Calculating Functional Obsolescence in Cost Approach
Regarding a functional obsolescence deficiency that lacks something, the calculation is the difference between the reproduction cost with the curable item and without it, as of the date of appraisal.  Note that this is reproduction cost and not replacement cost. Functional obsolescence is the excess cost of adding the item in question, such as an additional bathroom or the new kitchen, to the existing house compared to what it would have cost at the time of construction.  Since it is an added item, only the cost new is utilized.  Regarding a functional obsolescence deficiency that requires modernization (kitchen, bathroom or flooring), the cost to cure is based on the same principle as above, with the exception that the depreciated cost of the existing item must be deducted as most likely it will not be salvageable. 

Regarding a functional obsolescence superadequacy (most likely incurable), if the appraiser calculates the replacement cost in the cost approach, the functional obsolescence is eliminated.  In regard to the oversized swimming pool or a custom kitchen in a neighborhood not needing a custom kitchen, it would be the cost to eliminate or remove the existing item and replace it with an item considered acceptable for the area.  But this would be ludicrous because unless the superadequacy causes additional expense (heating an oversized swimming pool for instance), the appraiser would not do any calculation for functional obsolescence- superadequacy.  Again, if the appraiser considers replacement cost new of the swimming pool, it would be a typical size pool and not the oversized swimming pool.

An alternative approach to measure functional obsolescence would be to apply the rent loss difference between the house with the deficiency (i.e. the monthly rental rate of a four-bedroom/one bath house versus an acceptable four-bedroom/two bath house), and then apply the gross monthly rent multiplier to this rent loss, attributable specifically to this deficiency. This is also difficult to do but is certainly better than trying to perform a paired sales analysis to compute the functional obsolescence.

How is Functional Obsolescence Treated in Sales Comparison Approach?
FannieMae Form 1004 has line items regarding Design, Quality of construction and Functional utility.  An adjustment for any of these line items is difficult to determine.  All textbooks lean toward using a paired sales analysis. This is easier said than done. Design is based on the style of the house, such as a one-story versus a two-story or a ranch house versus colonial or Mediterranean.  This may be a matter of preference or taste, unless the subject’s design is out of place for the neighborhood.  A good example of this would be a two-story house in a predominately one-story neighborhood. 

Note that quality of construction should not be confused with condition of the building.  A good example of quality of construction is different roofing materials.  A house with a slate or cement tile roof would probably be considered superior to an asphalt shingle roof.  Sometimes the quality is based on the cost differential between the two materials, but again, in this situation, cost does not equate to a difference in value.  Functional utility is probably the best location to place an adjustment for functional obsolescence, but how can it be quantified?

Calculating Functional Obsolescence in Sales Comparison Approach (or do you?)
Functional obsolescence as a form of depreciation is not calculated in the sales comparison approach, only in the cost approach.  Functional obsolescence is “hidden” in adjustments in the sales comparison approach, such as outdated kitchens, bathrooms, old style wallpaper and carpeting (remember shag carpets?).  Line adjustments made in the sales comparison approach, for design, condition, etc. are, in essence, adjustments for functional obsolescence, but it is not referred to as such in the sales comparison approach. There is no line item for poor floor plan, superadequacy or deficiency.

Even though calculating the functional obsolescence of the subject is plausible, the purpose of the sales comparison approach is to compare the subject with sales of properties similar to it; any difference between the subject and the comparable sales would reflect an adjustment.  A comparable sale would reflect the functional obsolescence in its sales price. 

Other than the obvious, such as too few bathrooms given the number of bedrooms (four-bedroom/one bath house), how would you know if the comparable sale has functional obsolescence unless you either appraised the property or have first-hand knowledge of it?  Most likely you wouldn’t.  Design, quality of construction and functional utility, which was briefly discussed above as possible functional issues, cannot be determined in the comparable sale unless the appraiser has first-hand knowledge of that property. Any adjustment you intend to make regarding functional obsolescence to the comparables, in comparison to the subject, is almost impossible to support.

Instead of trying to calculate the amount of functional obsolescence in the sales comparison approach, consider going toward the lower end of the range in your adjusted sales price when reconciling and state why you went toward the lower end of the range.  One explanation you can give is to recognize that, more than likely, functional obsolescence exists in your subject property which would make the comparable sales superior to the subject, but that quantitative adjustment is difficult to support, therefore, a market value closer to the lower end of the range would be considered appropriate.

In conclusion, if your subject property has functional obsolescence, an adjustment for it in the cost approach could be made and supported. But it is difficult and nearly impossible to support an adjustment for functional obsolescence in the sales comparison approach, as the only logical method to use would be the rent loss method. This would require rental comparables for the subject with the functional obsolescence compared to a rental without the functional obsolescence - a near impossibility.

About the Author
Philip G. Spool, ASA, is a State-Certified General Real Estate Appraiser in Florida, appraising since 1973.  Formerly the Chief Appraiser of Flagler Federal Savings and Loan Association, he has been self-employed for the past 20 years. In addition to appraising, he is an instructor with Miami Dade College, teaching appraisal courses and continuing education.  He is Vice President and Chairman of Real Estate Programs with the Greater Miami Chapter of the American Society of Appraisers.  He can be reached at pgspool@bellsouth.net.

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