Economic Obsolescence (Real Estate)

What is Economic Obsolescence (Real Estate)?

Economic obsolescence refers to the loss of value of a real estate property that is caused by factors that are external to the property. Such a form of obsolescence is usually incurable and the owners cannot fix the specific cause of depreciation.

Economic obsolescence results in a decline in the value of a property, where the causal factors are not within the control of the property owners. It is sometimes referred to as external obsolescence.

Common Causes of Economic Obsolescence

Some of the common causes of economic obsolescence include:

1. Changes in aircraft flight patterns

Real estate properties may be affected by excessive noise from airplanes when their flight patterns change to pass over the property. Most people prefer buying homes close to key infrastructures such as airports for convenience when traveling. However, this also means that the property risks losing value if the airport decides to change flight patterns, such that departing or landing planes fly above the house. It can be a real noise nuisance for people looking for a family-friendly home. Property values may drop significantly.

2. Busy highways

The construction of highways near residential properties can subject residents to extra noise and traffic. Most property owners are looking to buy properties in areas that are accessible by road to make it easy to commute to work.

However, when the road is upgraded to accommodate more vehicles, that can inconvenience property owners due to the frequent traffic buildups during rush hours. Homes located near such roads may suffer from excess noise from cars and trucks, as well as air pollution from carbon dioxide and smog released by the vehicles.

Therefore, proximity to busy roads can be both a positive and a negative.

3. A rise in local crime

Most property owners are concerned about the safety of their neighborhood when deciding where to buy a property. Areas with a high crime rate tend to be less attractive to potential investors who prefer investing in more peaceful neighborhoods.

The safety of the neighborhood influences how people live, from comfort to the type of safety initiatives they may take. A higher crime rate in a neighborhood directly impacts property values because most investors will choose to stay away from such areas. As a result, property owners will face difficulties in finding suitable buyers for their properties.

4. Environmental hazards

Country or municipal directives to construct landfills and sewer lines subject the entire neighborhood to foul odors and noise from the large trucks moving in and out. When purchasing properties, investors may not be privy to information on the kind of future developments to be implemented in the neighborhood.

When such negative developments take place, it affects the livability of the area because nobody wants to live near a landfill or a sewer line. In addition, the landfill will be an environmental hazard and may cause health complications among the residents.

5. Loss of jobs

In certain locations, the real estate market is given a boost by the existence of key industries that employ thousands of residents. Most of the employees working in such industries form the majority of the tenants in nearby properties.

If one of the major industries closes, then thousands of people will be rendered jobless, and the local properties will decrease in value because people cannot afford the monthly rents or mortgage payments. The properties will suffer from low occupancy rates, which is beyond the control of property owners.

Functional Obsolescence vs. Economic Obsolescence

Economic obsolescence and functional obsolescence are often difficult to differentiate due to some of their similarities.

Functional obsolescence refers to a reduction in the usefulness of a property due to factors within it, except those due to physical deterioration. It occurs when a building experiences a relative loss of utility due to either outdated equipment, faulty building design, or a building being too small compared to others in the neighborhood.

Functional obsolescence can be curable or incurable. It depends on whether the cost to cure the obsolescence exceeds the value benefit of the improvement. For example, a five-story building without an elevator can be cured by installing an elevator if the structural design of the building allows it. The improvement can only be justified if the value gained by installing the elevator is greater than the cost of installing it.

Unlike functional obsolescence, which occurs within a property, economic obsolescence occurs outside the property and is beyond the control of the property owner. This means that the property is incurable because it would be too expensive to cure the problem.

For example, when the county approves the construction of a landfill within the neighborhood, the property owners will have no control over the new development because it is not within their property.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:

• Economic Depreciation
• Environmental Liability
• Locational Obsolescence
• Physical Deterioration
• See all commercial lending resources