SS127: What is Functional Obsolescence in Real Estate

SS127: What is Functional Obsolescence in Real Estate

The term functional obsolescence can be attributed to many different industries and products. Usually refers to an item that was previously useful but, now has been replaced by newer, better, technology. In this episode, Charles discusses functional obsolescence as it pertains to real estate; what it is, and why it is important to be aware of.

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Talking Points:

  • When investing in real estate, investors should be aware of how functional obsolescence will influence the value of their property; now, and in the future.
  • What is Functional Obsolescence?
    • Within the realm of real estate, functional obsolescence is the decrease of functionality or desire due to an outdated design, features, deterioration, or external factors that are typically outside of the control of any one property owner.
    • One other example would be; cell phones, computers, or TVs; as they age, they have more functional obsolescence, and their values rapidly decrease.
  • What are some examples of functional obsolescence:
    • Busy roads
    • Physical deterioration – poor property condition – disrepair
    • Small bedrooms or small bathrooms; or a lack of them – or a mismatched mixture of them; i.e., 4 bedrooms and 1 bathroom or 5 bedrooms and 1 and a half bathrooms.
    • An unfunctional floor plan: bathrooms on one level and bedrooms on another; requirement to enter a bedroom to get to another room; poor design
    • Low ceilings
    • No garage or a small driveway
    • External noise pollution, high crime
    • The property is out of place – not in the right neighborhood; a small 2-bedroom ranch in a neighborhood with 5,000 sq. ft luxury homes
  • There are 3 main types of functional obsolescence in real estate
    • Incurable functional obsolescence.
      • Incurable functional obsolescence happens when the costs for correcting the functional obsolescence, exceed the value of the property or they do not make sense. For example; buying a $100,000 house in a neighborhood of $125,000 houses and spending $100,000 remodeling, moving walls, and installing high-end finishes, etc. It just does not make financial sense.
      • This form of functional obsolescence is also referred to as external obsolescence. You cannot upgrade a house to a level where the busy street will become less busy or the crime rate will drop. These issues are outside of your control.
    • Curable functional obsolescence.
      • Curable functional obsolescence includes issues that can be fixed. Depending on the property, these could be easier fixes to more complex ones; it all depends on the property. Removing walls in a $600,000 house to open the kitchen and add an island might cost $30,000; but, the value might increase to $750,000 and the investment would be well worth it.
      • Or there is additional land next to the driveway to expand it and accommodate additional vehicles.
      • Or there are old windows at the property; but they are easily replaced to increase efficiency, appeal, and value.
    • A 3rdform of functional obsolescence that should also be mentioned is super adequacy.
      • This is where the property was over-improved and the over-improvement adds no additional value or the over-improvement is too expensive to maintain.
      • For example; a previous owner added an Olympic-sized pool to a $500,000 home in Maine, that can only be used 2-3 months a year. This improvement will scare away more potential buyers that it will attract.
      • A previous owner spent $75,000 updating a kitchen with high-end appliances, in a neighborhood where homes sell for $150,000. Most people buying a $150,000 house, do not have any use for a kitchen of that stature, and will not overpay for it.
    • Since we talk a lot here about commercial real estate; mainly 5+ unit apartment complexes; it is important to note 2 other types of functional obsolescence that are mainly discussed within the realm of commercial real estate.
      • Economic obsolescence – this happens when some external factor makes the property less desirable. For example; the change of traffic pattern, a new main road that avoids the property, the construction of an industrial park next door to a high-end apartment building, and a new 4,000-home development that is just breaking ground next to a small, luxury townhouse community. Residents will not be subjected to construction for years; along with an increase in traffic.
      • Physical obsolescence – this occurs when a property becomes physically obsolete because of mismanagement or another type of neglect that now creates a problem that is extremely expensive to remediate. An older, 10-unit apartment complex has had a leaking roof for several years and now the property is mold infested, and the cost to fix the problem, is nearly cost prohibitive.
    • Functional obsolescence is an issue that all real estate investors should be aware of before purchasing a property.
    • Some investors will convince themselves they are getting a deal when they see a property that is much less expensive when compared to the others in the neighborhood since there is some level of functional obsolescence. In the end, however, this might not be that much of a deal when they go to sell it since the deal they got when they bought it; they might need to offer it to the person who buys it from them.
    • This happened to me in 2010, I was flipping a house in New England and I thought it was a great deal; good neighborhood, good price, etc. The issue was, no basement. In New England, nearly every property has a basement. In order to sell it, I had to offer a discount to the buyers; a similar discount to what I received when I purchased it.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is functional obsolescence in real estate.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
When investing into real estate, investors should be aware of how functional obsolescence will influence the value of their property now and in the future. So what is functional obsolescence? Well, within the realm of real estate, functional obsolescence is the decrease of functionality or desire due to an outdated design features deterioration or external factors that are typically outside of the control of any one property owner typically. Examples would be outside of real estate would be cell phones or computers or TVs. As they age, they have more functional obsolescence and their values rapidly decrease. So what are some examples of functional obsolescence within real estate? Well, busy roads physical deterioration, poor property condition, disrepair, mismanagement small bedrooms or small bathrooms, or a lack of them, or a mismatched mixture of them. For example, a four bedrooms in one bathroom or five bedrooms in one and a half bathrooms. An an unfunctional floor plan. So bathrooms on one level, bedrooms on another. There’s a requirement to enter a bedroom to get to another room.

Charles:
It’s lacking a hallway or there’s just a poor design. Next would be low ceilings. No garages or a small driveway, external noise pollution or high crime. The order of the property is just out of place, so it’s not in the right neighborhood. A small two bedroom ranch in neighborhood with 5,000 square foot luxury homes. Now there are three main types of functional obsolescence in real estate. One is incurable functional obsolescence. Now, incurable functional obsolescence happens when the cost for correcting the issues exceed the value of the property or they do not make sense. For example, buying a hundred thousand dollars house in a neighborhood of $125,000 houses and spending $100,000 remodeling it, moving walls, installing high-end finishes, et cetera. It just does not make financial sense. This form of functional obsolescence is also referred to as external obsolescence. You cannot upgrade a house to a level that the busy street will become less busy or the crime rate will drop.

Charles:
These issues are outside of your control as the property owner curable functional obsolescence. Number two. Now, curable functional obsolescence includes issues that can be fixed depending on the property. These could be easier fixes to more complex ones. It all depends on the property. Removing walls in the $600,000 house to open the kitchen and add an island might cost $30,000, but the value might increase to $750,000 and the investment would be well worth it. Or there is an additional land next to the driveway to expand it and accommodate additional vehicles. Or there are old wounded windows at the property, but they are easily replaced to increase efficiency, appeal and value. Now, a third form of functional obsolescence that should also be mentioned is super adequacy. Now this is where the property was over improved, and the over improvement adds no additional value or the cost of over improvement is too expensive to maintain.

Charles:
For example a previous owner added an Olympic size pool to a half million dollar house in Maine that can only be used two or three months a year. This improvement will scare away more potential buyers than it will attract because of the cost and because it’s just not really functional. Now, a previous owner spent $75,000 updating a kitchen with high-end appliances in a neighborhood where homes sell for $150,000. Most people buying $150,000 house do not have any use for a kitchen of that stature and will not overpay for it and definitely don’t want to maintain it. Since we talk here a lot about commercial real estate, mainly five plus unit apartment complexes, and important to note two other types of functional obsolescence that are mainly discussed within the realm of commercial real estate. Number one is economic op obs excellence. So this happens when some external factor makes the property less desirable.

Charles:
For example, the change of a traffic pattern, a new main road that avoids the property, the construction of an industrial park next door to a high end apartment building a new 4,000 home development that is just breaking ground next to a small luxury townhouse community. You know, residents will, will be now subjected to construction for years along with increase in traffic. So it’s going to decrease the value because most people are not gonna wanna stay at that property if they’re renting, and most people are not gonna wanna move into that property when they see that construction happening. Next is physical obsolescence. Now this occurs when a property becomes physically obsolete because of mismanagement or an other type of neglect that now creates a problem that is extremely expensive to remediate. So an older 10 unit apartment complex has had a leaking roof for several years, and now the property is mold infested and the cost to fix the problem is nearly cost-prohibitive.

Charles:
Functional obsolescence is an issue that all real estate investors should be aware of before purchasing a property. Some investors will convince themselves they’re getting a deal when they see a property that is much less expensive when compared to the others in the neighborhood since there is some level of functional obsolescence in the end. However, this might not be as much of a deal when they go to sell it since the deal they got when they bought it, and they might need to offer to the person who buys it. Now, this happened to me in 2010. I was flipping a house in New England and I thought it was a great deal, good neighborhood, good price, and the issue was no basement in New England. Nearly every property has a basement in order to sell it. I had to offer a discount to the buyers, a similar discount to what I received when I purchased it. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics@globalinvestorspodcast.com. Look forward to two episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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