April 12, 2002
FOR IMMEDIATE RELEASE
The Journal of the International Machinery & Technical Specialties Committee of the American Society of Appraisers Publishes External Obsolescence and Complex Property Article.
This article was originally published in Volume 18, Issue 1, The Journal of
the International Machinery & Technical Specialties Committee
of the American Society of Appraisers, February,
2001, and is republished on our web site by
permission of the American Society of Appraisers.
The article was authored by Lester Rhodes,
Senior Manager of Valuation Services at Ryan
& Company. Mr. Rhodes is an Accredited
Senior Appraiser with the American Society
of Appraisers, and a State Certified General
Real Estate Appraiser in Texas.
Measuring external obsolescence is a central
issue in valuing complex property for ad valorem
taxation. Because specialized complex properties
are particularly sensitive to external conditions,
accurate measure of external obsolescence is
critical to achieving a fair property tax valuation.
In terms of contentious issues, it may very
well rate above intangible property taxation
and value in use versus value in exchange. In
appraisal theory, there are several ways to
measure external obsolescence using cost, direct
sales comparison, and income valuation techniques.
The cost approach to value, where accurate measure
of external obsolescence is critical, is generally
considered the most appropriate, and certainly
the most widely employed method of estimating
the value of complex properties. Measuring the
full extent of external obsolescence, however,
is a major weakness of the cost approach. External
obsolescence is difficult to isolate and measure
and many assessors and tax appraisers omit this
measure due to constraints of budget, time,
and information.
The income and sales comparison methods of estimating
the value of complex property are problematic.
Although all value loss, including external
obsolescence, is incorporated in value estimates
derived from these approaches to value, the
characteristics of complex properties often
render these methods incalculable. Complex properties
are often a unit in a vertically integrated
business operation or the major tangible asset
of a business enterprise. Complete financial
data are generally unavailable for an individual
property unit and, when available, often reflect
income allocation methods and operating synergies
rather than an appropriate market income. Sales
data, when available, often reflect the value
of the business enterprise thus allocation to
each of the operating units is impractical.
In addition, intangible and tangible asset value
is intrinsic in the income and comparable sales
data, creating isolation difficulties where
intangible property is exempt from taxation.
The Dictionary of Real Estate Appraisal defines
external obsolescence as "An element of accrued
depreciation; a defect caused by negative influences
outside a site and generally incurable on the
part of the owner, landlord, or tenant."1
Economic/external obsolescence is also defined
as the loss in value or usefulness of a property
caused by factors external to the property,
such as increased cost of raw materials, labor,
or utilities (without an offsetting increase
in product price); reduced demand for the product;
increased competition; environmental or other
regulations; inflation or high interest rates;
or similar factors.2
Characteristics of Complex Properties
Complex properties are typically industrial
in nature and are usually larger than commercial
property in area, volume, and land occupancy.
Function in complex property is more important
than aesthetics. Location with accessibility
to resources, utilities, and markets for finished
goods is critical for operating efficiency and
competitive production cost. Complex property
requires large investments with the investment
in machinery and equipment often exceeding that
of land and improvements. In addition the property
is highly non-liquid, with even less liquidity
as specialization of the property increases
to maximize productivity. Because of the degree
of specialization, complex property is highly
susceptible to technological and economic obsolescence.
Complex property is often referred to as special-purpose
or single-purpose property. Special purpose
property is usually limited to specific uses
within a given sector of manufacturing, for
example food processing and consumer good manufacturing.
While special purpose property may be converted
to similar alternative uses within the industry
sector, single purpose property is limited to
a single industrial use and not adaptable for
any occupancy other than as constructed.3
Examples of single purpose property include
power plants, refineries, cement plants, and
grain elevators. The Appraisal Institute text,
The Appraisal of Real Estate, addresses the
highest and best use of complex properties as
follows.
Because special-purpose properties are
appropriate for only one use or for a
very limited number of uses, appraisers
may encounter practical problems in specifying
their highest and best uses. The highest
and best use of a special-purpose property
as improved is probably the continuation
of its current use, if that use remains
viable. For example, the highest and best
use of a plant now used for heavy manufacturing
is probably continued use for heavy manufacturing,
and the highest and best use for a grain
elevator is probably continued use as
a grain elevator. If the current use of
a special-purpose property is physically
or functionally obsolete and no alternative
uses are feasible, the highest and best
use of the property as improved may be
realized by demolishing the structure
and selling the remains for their scrap
value or salvage value.4
Because machinery and equipment, the primary
components of complex property can be moved,
it is necessary for the appraiser to recognize
different value premises as well as different
markets. According to the American Society of
Appraiser text Valuing Machinery and Equipment,
"the market value premises are broadly classified
into three categories, distinguished mainly
by an asset's anticipated use."
5
The premises of value are continued use, installed,
and removal. This paper addresses the measurement
of external obsolescence in the context of market
value in continued use. The fair market value
in continued use premise presupposes the continued
utilization of the facility. This premise is
applicable when the facility is functionally
adequate and economically viable and the present
use is likely to continue. The buyer would likely
be an end user who would acquire the assets
for continued use.
Categories and Causes of External Obsolescence
External obsolescence is usually incurable as
the events, be they temporary or permanent,
causing the loss in value are outside of the
control of the property owner. If the conditions
are temporary, the predicted length of time
the external impairment will affect the subject
property should be considered in the measurement
of value loss.
External obsolescence is commonly categorized
as being locational, or non-systematic and economic,
or systematic. Economic factors can be either
industry wide or market wide. Locational causes
include zoning changes, changes in highest and
best use, incompatible development of adjacent
land, increased taxation, change in location
and sources of supply, and increased cost of
raw materials, labor or utilities. Industry
wide economic factors include reduced product
demand, increased competition, increased foreign
imports, environmental or other government regulations,
changes in product prices and profitability,
and decreased rates of return. Market wide conditions
can be national or international and include
increased import duties and tariffs, inflation,
economic recession, high cost of capital, and
government regulations.
Measuring External Obsolescence
The consequence of most external obsolescence
is a reduction in operating income and profit.
Some locational external obsolescence can be
measured by sales comparison, however, this
method is rare in complex property valuation
due to a lack of usable sales data. Estimates
of value loss, therefore, are often calculated
using various income valuation techniques. As
data are available, incidences of external obsolescence
can be measured individually or collectively,
using income valuation methods. Individual measurement
involves isolating each occurrence of external
obsolescence and capitalizing income loss attributable
to each cause. Collective measurement is accomplished
by capitalization of overall annual income loss,
or by the discounting of a periodic, measured
income deficiency. A determination of "inutility"
can also form the basis of a value loss estimate
employed in the cost approach to value. Typically,
estimates of value loss are expressed in whole
dollars, percentages, or mathematical factors.
A common formulation of the cost approach is
as follows.
|
MV = RCN * PDF * FOF * EOF |
| |
| |
Where, |
| |
MV |
= Market Value Estimate |
| |
RCN |
= Replacement Cost New |
| |
PDF |
= Physical Depreciation Factor |
| |
FOF |
= Functional Obsolescence Factor |
| |
EOF |
= External Obsolescence Factor |
Expressing value loss in the form of multipliers, or percent
good factors, facilitates allocation of value
to various categories, units, or individual
items of property. For purposes of this paper,
each measure of external obsolescence is expressed
as a factor to be applied to replacement cost
new less physical depreciation and functional
obsolescence.
Inutility
Inutility exists when the operating level of
a property is significantly less than practical
capacity. Lower capacity utilization translates
to lower property value. Depending on the level
of fixed cost, inutility accelerates reduction
in profit. The extent to which a business uses
fixed costs (compared to variable costs) in
its operations is referred to as "operating
leverage". The greater the use of operating
leverage, the larger the increase in profits
as sales rise and the larger the increase in
losses as sales fall. The Crawford and Cornia
paper "The Problem of Appraising Specialized
Assets" discusses the use of operating leverage
in the standard inutility model, describing
the problems of estimating specialized-asset
obsolescence by emphasizing the relationship
of fixed and variable costs to the measure of
obsolescence.
6
The inutility models presented in Table 1 and
2 depend on an accurate and standard method
of capacity determination and representative
variable cost, fixed cost, and operating profit
at the determined practical capacity level.
The following capacity definitions are provided
in order to provide a clear understanding of
various capacity terminologies. Theoretical
capacity is the maximum productive output for
a given period assuming all machinery and equipment
are operating at optimum speed without interruption.
Practical capacity is theoretical capacity reduced
by normal and expected work stoppages. Normal
capacity is the average annual level of operating
capacity needed to meet expected sales demand.
7
Excess capacity is the difference between either
theoretical or practical capacity, and normal
capacity (actual production).
The U.S. Department of Commerce survey of plant
capacity utilization provides a standard for
determining practical capacity. The survey requests
the maximum level of production that an establishment
could reasonably expect to attain under normal
and realistic operating conditions, assuming:
- The machinery and equipment in place and ready
to operate will be utilized.
- Normal downtime, maintenance, repair and cleanup.
- Number of shifts, hours of plant operations, and
overtime pay that can be sustained under
normal conditions and a realistic work schedule.
- Availability of labor, materials, and utilities are not
limiting factors.
- A product mix that was typical or representative
of production during the year.
The inutility model shown in Table 1 serves
to measure ss in value due to external factors affecting
production and, therefore, operating profit.
In this example, domestic raw material shortages
have reduced production. The condition is considered
temporary and full practical capacity is expected
to return, in a linear pattern, over the next
five years. Lines 1 - 3 contrasts practical
capacity and actual production. Lines 4 - 7
delineate fixed and variable operating costs
and profit in relationship to total revenue.
Line 5 shows the change in variable cost due
to the decline in production and the resulting
impact on operating profit in Line 7. The utilized
capacity factor in Line 8 reflects the change
in operating profit and Line 9 is the excess
or unused capacity factor. Lines 10-12 contain
the components for calculating the present value
of the excess capacity. The sum of the utilized
capacity factor in Line 8, and the present value
of the excess capacity in Line 12 provide the
total value impact of inutility, expressed as
a factor to replacement cost new less physical
and functional depreciation.
When the external condition causing reduced
capacity utilization is permanent, a different
measure of inutility is necessary because
the value of excess capacity is very likely
no more than its scrap, or salvage value.
|
Table 1. Inutility Model - Temporary
External Obsolescence |
|
Line
|
|
Full Utility
|
Inutility
|
| |
|
|
|
|
1
|
Practical Capacity (Tons/Year)
|
60,000
|
60,000
|
|
2
|
Production |
60,000
|
47,500
|
|
3
|
Capacity Utilization |
1.000
|
0.792
|
|
|
|
|
|
|
4
|
Total Revenue |
1.000
|
0.792
|
|
5
|
Variable Cost |
0.650
|
0.515
|
|
6
|
Fixed Cost |
0.150
|
0.150
|
|
7
|
Operating Profit |
0.200
|
0.127
|
|
|
|
|
|
|
8
|
Utilized Capacity Factor |
|
0.635
|
|
9
|
Excess Capacity Factor |
|
0.365
|
|
10
|
Discount Rate |
|
0.125
|
|
11
|
Absorption Period (Years) |
|
5.000
|
|
12
|
Present Value of Excess Capacity Factor
|
|
0.260
|
|
13
|
Inutility Factor (Line 8 + 12)
|
|
0.895
|
Table 2 shows the components of the inutility
model for measuring permanent external obsolescence.
Table 2 is identical to Table 1 until Line
9. In this model, the purpose of the inutility
factor is to balance, or "right size" the
plant to match utility. A scale factor or
size exponent is necessary because the capital
cost of facilities of different capacities
varies exponentially rather than linearly
due to economies of scale. In other words,
as capacity increases, cost also increases
but at a different rate.
8
Note that the difference between the measure
of temporary and permanent external obsolescence
by the inutility method relates to the contributory
value of the excess capacity. In addition,
the inutility factor only provides an adjustment
for the degree of use, and other external
factors such as reduced product price or
higher feed stock prices, must be considered
in addition to inutility. When reduced capacity
utilization is permanent, the appraiser
may choose to adjust the replacement cost
new estimate to reflect the probable capacity
of the replacement facility and measure
as excess operating cost the cost of maintaining
the excess capacity.
Income Valuation Techniques
When appropriate income data can be assembled,
the income approach to value techniques
provide an accurate and defensible measure
of external obsolescence. When obsolescence
exists, however, it is often in several
forms and insolating income loss associated
with each occurrence becomes very difficult.
For this reason, external obsolescence may
be measured individually or collectively,
or both.
Because external obsolescence usually results
in increased costs, the loss in value can
be measured
by capitalization of excess operating costs.
|
Table 2. Inutility Model - Permanent
External Obsolescence |
|
Line
|
|
Full Utility
|
Inutility
|
|
|
|
|
|
|
1
|
Practical Capacity (Tons/Year)
|
60,000
|
60,000
|
|
2
|
Actual Production |
60,000
|
47,500
|
|
3
|
Capacity Utilization |
1.000
|
0.792
|
|
|
|
|
|
|
4
|
Total Revenue |
1.000
|
0.792
|
|
5
|
Variable Cost |
0.650
|
0.515
|
|
6
|
Fixed Cost |
0.150
|
0.150
|
|
7
|
Operating Profit |
0.200
|
0.127
|
|
|
|
|
|
|
8
|
Utilized Capacity Factor |
|
0.635
|
|
9
|
Scale Factor |
|
0.600
|
|
10
|
Inutility Factor |
|
0.762
|
Table 3 measures loss in value due to the
increased transportation cost of raw materials.
In this example, domestic feed shortages
have dwindled and must be purchased
overseas and shipped to US ports. An inland
shipping premium of $40 per ton represents excess
operating costs incurred by the operation. This
condition is expected to be permanent and continue
throughout the remaining life of the plant.
Line 6 contains the total annual excess cost,
the result of multiplying Line 4 and Line 5.
Adjusted for taxes, the net annual excess cost
is $780,000 (Line 8). The present value of the
excess operating cost, and the estimated loss
in value, is $4,318,416 (Line10). If each item
of external obsolescence can be identified and
income loss isolated, this model presents the
most defensible method of measuring external
obsolescence.
Value loss due to obsolescence can also be estimated
utilizing conventional discounted cash flow
techniques. The plant is considered obsolete
to the degree income fails to satisfy current
investment requirements. Comparing the present
value of projected income from plant operations
with the present value of an income stream generated
at a market rate of return provides the measure
of external obsolescence.
|
Table 3. Excess Operating Cost |
|
Line
|
|
|
|
1
|
Plant Remaining
Life |
10
|
|
2
|
Discount Rate
|
12.5%
|
|
3
|
Income Tax Rate
|
35.0%
|
|
|
|
|
|
|
Increased Transportation
Cost |
|
|
4
|
Capacity(Tons)
|
30,000
|
|
5
|
Additional Cost/Ton
|
40.00
|
|
6
|
Annual Excess Transportation
Cost |
1,200,000
|
|
7
|
Income Tax
|
420,000
|
|
8
|
Net Annual Excess
Transportation Cost |
780,000
|
|
9
|
Present Value Factor
|
5.53643
|
|
10
|
Value Loss
|
4,318,416
|
In Table 4, the replacement cost new less
depreciation (RCNLD) is $50.0 million. Since
projected cash flow (CF) is less than market
cash flow (MCF)
1
, the income deficiency (CF-MCF) should
be discounted to present value at an appropriate
discount rate. In this example, the discounting
of the income shortfall provides a measure
of external obsolescence of approximately
$11.5 million.
Rates of Return and Valuation Ratio Comparisons
External obsolescence may also be estimated
though an analysis of relative change in various
macroeconomic factors. Some appraisal practitioners
argue that this method is two simplistic and
generalized, and that other forms of depreciation
may be "double counted." There is also, however,
considerable support for including the comparative
analysis of rates of return and valuation ratios
in the estimation of external obsolescence.
According to the text, Valuing Machinery and
Equipment:
It should be noted that other measures of
economic obsolescence can be developed based
on analyses of industry returns, supply/demand
relationships, margin analysis, product
or raw material price changes, stock prices,
the relationship between replacement cost
new and cash flows the hypothetical replacement
facility is capable of generating, and other
economic evidence indicating that the value
of the subject property has been reduced
by external factors.9
In Robert Reilly's widely published article
on economic obsolescence, he states that "a
current and sustained reduction in the level
of investor returns, compared to historical
industry averages, also indicated economic obsolescence
on an industry-wide basis. Appropriate measures
of investor returns would include return on
net assets, return on total assets, return on
investment, return on equity, and return on
tangible assets."
10
|
Table 4. Free Cash Flow Comparison($000) |
|
RCNLD (Before External Obsolescence) |
50,000 |
|
|
Growth Rate |
|
3.00% |
|
Discount Rate |
|
12.50% |
|
Capitalization Rate |
|
9.50% |
|
External Obsolescence |
11,495 |
|
|
External Obsolescence Factor |
0.77 |
|
| |
|
Year
|
Free Cash Flow(CF) |
Market Cash Flow(MCF) |
CF-MCF |
Present Value Factor(PV) |
PV CF - MCF |
|
1 |
3,658 |
4,750 |
(1,092) |
0.88889 |
(971) |
|
2 |
3,768 |
4,893 |
(1,125) |
0.79012 |
(889) |
|
3 |
3,881 |
5,039 |
(1,159) |
0.70233 |
(814) |
|
4 |
3,997 |
5,190 |
(1,193) |
0.62430 |
(745) |
|
5 |
4,117 |
5,346 |
(1,229) |
0.55493 |
(682) |
|
Reversion |
44,638 |
57,964 |
(13,326) |
0.55493 |
(7,395) |
| |
|
|
|
|
(11,495) |
Table 5 provides historical rate of return data
for the basic material sector. This sector has
been particularly affected by increasing environmental
legislation and other government regulations,
foreign competition, and worldwide economic
events. The table presents a 5-year average
rate of return and the trailing twelve months
(TTM) rate of return on assets (ROA) and on
investment (ROI). Obsolescence Factor 1 may
provide an estimate of external obsolescence
resulting from industry wide factors, such as
changes in product price, raw material costs,
etc. The measure compares current industry returns
(TTM) to 5-year average industry returns. When
certain types of external obsolescence affect
particular industries or sectors, and the impact
has been long term, comparisons outside the
specific industry may be more appropriate. For
example, in order to gauge the impact of environmental
regulations on a particular industry, it may
be necessary to make a comparison to industry
in general. Obsolescence factor 2 compares returns
in the subject industries to returns in the
S&P 500. The S&P 500 Index is widely regarded
as the standard for measuring large-cap U. S.
stock market performance and contains a representative
sample of leading companies in leading industries.
Other index measures of general industrial performance
that can be used for benchmarking rates of return
include the S&P 100, 400, and 600.
|
Table 5. Rate of Return Comparison |
|
|
5-Year Average |
TTM |
Obsolescence Factor1
|
Obsolescence Factor2
|
|
INDUSTRY |
ROA |
ROI |
ROA |
ROI |
ROA |
ROI |
ROA |
ROI |
|
As of 1/1/2001 |
|
|
|
|
|
|
|
|
|
Chemical Manufacturing |
6.16 |
8.27 |
5.45 |
7.23 |
0.88 |
0.87 |
0.74 |
0.63 |
|
Chemicals - Plastics & Rubber |
6.01 |
7.56 |
3.84 |
4.47 |
0.64 |
0.59 |
0.73 |
0.57 |
|
Containers and Packaging |
5.52 |
7.65 |
5.37 |
7.61 |
0.97 |
0.99 |
0.67 |
0.58 |
|
Fabricated Plastic and Rubber |
5.75 |
7.44 |
6.41 |
8.25 |
1.11 |
1.11 |
0.70 |
0.56 |
|
Forestry & Wood Products |
5.33 |
5.98 |
4.99 |
5.64 |
0.94 |
0.94 |
0.64 |
0.45 |
|
Gold & Silver |
-3.90 |
-4.38 |
0.95 |
1.36 |
(0.24) |
(0.31) |
(0.47) |
(0.33) |
|
Iron & Steel |
6.26 |
7.65 |
3.89 |
4.59 |
0.62 |
0.60 |
0.76 |
0.58 |
|
Metal Mining |
7.01 |
8.52 |
6.39 |
8.15 |
0.91 |
0.96 |
0.85 |
0.65 |
|
Miscellaneous Fabricated Products
|
8.86 |
11.69 |
7.95 |
10.42 |
0.90 |
0.89 |
1.07 |
0.89 |
|
Non-Metallic Mining |
3.12 |
3.99 |
-1.38 |
-1.67 |
(0.44) |
(0.42) |
0.38 |
0.30 |
|
Paper & Paper Products |
5.11 |
7.08 |
7.33 |
10.05 |
1.43 |
1.42 |
0.62 |
0.54 |
| |
|
Sector-Basic Material |
5.02 |
6.50 |
4.65 |
6.01 |
0.93 |
0.93 |
0.61 |
0.49 |
|
S&P 500 |
8.27 |
13.20 |
9.17 |
13.14 |
1.11 |
1.00 |
1.00 |
1.00 |
¹Compares trailing
twelve month (TTM) return with 5-year average
return.
²Compares industry
5-year average return to S&P 500 5-year average
return.
Summary
Complex properties and external obsolescence
present unique valuation challenges. The problem
is both in identifying the external causes of
obsolescence and measuring the loss in value.
When income loss can be reasonably determined,
the various income capitalization and discounting
techniques provide an acceptable means of translating
income loss into a capital sum, and therefore
a loss in value estimate. When the use of income
valuation techniques is impractical, the inutility
model should be developed.
The traditional inutility model, the extent
of which involved the application of a scale
factor to throughput, is overly simplistic and
unenthusiastically received by assessors as
a measure of value loss. The addition of operating
leverage in the formulation dramatically improves
the accuracy, and the acceptance, of the inutility
measure. The operating profit and cost ratios
must, however, be in proper balance with the
practical capacity estimate.
Still, the problem of valuing the excess capacity
in the inutility model was obviously missing.
When the cause of the external obsolescence
is temporary, the unused capacity will likely
add value in the future as growth consumes capacity.
The model deficiency can be resolved by adding
a simple present value calculation to the inutility
model. If you assume that absorption of excess
capacity is linear, then the only input variable
required is absorption period and discount rate.
The overall inutility factor is now the sum
of the factors for both utilized capacity and
unutilized capacity.
While not all causes of external obsolescence
have been identified and not all methods of
measuring external obsolescence have been covered
in this paper, it should be clear that external
forces exert powerful positive and negative
pressures on complex property value. External
obsolescence is not just "the cost of doing
business", as one assessor argued, but a tangible
and measurable loss in value.
If you have any questions regarding this document,
please call Lester Rhodes at 972.934.0022 x101225.
You can also reach Mr. Rhodes by
e-mail.
1 Market cash
flow in this case is the income generated from
a $50.0 million investment at a market rate
of return.
1 Appraisal Institute.
The Dictionary of Real Estate Appraisal, 3rd
ed. Chicago: Appraisal Institute, 1993. 128.
2 American Society
of Appraisers. Valuing Machinery and Equipment,
Washington: American Society of Appraisers,
2000. 99.
3 Industrial
Property Appraisal, Course 207. Chicago: International
Association of Assessing Officers. 1997. 1-6.
4 Appraisal Institute.
The Appraisal of Real Estate, 11th
ed. Chicago: Appraisal Institute, 1996: 316.
5 American Society
of Appraisers. 2.
6 Robert Crawford,
PhD and Gary Cornia, PhD. "The Problem of Appraising
Specialized Assets." Appraisal Journal Jan.
1994: 75-85.
7 Belverd Needles,
Henry Anderson, and James Caldwell. Principals
of Accounting, 5th ed. Boston: Houghton
Mifflin Company, 1993: 844.
8 American Society
of Appraisers. 101.
9 American Society
of Appraisers. 104,105.
10 Robert Reilly.
"Identification and Quantification of Economic
Obsolescence." Journal of Property Taxation
1.1 (1988): 45-62.
<< Back to Tax Developments