not able to respond quickly enough in 1987, but while 22,000 units had been added the year before, only about 9,000 units were added to the market in 1987, slightly stemming the flow of the supply wave.

The following two years proved that 1987 was an anomaly as expenses that had curtailed in 1987 (e.g., maintenance) and those that had fallen with declining values and occupancy (e.g., taxes, management fees, utilities, insurance) increased significantly as required by competitive pressures and increasing revenues. Rental rates basically remained static over this period, but occupancy crept up 5% between 1987 and 1989, partially offsetting the expense increase. The income/cost analysis indicates only a slight increase in the average external obsolescence, to 36.1% and 36.7% in 1988 and 1989, respectively. Slight recovery was noted in 1989, with nearly 11,000 units of net absorption. After industry experts had opined that Dallas had hit bottom in each of the past three years, wary investors signaled cautious confidence in values.

Market improvement was clear in 1990 as revenues recorded a double-digit spike and values surged 10.5% above the previous year. Correspondingly, the income/cost analysis implies that average external obsolescence fell below 30% for the first time since 1984. A considerable assist in the recovery should be given to developers and lenders, as fewer than 300 units were completed in 1990--easily the smallest addition to the inventory that has occurred in the past decade.

The primary weakness of the income/cost analysis is derivation of overall rates; as always, this is a subject of debate. Sales used in the earlier technique, the investor criteria examined, and the apartment market specialists interviewed for this article, however, indicate a clear consensus to the rates used in this study. The authors also recognize that the preceding discussion incorporates average parameters for the entire market. While the analysis may not be relevant for certain subsectors, the application of the technique would nonetheless be useful in measuring external obsolescence in any given market or for other property types.

In addition to measuring the external obsolescence for any given point in time, these techniques can be applied to examine the relationship of macroeconomic characteristics of a region to the calculated external obsolescence. For instance, in the course of this article the authors allude to the impact of population and employment, foreclosures, sale velocity, and new supply. The point here, however, is that appraisers should be aware of the relationships that currently exist and be attuned to the changes that can occur as a result of supply saturation.


For 1985, the two techniques provide vastly different estimates: the sales/cost technique reflects market momentum and tax benefits, while the income/cost technique clearly demonstrates value loss caused by oversupply. Thus, use of these methods would have alerted analysts to divergent opinions and pending market decline, which reinforces the importance of using both techniques. The results of both techniques reflect a tighter range for 1986 through 1990; this supports the reliability of the analyses and the estimates extracted.

The sales/cost technique is enhanced by the limited number of assumptions it entails; the reliability of this technique is assured if the cost analysis is properly developed. This technique is also contingent on availability of comparable data; in declining markets a lack of conveyances can diminish use of the sales/cost technique. Comparable sales that include seller financing, atypical motivation, functional issues, or other elements that require adjustment are also more difficult to analyze.

The income/cost technique provides a valid indicator based on property economics. Estimation of additional variables (e.g., market rent, vacancy and collection loss, expenses, overall rates) increases the potential for error; still, these inputs are reliably supported by market research. Also, regardless of market sale velocity, income inputs can be derived from the market. Care must be exercised to recognize extraneous events (e.g., lack of equity and debt capital, returns on alternative investments, economic uncertainty, world events) that may affect investor yield parameters and may not be reflected in overall rates derived from sales.

The application of the two techniques to Dallas/Fort Worth apartment properties enhances understanding of value loss caused by the supply saturation. At the market peak (1985) the income analysis portends decline while the sales/cost technique reflects profit; this demonstrates the importance of using both techniques. In many areas, particularly in the Northeast, appraisers are uncertain about the depth of the market decline. Use of both techniques should help alleviate some of this uncertainty and assist in the interpretation of the external changes exhibited by both property sales and revenue levels. These techniques inherently incorporate economic considerations into the appraisal process, enhancing the reliability of the results.

The results of the two techniques correlated more closely in 1986, and indicate Dallas/Fort Worth apartments suffered external obsolescence of approximately 45%. In other words, at the depth of decline, virtually new properties were worth 50% of replacement cost. The techniques demonstrate gradual market recovery from 1987 to 1990. Gradually declining external obsolescence reflects improving market conditions, although the data analyzed for this study probably understate the recovery in Dallas (because averages are used); this is evidenced by development of new apartments in certain subsectors in 1990. Further, because so much supply was added in such a short period, this age group of supply became tiered and poorly located, conceived, or constructed. These properties have lagged the market in occupancy, rents, and values, distorting market statistics. Even when feasibility is attained, these market laggards languish. In addition, the data indicate newer properties tend to suffer more external obsolescence than older properties.


The primary purpose of this article is to present two techniques that may be used to quantify supply-saturation-induced external obsolescence. Under the sales/cost technique, sale prices are compared to depreciated replacement cost estimates; the difference is considered external obsolescence (or profit). Similarly, use of the income/cost technique entails estimation of a property value using income inputs; subsequent comparison to depreciated replacement cost yields an estimate of external obsolescence or excess profit. A strength of both techniques is that the analyses can be applied with or without entrepreneurial profit. The methods are demonstrated through application to Dallas/Fort Worth apartment properties, and the results demonstrate the importance of using both methods, especially in rapidly declining markets with a dearth of sales. Although the techniques were applied to apartment properties, the analysis can also be used for other property types, with a caveat for leased fee properties--contractual agreements are not recognized in the analysis. Finally, as a benchmark for markets still in decline, the analysis presented here indicates that 50% value loss as a result of external obsolescence was not unusual for Dallas/Fort Worth apartments at the depth of the market.

MacKenzie S. Bottum, MAI, is president of MacKenzie S. Bottum and Associates, Inc., a Dallas-based real estate appraisal and counseling firm. Mr. Bottum received a BS in real estate from Indiana University and has published previously in The Appraisal Journal.

Scott D. Evans, MAI, is a senior manager in Ernst & Young's valuation services group in Dallas, Texas. Mr. Evans received a BA in telecommunications and an MBA in finance from Indiana University.
COPYRIGHT 1993 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Author:Bottum, MacKenzie S.; Evans, Scott D.
Publication:Appraisal Journal
Date:Oct 1, 1993
Previous Article:Stein rule estimation in real estate appraisal.
Next Article:Three approaches?

Related Articles
Appropriate uses of economic characteristics in the sales comparison approach.
Categorizing external obsolescence.
The valuation of intangible assets.
Valuing the assets of a manufacturing company.
Accrued depreciation redefined and reordered.
The cost approach: an alternative view.
Solving the Functional Obsolescence Calculation Question?
Solving the Functional Obsolescence Calculation Question? Part II.
You can't get the value right if you get the rights wrong.
Comments on "You Can't Get the Value Right If You Get the Rights Wrong".

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters