Commercial real estate obsolescence is a challenge investors face that can affect the long-term success of their acquisition. Since ROI expectations, the environment, and the market constantly change, obsolescence is a threat that investors must carefully monitor.
These changes can cause a commercial property to have a positive cash flow one day and be unappealing the next. As occupant desires or other internal and external factors arise, a building that was once in demand may become useless over time.
Obsolescence in this context can take various forms. It impacts the investment’s risk profile and how much capital is necessary to maintain or update the property. It’s crucial to understand the role obsolescence plays in a commercial real estate investment, and we’ll outline why.
What Is Obsolescence in Commercial Real Estate?
Generally, investors receive dividends from their commercial real estate investment after an extended period. Generally, the standard holding time for these properties is nearly a decade.
This setup is excellent for returns but also increases the risk that specific property components can be rendered obsolete during that time.
As mentioned, real estate constantly changes. Investors must prepare for how these factors will affect the investment, whether it be the property itself or the circumstances surrounding it. It will inevitably deteriorate, but that doesn’t mean it can’t experience a price jump as well.
Why Is Obsolescence an Important Factor to Consider?
There are two reasons that understanding obsolescence is pivotal for an investor that does their due diligence when considering what to purchase: cost and risk.
Commercial Real Estate Investment: How Does Obsolescence Affect Risk
Regarding risk, the investor should understand the potential form of commercial real estate obsolescence that they might be subject to endure. It helps them know how much they stand to lose.
You see this play out when you consider how older properties cost less than newer ones. The reason is that there’s more of a risk that the investor takes on in that it could become obsolete somehow.
Commercial Real Estate Investment: How Does Obsolescence Affect Cost
From the cost standpoint, when the investor does an excellent job of understanding the potential ways that things can become obsolete, they can get an idea of the cost to fully or partially cure the obsolescence.
For example, if the property has some functional obsolescence, an investor will want to investigate the costs associated with curing the problem.
They’ll add this to the total amount of money they calculate with their cash flow model. Ultimately, it paints a clearer picture of what they can expect to receive back.
The possible cost issues that could occur when factoring obsolescence into the situation highlight the necessity of a private equity firm with the knowledge, resources, and experience to handle the problem.
We advise Investors to review the three types of commercial real estate obsolescence before striking a deal. This is where the expertise of another firm can help provide insight into what investors can expect before taking on certain projects. At EXtrance, we make sure to provide this information.
Examples of Commercial Real Estate Obsolescence
Real estate obsolescence can be divided into three.
Functional obsolescence indicates that a commercial property has decreased in value because of changes to the style, amenities, design, technology, or the market itself. It means that modern tenants have expectations that still need to be met.
An example is if you have an old house that only has one bathroom but it’s in a neighborhood with newer homes that contain at least three bathrooms. Or, an old office building built 40 years ago may not have the technologies required to keep the interest of office tenants today.
Without updates, the building probably wouldn’t have video conferencing, high-speed WiFi, an energy-efficient structure, security systems, and more. Thus, it would be functionally obsolete.
After letting functional obsolescence persist, it eventually causes a decline in the real estate appraisal. This can be disastrous; we offer assistance to help you fully manage your property and make it easier to plan for any drawbacks.
External, or economic obsolescence, occurs when a property depreciates because of factors the owner cannot control.
An example of economic obsolescence is when traffic patterns change; there are zoning alterations, flight patterns rearranged, or constructing new buildings in the area. Other issues like higher crime, rising unemployment, and more can cause commercial real estate obsolescence.
For example, suppose a city makes the decision to expand or build an airport using local commercial space. In that case, the properties will depreciate due to noise pollution, which inevitably leads to economic obsolescence.
Although the property owner would’ve had no input on the decision, they would still suffer the consequences in two distinct ways. The first ramification is that tenants are more likely to leave. This can increase vacancy levels on a particular property.
The second consequence is that due to the uptick in vacancies, rents will have to come down to where potential tenants perceive the offer as a deal when the noise pollution gets factored in.
When these two factors converge on the same property, they’ll experience a shortfall in operating income and drive the property value lower, possibly to an amount considered economically obsolete.
Unfortunately, managers and commercial property owners can’t do much to combat economic obsolescence because this kind of obsolescence stems from societal challenges or issues instead of the failure of a business resting squarely on its shoulders alone.
Physical obsolescence is when a piece of commercial real estate loses value because of mismanagement or neglect that leads to terrible conditions that are too costly to fix.
In some situations, the repairs are so severe that it’s cheaper to renovate or completely tear the building down and start over.
All real property assets will inevitably experience physical deterioration over time, but through proactive maintenance as well as a replacement program, investors can manage it.
For instance, if a property owner disregarded their maintenance responsibility virtually every day, over time, a simple leaky roof could worsen, allowing harmful water to start leaking behind the walls each time there’s medium to heavy rainfall.
As the property’s poor condition festers, the water damage will cause mold growth and proliferate throughout the entirety of the property. Circumstances such as these can lead to considerable financial losses through costly repairs and more.
Of course, as the property continues to deteriorate, the value of the property will likely result in operating losses, decreased economic life, decreased occupancy, and capital loss.
Whether or not physical obsolescence is reversible or curable, depends on the replacement cost to fix it.
If the repair costs are cost prohibitive or the funds can get recovered through higher rents or increased occupancy, it’s irreparable. On the other hand, if the price is relatively minor, you can easily fix the issue.
Categories of Obsolescence
For both kinds of real estate obsolescence described previously, you can further classify them as whether they are curable or incurable. Curable means that it’s fixable; if it’s incurable, you cannot fix it.
Curable obsolescence means any items that are physically deteriorating or functionally obsolete in some way that are economically feasible to remedy.
An example of curable obsolescence would be a home that lacks modern plumbing fixtures. It’s relatively easy to correct this problem by just updating the plumbing system.
It’s essential to note that investors can take curable obsolescence too far and end up over-improving the property. It’s called superadequacy and an example is if you were to add an indoor pool to a home.
Well, that’s expensive to maintain, and the value of the house may actually have to decrease in order to account for the amount of money necessary to maintain an upgrade that is so luxurious.
Incurable obsolescence is generally caused by external factors outside the property owner’s control. Investors can conduct thorough research on the most recent trends and designs to prevent such obsolescence before fully committing to a risky real estate investment.
Incurable obsolescence is the kind of obsolescence that is not practical from a financial perspective to cure. It’s evident when it’s exorbitant to fix the problem.
For instance, an old residential building surrounded by modern residential houses can be deemed incurable because it would require hefty renovations to modernize it and improve its resale value.
The cost of renovations will dwarf the amount of money you’ll get back when it’s sold. Generally speaking, investors can avoid incurable obsolescence during the initial stages of real estate analysis and valuation before acquiring it.
Streamline Your Real Estate Investment Process
Obsolescence is a prime example that commercial real estate investments should receive constant oversight. Building trust with investors before they agree to invest in a commercial property is essential to the partnership working.
Dedicating that much attention to keep a property running and looking optimal can feel overwhelming for many investors. Thus, we recommend going into business with a firm that has knowledge and experience that can prove to be beneficial.
Contact EXtrance today to learn more about how we can streamline your current commercial real estate investment processes.