As a general rule, commercial real estate investment returns are made over the long run. In fact, the typical investment holding period for a commercial property usually ranges from five to ten years. While this holding period may be great for investment returns, it can also introduce a risk that certain aspects of a property can become obsolete over that time period.
In this article, we discuss the three types of obsolescence in commercial real estate: economic obsolescence, functional obsolescence, and physical obsolescence. We will define what each type of obsolescence is, why the types of obsolescence matter, and how investors can protect against them. By the end, readers should be able to identify potential obsolescence and use this knowledge as part of their investment due diligence process.
At First National Realty Partners, we invest a significant amount of resources in the pre-purchase due diligence process to minimize the risk of obsolescence in our investments. To learn more about our current investment offerings, click here.
What is Obsolescence in Real Estate?
The term “obsolescence” refers to something that is either out of date or no longer in line with market requirements. In real estate, obsolescence can be categorized as curable or incurable, meaning it can be fixed or not. Obsolescence can also impact the risk profile of a real estate investment and the capital needed to update or maintain a property.
In commercial real estate, there are three types of obsolescence:
- Functional obsolescence
- Economic obsolescence
- Physical obsolescence
Each is explained in detail below.
What is Functional Obsolescence?
Functional obsolescence is when the property loses market value due to some element of its architectural design, changing market tastes, or function.
To illustrate the point of functional obsolescence in commercial real estate, think about office buildings that were built in the 1970s or 80s. If the buildings haven’t been updated, they risk becoming functionally obsolete because modern office tenants require open spaces, high-speed wireless internet, video conferencing systems, security, and materials that are sustainable and energy efficient.
The good news about functional obsolescence is that it is often “curable,” meaning it can be fixed. An example of curable functional obsolescence is outdated property finishes, because they can be easily updated. A new property owner could purchase a 1970s office building at a good price and invest a certain sum of money into updates to bring the building to current-day standards. This type of “value-add” effort usually has a positive impact on the property’s market value.
An example of incurable functional obsolescence is an outdated architectural design, because it could require a building to be completely overhauled.
What is Economic Obsolescence?
Commercial real estate becomes “economically obsolete” when it loses value due to some external factor, such as a traffic pattern change, construction noise, or the construction of an undesirable property type like a sewer treatment plant.
For example, FNRP specializes in the purchase and management of grocery store anchored shopping centers. One of the things that we look for in potential real estate investment properties is a signalized intersection and/or a dedicated turn lane into the property. Suppose that we found a property with this feature and bought it. But, three years into our investment, the city decided – for whatever reason – that the signalized intersection needed to go away. Such a change would be economic obsolescence, making it more difficult for shoppers to access our property, which in turn means it could become less desirable to potential tenants. In a worst case scenario, vacancy rises and the property loses value.
In most cases, a property owner has no control over economic obsolescence. But, they can be aware of its existence and take proactive steps to avoid it if they see it happening. In the scenario above, we could check city plans prior to purchase. Or, once we become aware of a proposed change, we could be proactive in reaching out to city officials to voice our opposition to the planned change.
What is Physical Obsolescence?
Commercial real estate can become physically obsolete when its valuation declines due to mismanagement or some type of physical neglect that results in a condition that is incredibly expensive to repair. In some cases, the repair bill could be large enough that it may be cheaper to either gut renovate or demolish the property and build anew.
For example, suppose that a property owner completely ignored their property in almost every way. Over time, a leak developed in the roof, causing water to seep into the walls every time it rained. Over even more time, the constant water damage causes mold to form and spread throughout the entire property. A situation such as this can result in significant reductions in property value and a major headache to repair. It could also make a property physically obsolete.
Curable vs. Incurable Obsolescence
For each of the types of real estate obsolescence (functional, economic, and physical), a further classification can be made as to whether it is curable or incurable. Curable obsolescence can be fixed, whereas incurable obsolescence cannot.
A traffic shift that causes a property to become economically obsolete is incurable, for example, because fixing it is outside the control of the property owner. Sure, they could lobby city officials for a change, but the ultimate decision is up to someone else.
At the other end of the spectrum, functional obsolescence or certain types of physical obsolescence are curable because they can be fixed quickly and for a reasonable cost. For example, if a property becomes physically obsolete due to dated finishes, this is a relatively easy fix.
Why is Understanding Real Estate Obsolescence Important?
For investors, understanding obsolescence is an important element of the real estate due diligence process for two reasons: risk and cost.
Risk Profile
From a risk standpoint, understanding potential types of obsolescence can help to establish the risk profile of a real estate investment. This is exactly why an older property is less expensive than a newer one, because there is more risk associated with it becoming obsolete in some way.
Cost Requirements
From a cost perspective, understanding obsolescence is important because it allows real estate investors to have a better sense of what it could or would cost to cure some amount of obsolescence. For example, if a property is approaching some level of functional obsolescence, a potential investor will want to know how much it will cost to cure and factor this amount into their cash flow models to have a more accurate picture of potential return.
How Does Obsolescence Impact the Real Estate Market?
Regardless of the type of property, the impact of obsolescence tends to be the same: obsolescence causes the value of a property to decline.
For example, if a property becomes functionally obsolete, the value may not decline right away or all at once. Instead, a functionally obsolete property may start to lose tenants to newer properties, causing occupancy to suffer. Lower occupancy means less cash flow, which means lower property valuations. This is a scenario that could play out slowly, over a number of years if not addressed.
Causes of Obsolescence in Commercial Real Estate
The reasons for real estate becoming obsolete can be grouped into two buckets: internal and external.
Internal Causes
The major internal reason for obsolescence is simply neglect. Commercial properties need constant maintenance and repair. For example, the HVAC system needs to be cleaned periodically and its air filters need to be changed. If it isn’t, its economic life/useful life could be shortened and its function could be diminished. A non-functioning HVAC system increases the risk that a property becomes obsolete.
External Causes
External reasons may be more difficult to manage since they are mostly out of the property owner’s control. External causes of obsolescence include things like: changing market tastes, new zoning rules, new construction, or changes in traffic patterns. Sometimes they could come as a surprise, but more often they happen slowly over a long period of time so it is important that investors have a high level of awareness of market conditions.
Obsolescence & Private Equity Real Estate
Obsolescence is just one reason that commercial real estate investments need near constant oversight. For many individual investors, this level of attention and the expertise needed to address potential issues can be overwhelming. For this reason, it may be preferable to partner with an expert – like a private equity firm who can bring years of experience to a transaction.
This type of experience can be incredibly valuable, can prevent impairment due to obsolescence, and can proactively take steps to address it. In a typical private equity investment structure, investors can simply provide capital and leave the hard work of worrying about obsolescence to the firm who has the experience and resources necessary to address it.
Summary & Conclusion
- “Obsolescence” is the term used to refer to something that is either out of date, or no longer in line with market requirements.
- As it relates to a commercial real estate investment, there are three types of obsolescence: functional, economic, and physical.
- Obsolescence can be categorized as curable or incurable, meaning it can be fixed or it can’t. An example of curable functional obsolescence is outdated property finishes because they can be easily updated. Whereas an example of incurable functional obsolescence is an outdated architectural design because it could require a building to be completely overhauled.
- Obsolescence impacts both the risk profile of an investment and the capital needed to update/maintain a property.
- For individual investors, the risk that obsolescence brings to a deal highlights the benefit of working with a private equity firm because they have the experiences and resources needed to address it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
