A neighborhood's sole employer announces a permanent shutdown and local prices sag. For the cost approach this is best classified as:
Correct Answer
B) External obsolescence with an economic cause
Why this is correct: External obsolescence is a loss in value from causes outside the property itself. It can be locational (e.g., bad neighbor) or economic. The permanent loss of a major employer is an economic cause that reduces demand and value for all properties in the area, making it external obsolescence. Why the other choices are wrong: "Functional obsolescence" relates to flaws within the property's design or features. "Temporary market noise, excluded from the analysis" is wrong; a permanent plant closure is a lasting economic fact that must be considered. "Physical deterioration accelerated by vacancy" describes physical wear and tear, not the root economic cause. Exam tip: External obsolescence originates outside the property lines and is often incurable.
Why This Is the Correct Answer
External obsolescence with an economic cause is precisely right: the cause lies outside every property boundary and operates through the local economy rather than through location-specific nuisance. The permanence of the shutdown matters, because a temporary layoff might be absorbed while a permanent closure resets the demand base. Because the loss affects an entire market, it is generally incurable at the property level, and the appraiser measures it from market evidence rather than from cost. In practice the appraiser must also check whether the site value used in the cost approach already reflects the decline, to avoid deducting the same loss twice.
Why the Other Options Are Wrong
Option A: Functional obsolescence of the housing stock
Functional obsolescence requires a defect in the property itself, whether a deficiency such as an inadequate bathroom count, a superadequacy such as an over-improved kitchen, or an outdated layout. The houses in this scenario are unchanged; only the demand for them fell. Attributing an economy-wide loss to the design of individual homes misplaces the cause entirely.
Option C: Temporary market noise, excluded from the analysis
A permanent shutdown is a durable change in the economic base rather than transient noise, and appraisers are required to analyze relevant market conditions as of the effective date. Excluding a known, lasting market fact would produce a value opinion the market does not support and would render the report misleading. Even where an appraiser expects eventual recovery, the effective-date market is what the opinion must reflect.
Option D: Physical deterioration accelerated by vacancy
Physical deterioration measures wear on the improvements, and while prolonged vacancy can accelerate physical decline through unmaintained systems and vandalism, that would be a secondary consequence rather than the classification of the value loss described. The stem describes prices sagging immediately on the announcement, before any physical change could occur. Naming a downstream effect misses the cause the item is testing.
Inside, Outside, Worn Out
Three questions in order. Is it worn out? Physical. Is the problem inside the property line? Functional. Is the problem outside it? External, and then ask whether the outside cause is a place problem or a money problem.
How to use: When a stem names an employer, an industry, an interest rate, or an oversupply, answer external obsolescence with an economic cause. When it names a highway, a landfill, or a neighboring use, answer external with a locational cause.
Exam Tip
Check how site value was derived before deducting external obsolescence from the improvements. If the land comparables came from the same affected market, the loss may already be captured and deducting again would double count.
Common Mistakes to Avoid
- -Classifying a market-wide economic loss as functional obsolescence
- -Double counting external obsolescence when land value already reflects it
- -Treating a permanent economic change as temporary and excluding it from the analysis
Concept Deep Dive
Analysis
Depreciation is classified by where the cause originates. Physical deterioration comes from wear, use, and the elements. Functional obsolescence comes from something inside the property line: a design deficiency, a superadequacy, or an outdated layout the market no longer accepts. External obsolescence comes from outside the property line and is subdivided into locational causes, such as a new highway, an adjacent nuisance, or a rezoning, and economic causes, such as a collapse in local employment, a change in the industry that supports the area, or an oversupply of competing space. A sole employer's permanent shutdown is the textbook economic cause: nothing about any individual house changed, yet demand for all of them fell because the income that supported the market disappeared. External obsolescence is almost always incurable, since no owner can restore the employer, and it is typically measured by paired sales comparing affected and unaffected areas or by capitalizing the rent loss attributable to the condition.
Background Knowledge
You need the three categories of depreciation, the locational and economic subdivisions of external obsolescence, and the general rule that external obsolescence is incurable. You should also know the two standard measurement techniques, paired sales analysis and capitalization of rent loss, and the caution that external obsolescence may be reflected in land value, improvements, or both.
Real-World Application
An appraiser in a mill town after a plant closure pairs sales against a comparable town with a diversified economy, isolates the price differential attributable to the closure, allocates it between site and improvements, and confirms that her land comparables were drawn from unaffected areas before applying the deduction.
More Cost Approach Questions
In a cost approach for a proposed building, the appropriate cost basis is generally:
A warehouse cost $210,000 to build when the cost index stood at 105. The index is now 210. Its indicated current cost is:
The age-life method expresses depreciation as:
Market extraction of depreciation is limited by the fact that it:
Functional obsolescence caused by a deficiency is measured as curable when:
Curable physical deterioration is measured at cost to cure because:
A 2,050 sq ft dwelling is priced at $178 per square foot with a $34,000 detached garage and $21,500 of site improvements. Cost new is:
A house has three bedrooms sharing one bathroom, and adding a second bath is economically justified. This is:
Direct costs in a construction budget include:
An appraiser writes that a 40-year-old house has an effective age of 10 but describes original wiring, original kitchen and a 25-year-old roof. The report's problem is:
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An owner installed a swimming pool at a cost of $45,000. Paired sales indicate pools add $18,000 in this market. What functional obsolescence does the pool represent?
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A 15-year-old house has cost new of $420,000 with short-lived items totaling $58,000 in cost and $24,000 of depreciation charged against them. If the long-lived ratio is 18%, total physical depreciation is: