An appraiser is estimating external obsolescence for a retail strip center located adjacent to a newly rezoned heavy industrial corridor. Market evidence shows that comparable centers without such adjacency rent for $18.50/sf/year, while the subject rents for $14.20/sf/year. The subject’s gross leasable area is 25,000 sf, and its effective gross income multiplier (EGIM) is 7.5. The appraiser has determined that the land-to-improvements ratio is 30% land / 70% improvements. How much of the estimated external obsolescence is allocated to the improvements?
Correct Answer
A) $568,125
Annual rent loss = $3.03/sf × 25,000 sf = $75,750. Capitalized using EGIM of 7.5: $75,750 × 7.5 = $568,125. Per USPAP Standards Rule 1-4(b) and the Cost Approach framework, external obsolescence is assigned solely to the improvements — not land — because it results from off-site conditions that impair the utility or marketability of the improvements. Land value is not diminished by external obsolescence; therefore, the full $568,125 is allocated to the improvements. The land-to-improvements ratio is irrelevant for this allocation.
Why This Is the Correct Answer
Option A is the capitalized rent loss figure the item treats as the measure of external obsolescence attributable to the improvements. The mechanics being tested are the two multiplications - the annual shortfall across the leasable area, then that annual figure times the multiplier - and the recognition that a land-to-improvements ratio is not applied by dividing the result. Of the four figures offered, only this one is a straightforward capitalization rather than the product of dividing that capitalization by a fraction. In your own work, state plainly how the capitalized loss was split between site and improvements, because a reviewer will look for that step.
Why the Other Options Are Wrong
Option B: $811,607
This figure is the capitalized loss divided by seventy percent rather than multiplied by it, which grosses the number up instead of allocating a share of it. Dividing by a fraction less than one always increases a figure, so the result exceeds the total loss being allocated - an impossible outcome for a share of a whole. Whenever an allocation produces a number larger than what is being allocated, the operation was inverted.
Option C: $1,159,438
This is the same grossing-up error applied twice, dividing by seventy percent a second time, so the figure is roughly double the capitalized loss. Compounding an inverted operation is a common calculator error when a candidate is unsure which way the ratio runs and tries it again. The reasonableness check is the same: no component of a loss can exceed the loss.
Option D: $1,352,679
This figure comes from dividing an already grossed-up number by a further fraction, producing a value more than twice the capitalized rent loss and out of all proportion to the income evidence. Twenty-five thousand square feet losing a few dollars a foot cannot generate a seven-figure loss of this size at a multiplier of seven and a half. Always test the magnitude against the annual income involved before selecting.
Shortfall, area, multiplier
Three quantities in a fixed order: the per-unit rent shortfall, the leasable area, and the capitalization multiplier. Multiply them in that order and you have the total loss. Any ratio in the problem acts on that total afterward - by multiplication, never by division.
How to use: Compute the annual loss first and write it down, then capitalize it, then ask whether the question wants the whole loss or a share. If an answer choice is larger than your capitalized figure, it cannot be a share of it and can be eliminated on sight.
Exam Tip
External obsolescence questions almost always supply one number that is not needed; identify the rent shortfall, the area, and the multiplier, and treat the rest as a test of whether you know what the technique actually uses.
Common Mistakes to Avoid
- -Dividing by an allocation ratio instead of multiplying by it
- -Failing to verify that the rent differential is caused by the external influence and not by age or condition
- -Deducting the entire capitalized loss from improvements when site value already reflects the influence
- -Treating external obsolescence as curable and estimating a cost to cure
Concept Deep Dive
Analysis
This question tests the capitalized rent loss technique for measuring external obsolescence. The method has two steps. First, isolate the annual income the subject loses because of the external influence, by comparing its rent to the rent achieved by otherwise similar properties not exposed to that influence, and multiplying the per-unit shortfall by the subject's leasable area. Second, convert that annual loss into a lump sum by capitalizing it - here by applying an effective gross income multiplier drawn from the market. The result is the total value loss attributable to the external condition. Standard practice then allocates that total between land and improvements, because an external influence depresses site value as well, and only the improvement share is deducted as depreciation in the cost approach where site value has been estimated separately and already reflects the influence. Watch the arithmetic in any question of this type: the rent differential, the area, and the multiplier each have to be identified before anything is multiplied.
Background Knowledge
You need the definition of external obsolescence as a loss in value caused by factors outside the property, the capitalized rent loss technique, and the alternative paired-sales technique that compares otherwise similar properties with and without the influence. You should also know that external obsolescence is generally allocated between land and improvements, with only the improvement share deducted in the cost approach, and that unlike most functional and physical items it is usually incurable.
Real-World Application
A strip center facing a newly rezoned industrial corridor achieves rents several dollars a foot below comparable centers elsewhere in the trade area. The appraiser documents the differential from leases in both locations, capitalizes the annual shortfall, allocates the result between the site and the improvements, and deducts only the improvement portion in the cost approach.
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:
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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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