It's critical for owners to identify both economic and functional obsolescence in order to fight unfair tax assessments
By Brian J. Morrissey, Esq.
New technologies, shifting markets and aging buildings can drive economic obsolescence across entire industries. Equally important for the taxpayer, these factors also affect individual property values from a functionality perspective. Understanding both economic and functional obsolescence is essential to properly evaluate tax assessments for accuracy.
Determining functional obsolescence requires an analysis of the property's layout and technologies in use. This exercise attempts to quantify any adjustment in value that amplifies or outpaces downward trends occurring in the market, or accelerates depreciation beyond a straight-line basis. This may include external trends having a unique negative effect on the property's functionality.
Likewise, economic obsolescence can affect a property's value.Such an analysis involves external factors not necessarily specific to the property that may compromise its value on the open market.Declining trends in markets within an industry can signify reasons for impaired values both nationally and regionally.Moreover, international competition may underscore weaknesses within an industry that explain a reduction in a particular property's value.
In ascertaining the decline in a property's value due to economic obsolescence, the analysis must attempt to quantify that decline and offer reasons explaining it.These reasons need to be identified and reasonable, a rationale correlating values assigned to those reasons. For example, a facility may have a decline in excess of industry averages, such as changes in transportation costs and infrastructure in comparison to other supplying markets.It could become much less expensive to ship product from South America than to ship by rail in parts of the United States.
In an uncertain economic climate or a declining or stagnant real estate market, the need to evaluate obsolescence in property assessments is obvious. But even in times of growth and rising real estate prices, taxpayers should consider functionality in reviewing an assessment.
In Georgia, for example, regulations governing property assessments require local taxing authorities to take obsolescence into account. The statute lacks any description of the precise mechanics involved in measuring obsolescence, however, and assessors often forego such an evaluation.
A given jurisdiction's tax return may apply depreciation schedules, but those may not incorporate the concept of functionality. If unaddressed in depreciation schedules, then functional obsolescence needs to be captured as an adjunct to depreciation. Poor economic times or deterioration in a property's utility will exacerbate normal depreciation.
The degree of functional obsolescence is reflected in the utilization of the property. A comparison between full versus actual property usage can indicate the degree of functional obsolescence. Look for evidence of the gap between full and actual historical changes in operating income and production.
Functional vs. Economic Obsolescence
Given that the discrepancy between full and actual property utilization is unique to the facility and not industry-wide, it is functional. This could be explained by technological differences between competing facilities and the subject property. At the same time, external economic factors may contribute to the property's comparative decline.
For example, a printer may use antiquated equipment and technology that require it to keep large facilities for both production and warehousing. Comparisons will identify a gap in functionality between the property and those of more modern competitors using smaller facilities and newer technology. Faster production at newer printing operations may also require less warehousing, because projects are completed more quickly for shipping. The impact of this obsolescence on value is unique to the subject property, reflecting reduced functionality.
On the other hand, great changes are transforming the printing industry. These external factors may be detected in exactly the same way as functional change, but on an industry-wide basis.
Declining demand for an industry overall can impair a particular property's value. Such a sea change can exist within a robust economy, too: In our example, a digital culture has rejected the traditional model for printing to a significant degree, as the widespread use of electronic records and communication has reduced demand for paper printing.
A mine provides another example. Over time, miners extract the most accessible minerals using the least costly means. The layout and operation would have been originally set up to facilitate this process.
As mining continues, the remaining minerals may become more expensive to extract per unit of raw material. This added cost reduces operating income. The mine may require new infrastructure to continue operations. These periodic expansions may be inefficient, again increasing processing costs.
It may be true that, were the mine to be redesigned from scratch, no one would duplicate the existing operation because of the production costs. This reflects deteriorating functionality. On the other hand, industrial demand for the mined product may evaporate due to innovations that make the material unnecessary in processes that once required it.
Changing market forces can impact value. Until recently, the United States was a net importer of natural gas, supporting demand for facilities that enabled the import of liquid natural gas. Now that the United States is a net exporter of natural gas, those same facilities that handled the import of natural gas are more obsolete and less valuable.
Obsolescence is an important consideration in valuing property, regardless of economic conditions. This is especially true for functional obsolescence, but can also be true for economic obsolescence. In valuing property, it is important to remember there is significant overlap between the two, and many factors and influences may explain overall obsolescence.