In appraisal, functional obsolescence is difficult to calculate and often not well described. For investors, the same issue may be better understood when studied as functional utility rather than as a mathematical adjustment to value.
If you judge a property based on utility, this makes sense. As an investor, the point of view of a potential property includes understanding how utility affects rental value. So every investor makes value judgments concerning a building's condition and the quality of construction. These are no doubt factored into the listed price of a property. For example, the age of materials and systems within the property clearly affects overall value and also includes adjustments for functional utility, even if not stated as such in the appraisal. When appraisers adjust for outdated style and design, they are estimating functional utility. In the sales comparison approach, functional obsolescence is not calculated but it clearly is a factor in adjusting between the subject property and comps included in the valuation. Ideally, the same levels of obsolescence would be found in two or more properties of similar age and condition, but this is not always the case. Adjustment are made because no tow properties are precisely identical in terms of quality, age, design, size, or location.
As a form of depreciation, functional obsolescence reflects changing tastes as well as wear and tear. So it definitely is an adjustment, but is it also a reflection of conformity adjustments between two or more properties. An outdated property (in terms of basic design) is non-conforming if and when other properties in the same area are more modern and with different design standards. In this case, functional obsolescence is not simply a depreciation factor, but an adjustment based on conformity as well as other features and conditions.
Investors considering investing in a property have to consider functional obsolescence as one of many factors adding up to the listed price. However, the ultimate test of an investment's viability is in its rental value - and of course, the degree of positive or negative cash flow that entails. With this in mind, it also makes sense to critically evaluate the appraised value. The usual appraisal method can be compared to the estimated value on the income method, which varies by community and also by the design quality of the property and its functional obsolescence. This test - income approach versus the more widely used cost or comparable sales methods, is sensible considering that the purchase will be made to generate income.
So the overall question of investment value contains two general issues: Comparable value of the property as a residence, versus income value. This added calculation may help identify bargain level pricing versus inflated values.
Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been writing professionally for nearly 40 years, including several published books about real estate, written for Amacom, Wiley, Consumer Reports, McFarland, and others. He also spent several years as a landlord and real estate investor in the 1990s in Washington State, before moving to Nashville, Tennessee.