Functional Obsolescence in Real Estate Explained

Functional obsolescence in real estate describes a property that has decreased in desirability or functionality due to an outdated design feature, physical deterioration, or undesirable external factors.

Looking to other industries can help make better sense of how functional obsolescence works in real estate. For example, in the consumer electronics industry, new technologies are introduced so frequently that new products—such as smartphones and TVs—tend to depreciate rapidly. The same goes for real estate. For example, a house with a one-car garage might be considered functionally obsolete in an area where new homes are being built with two-car garages. In the same way that trends affect the value of televisions, market tastes and standards affect the market value of homes.

Functional obsolescence is a form of depreciation that can impact the market value of a home. During the home-buying process, a qualified appraiser runs an assessment to determine the value of a home and reports their findings in the form of an appraisal. The appraisal will take into consideration factors that could contribute to functional obsolescence such as undesirable external factors, outdated design features, or if the home doesn't meet the market tastes and standards—like an old house in a neighborhood of new homes.

Functional obsolescence is most likely to occur in one of three ways.

1. 1. Incurable functional obsolescence: This form of functional obsolescence—sometimes called external obsolescence or economic obsolescence—occurs when the remedies needed to increase a property's value are outside of your control. For example, there's no way to remedy the location of a home situated on the corner of a busy intersection. Incurable obsolescence can also apply when the costs of repairing or remodeling a home exceed the value of the home.
2. 2. Curable functional obsolescence: Curable obsolescence is the term for the physical deterioration of the subject property that can easily be remedied, or cured, by the new homeowner.
3. 3. Superadequacy: While it may seem counterintuitive, a property owner can over-improve their home to the extent that it lessens the resale value. For instance, a home with an indoor swimming pool may be too costly for most homeowners to maintain. Depending on the appraisal method an appraiser uses to determine the value of the home, the appraiser may lessen the market value to account for the additional cost of maintaining or removing the over-improvement.

There are several ways functional obsolescence can affect a property’s value.

1. 1. External factors: External factors include environmental, social, and economic forces that are outside of your control. This can include homes built too close to a loud factory or in areas suffering from high unemployment rates.
2. 2. Out of place: Sometimes a home is deemed functionally obsolete when it does not fit aesthetically or functionally with the rest of the neighborhood. For example, a small, single-story house built in a gated neighborhood with large, two-story homes may be out of place. Even if the house is in good condition, it may be considered functionally obsolete because it doesn't align with the tastes and standards of the market.
3. 3. Poor layout: A home that has two bedrooms and one bath in a neighborhood with mostly four-bedroom, two-bath homes would be considered functionally obsolete. Similarly, a home with too many bedrooms crammed into a small space could be considered functionally obsolete.
4. 4. Physical deterioration: Sometimes a home's physical deterioration is too great to remedy, which can lead to functional obsolescence. Likewise, a home that's fallen into disrepair in a neighborhood with otherwise well-kept homes could be subject to functional obsolescence.

Not all homeowners or property investors will find functional obsolescence to be a deal breaker. In some cases, your real estate agent may be able to help you negotiate down the price of a home once you're made aware of its obsolescence. Some appraisers might deem a home obsolete for functional features that you deem more aesthetic or are willing to remedy yourself.

If you're aware of a property's obsolescence, you may ask the appraiser to use the cost approach to valuation instead of the sales comparison approach. Instead of comparing the value of the obsolete home with comparable homes on the market, the appraiser will value the home based on what it would cost to tear down and rebuild the home. This is known as the replacement cost.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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