Understanding Functional Obsolescence Can Reduce Your Property Taxes

By Michael B. Shapiro, as published in Corporate Real Estate Executive, October 2000

In almost every state, real property must be valued for property tax purposes based on its market value (i.e. value in exchange) as opposed to the value in use to the owner or occupant.  however, this significant distinction often is obliterated by assessors and appraisers when valuing owner-occupied property.  This frequently occurs through misuse of the coast approach - more specifically, the failure to understand and properly account for functional obsolescence.

The purpose of this article is to show owners how the proper application of functional obsolescence can contribute to property tax savings.  many owner-occupied properties are constructed for owner use in connection with a business and not with a view to sell or lease the property to another party.  In short, an owner-occupant typically constructs property because it believes its use of the property, or the image created for its business by the property, justifies the cost of construction.  Typically, this construction takes place with no consideration whatsoever of what price or rent the property would generate if offered in the market.

An assessor or appraiser may begin a cost approach with the cost to duplicate an existing building.  This is "reproduction cost."  A properly prepared cost approach requires calculation of the cost that would be incurred by a typical purchaser to replace the utility of the existing building.  This the "replacement cost."  The difference between reproduction and replacement cost is one form of functional obsolescence, commonly and appropriately referred to as "functional obsolescence due to excess construction cost."

To value an owner-occupied building using the cost approach, the assessor or appraiser must determine replacement cost.  This cost may be significantly different than the owner's actual cost or reproduction cost.  this is because replacement cost represents the cost to replace utility of the property (e.g. usable square footage in an office building or usable volume in a warehouse) with what a typical purchaser would construct (using modern materials, layout and design).

Once replacement cost is estimated, an assessor or appraiser must consider forms of depreciation other than that due to excess construction cost.  In this context, depreciation means loss in value that must be deducted from replacement cost.  These other losses in value include not only physical depreciation and external obsolescence, but also other forms of functional obsolescence.

In many cases a typical buyer of an owner-occupant property would make changes to the property constructed by the owner-occupant for its business use.  These desired changes can be economically curable or incurable.  When they are curable, the cost to cure must be deducted from replacement cost to properly estimate the market value of the property.  Similarly, when these deficiencies are not economically curable, the present value of the excess operating expenses or lost rent (compared to the property represented by replacement cost) must be deducted from replacement cost.  In either situation, this loss in value is attributable to functional obsolescence.

A simple illustration demonstrates the proper application of the cost approach and functional obsolescence.  Assume a building is built for an owner's specific business needs at a cost of $9 million.  This is the building's reproduction cost.  Further assume the building could be replaced with the utility that a typical buyer in the market would desire (without need for modification) for $7 million, which is the building's replacement cost.  Also assume the cost to modify the building for a typical buyer is $2 million.  The question is (assuming no other depreciation) what is the market value (value-in exchange) of the building?  The answer is clearly $5 million ($7 million based on the replacement cost of the building, without any modification required, less $2 million of functional obsolescence to modify the building to what would be desired in the marketplace).  It is the building, without its required modification, that is being valued - not the theoretical replacement facility that has no functional obsolescence and, therefore, needs no modification.  Clearly, the reproduction cost of the building would pay no more than replacement cost.

In consulting a property tax lawyer, you may discover that the proper application of functional obsolescence can be used to reduce your property taxes.

Michael B. Shapiro is a partner in the Detroit law firm of Honigman Miller Schwartz and Cohn which is the Michigan member of American Property Tax Counsel, the National Affiliation of Property Tax Attorneys.