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Consideration of Functional and Economic Obsolescence in ...

Consideration of Functional and Economic Obsolescence in the Assessment of Industrial or Commercial Property BY ROBERT F. REILLY. T he current Economic climate has caused decreases in value for many types of industrial and commercial fourth, this discussion suggests practical procedures to categorize the various types of property Obsolescence . properties. Taxing-authority assessors consider these current market condi- Industrial and Commercial tions in their property assessments. Property Valuation Approaches In particular, assessors consider the Assessors typically attempt to apply the impact of current market conditions market (sales comparison) approach, in the application of the cost approach income approach, and cost approach for industrial and commercial property methods in the property tax valuation valuation.

48 Journal of Property Tax Assessment & Administration • Volume 10, Issue 1 replacement plant rather than buying the actual plant. All cost components—i.e., direct costs, indirect costs, developer’s profit, and entrepreneurial incentive—should be

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Transcription of Consideration of Functional and Economic Obsolescence in ...

1 Consideration of Functional and Economic Obsolescence in the Assessment of Industrial or Commercial Property BY ROBERT F. REILLY. T he current Economic climate has caused decreases in value for many types of industrial and commercial fourth, this discussion suggests practical procedures to categorize the various types of property Obsolescence . properties. Taxing-authority assessors consider these current market condi- Industrial and Commercial tions in their property assessments. Property Valuation Approaches In particular, assessors consider the Assessors typically attempt to apply the impact of current market conditions market (sales comparison) approach, in the application of the cost approach income approach, and cost approach for industrial and commercial property methods in the property tax valuation valuation.

2 Of a complex industrial or commercial First, this discussion summarizes property. This statement is true for the cost approach to the property tax appraisals prepared for property tax as- valuation of industrial and commercial sessment, appeal, or litigation purposes. property with an emphasis on the various However, for many complex, large-scale, types of Obsolescence that are recognized and special purpose properties, asses- in a cost approach analysis. Second, this sors often have to rely principally (if not discussion presents the practical proce- exclusively) on cost approach valuation dures that either a taxpayer corporation methods. or a taxing-authority assessor can use The income approach is often difficult to recognize the existence of property to apply in the appraisal of such special Obsolescence .

3 Third, this discussion con- purpose properties because it can be siders practical procedures for analyzing challenging to allocate the total amount Economic Obsolescence independently of income generated at the special pur- from an income approach analysis. And, pose facility between (1) the property Robert F. Reilly is a managing director of Willamette Management Associates in Chicago, Il- linois. He has been the principal analyst on more than 2,500 valuations of businesses, business interests, and intellectual properties in virtually every industry and business sector. He is a certi- fied public accountant, accredited in business valuation and certified in financial forensics, as well as a chartered financial analyst.

4 Robert holds a master of business administration (MBA) in finance and a bachelor of arts degree in economics, both from Columbia University in New York. Journal of Property Tax Assessment & Administration Volume 10, Issue 1 45. income related only to the subject land, confidential, for both strategic and com- buildings, and equipment and (2) the petitive reasons. business income generated by the tax- Some forms of property Obsolescence payer intangible assets. The market (or analysis are comparative in nature. sales comparison) approach is also dif- That is, the Obsolescence analysis often ficult to apply because there may be very compares the subject taxpayer facility few recent sales of sufficiently compara- with the Obsolescence in place to a hy- ble industrial or commercial properties pothetical replacement facility without available for Consideration .

5 In addition, Obsolescence . For example, a property even when there are comparable prop- Obsolescence analysis could compare erty sales, the assessor still has to address the subject facility (with its actual obso- the issue of allocating the comparable lescence) that requires excess operating property's sale price between: (1) the costs to a hypothetical replacement land, buildings, and equipment and (2) facility (without any Obsolescence ) that the business intangible assets operating experiences reduced operating costs. at the comparable property. Since the hypothetical replacement fa- For these reasons, assessors often rely cility does not actually exist, there may principally on the cost approach in the be uncertainty about the hypothetical appraisal of complex, special purpose, (and reduced) operating costs of that or operationally integrated industrial replacement facility.

6 And commercial facilities. The identifi- The taxpayer/property owner typically cation and quantification of all forms of does not measure the amount of or Obsolescence is also a fundamental pro- even consider the existence of property cedure in the cost approach valuation of Obsolescence . For example, other than industrial or commercial property. While the property's original cost accumulated the necessity of performing this obso- depreciation, there is no provision in lescence analysis is rarely disputed, the taxpayer financial statements for the specific quantification of Obsolescence recognition of either Functional or eco- is often the source of controversy in ad nomic Obsolescence . For example, the valorem property tax valuation.

7 Taxpayer management may be aware Other than the physical deterioration that competing industrial or commercial component, property Obsolescence is facilities are more productive or more often difficult for the assessor to physi- cost effective than its facility. However, cally observe. In other words, it may be the taxpayer management may not even difficult for an assessor to visually identify associate such indicia of Functional or the results of Functional Obsolescence or Economic Obsolescence with the facility's external Obsolescence . In fact, with re- property value. gard to external Obsolescence , the causes of such Obsolescence are, by definition, Cost Approach Procedures physically outside of the industrial or Cost approach appraisal methods are commercial property.

8 Based on the economics principle of The data needed to quantify some substitution. That is, the value of an forms of property Obsolescence are industrial or commercial property is often taxpayer-specific. That is, these influenced by the cost to create a new data have to be supplied to the asses- substitute property. All cost approach sor by the taxpayer/property owner. In methods apply a comprehensive defini- addition, these data often cannot be tion of cost, including Consideration of verified or compared in the industrial an opportunity cost during the property or commercial real estate marketplace. design and construction stage. And, the And, some taxpayer corporations may cost of the new substitute property want to keep these facility-specific data 46 Journal of Property Tax Assessment & Administration Volume 10, Issue 1.

9 Should be reduced (or depreciated) in an economics concept that describes order to make this hypothetical new the ability of a property to provide an property comparable to the actual old equivalent amount of satisfaction to the property. owner or operator. Cost approach methods are particu- Regardless of the specific definition larly useful in the appraisal of a special of cost that is used in a cost analysis, all purpose industrial or commercial prop- cost measurement methods (including erty. In the case of a relatively new reproduction cost new, replacement cost property, the taxpayer may have recent new, or some other cost measurement). construction cost data available and ac- require a comprehensive cost analysis.

10 Curate as-built construction plans and Any current cost measurement should drawings. In addition, cost approach consider the following components: (1). methods can be useful in the appraisal of direct costs ( , materials and supplies), a functionally integrated or process type (2) indirect costs ( , engineering and facility, where it is difficult to segregate design expenses, legal fees, and the like), tangible property rental income from (3) developer's profit, and (4) an oppor- intangible property ( , business enter- tunity cost/entrepreneurial incentive. prise) operating income. Also, the cost Typically, property construction mate- approach is particularly useful for the rial, labor, and overhead costs are easy to appraisal of functionally unique proper- identify and quantify.


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