Functional Obsolescence

What is functional obsolescence? This post will be interesting to people buying a home, Realtors, appraisers, and most anyone involved in the real estate process.

I recently had a loan get rejected, which I am currently working to get approved. The loan was rejected due to “an unacceptable property”. Upon further questioning, the bank told me this was due to “functional obsolescence”.

The Fannie Mae definition

The Fannie Mae Seller/Services Guide says, “Functional depreciation (which is traditionally referred to as functional obsolescence) is a loss in value that is caused by defects in the design of the structure—for example, inadequacies in such items as architecture, floor plan, or sizes and types of rooms. It also can be caused by changes in market preferences that result in some aspect of the improvements being considered obsolete by current standards—for example, the location of a bedroom on a level with no bathroom, or access to one bedroom only through another bedroom.

In reviewing the appraisal report, the lender should make sure that the appraiser’s analysis and comments for the cost approach to value are consistent with comments and adjustments mentioned elsewhere in the appraisal report. For example, if the neighborhood or site description reveals that the property backs up to a shopping center, the lender should expect to see an adjustment for external depreciation in the cost approach. Similarly, if the improvement analysis indicates that it is necessary to go through one bedroom to get to another bedroom, the lender should expect to see an adjustment for functional depreciation.”

This citation does not say for the lender to reject the loan outright, it only says to make sure the appraiser adjusts the value downward for this perceived obsolescence.

A real life example

The property I am doing a loan for is a 2 bedroom, 1 bath home, on Capitol Hill in Washington DC. It is a 3 level home, with the third floor being where the 2 bedrooms and the bathroom are. The underwriter says that because the home only has one bathroom, and that bathroom is only accessible by walking through someone’s bedroom, that creates obsolescence compared to modern housing stock. And she is right because today no one would accept that design in a new home, except that in an old, historic area with no available land for development, there is no “modern housing stock.” The entire area is comprised of historic homes. There are new condos but those cannot be used as comparables for a single family home.

After talking to two other appraisers, Realtors, and the buyers, they all say, “who cares?” If the marketplace accepts it, and a buyer is willing to deal with it, it cannot be considered obsolete. There were multiple offers on this property, and the final sales price was above the asking price!

Here is what the Fannie Mae manual says: “A loss in value that is caused by defects in the design of a structure or by changes in market preferences that result in some aspect of a property being considered obsolete by current standards.”

My take

First, market preferences have not changed and the market does not see a defect in design, because the subject had multiple offers, above asking price, and sold in just days. So clearly the marketplace wants and accepts this design.

Second, this is Capitol Hill, where there is NO NEW HOUSING STOCK. There is no new design, or new standards. People buy properties like this all the time on Capitol Hill, because there is no alternative, and it is impossible to find an alternative, because there is no space to develop for more homes.

In real estate functional obsolescence is something which is not acceptable in the marketplace, like lack of heat. Having to go through a bedroom to get to a bathroom does not mean that you can no longer get to the bathroom!

More on functional obsolescence in real estate:

“When properties are built, they don’t always adhere to the standards of a given neighborhood, floor plan, or site design. When this happens, depreciation is caused by a loss of building utility, otherwise known as functional obsolescence. In other words, if a building has reduced usefulness due to poor design, the value must be reduced.

Examples include buildings that are too big or lavish within a certain area which is considered an over-improvement (as in the picture associated with this blog post), or a property that is relatively small or poor compared to those around it, which is considered an under-improvement. If a building is said to be out-of-place or poorly designed for its location, it could be considered functionally obsolete.

If a property lacks a feature such as side yard when other properties in the market have side yards, or only contains one bathroom despite having five bedrooms, functional obsolescence occurs.”

On the loan in question we have one bath for two bedrooms, and can find comparable sales to show it exists elsewhere in the marketplace, and while it is not commonplace, it is hardly functionally obsolete.

I think I have made my case that functional obsolescence does not exist in this case. Wish me luck with the underwriter, they tend to be inflexible.