Adjustments and Valuation Methods for Land Appraisal

Chapter: Adjustments and Valuation Methods for Land Appraisal

This chapter will delve into the adjustments applied and various valuation methods used specifically for land appraisal. Understanding these techniques is critical in the context of financial institutions and real estate appraisal regulations because land value forms the foundation of many real estate transactions and investments. We will explore the scientific underpinnings, practical applications, and inherent limitations of each method.

I. Adjustments to Comparable Sales Data

The cornerstone of land appraisal, and indeed most real estate appraisal, is the Sales Comparison Approach. This approach relies on identifying comparable land sales and adjusting their sale prices to reflect differences between the comparable properties and the subject property. Adjustments are always made to the comparable sale price, not the subject property’s characteristics. This maintains objectivity.

• A. Principles of Paired Data Analysis: The scientific basis for making adjustments lies in paired data analysis. This statistical technique identifies the market’s reaction to a specific difference by isolating pairs of similar sales where only one significant characteristic differs. By observing the price difference, we infer the value attributable to that characteristic.

  • 1. Example: If two identical lots sold, and one had access to sewer lines while the other required a septic system, the price difference (Sale Price with Sewer - Sale Price without Sewer) suggests the market value of sewer access. This value is then applied as an adjustment to comparables lacking this feature.

• B. Types of Adjustments: Adjustments compensate for variations in:

  • 1. Property Rights Conveyed: Did the comparable sale include mineral rights, air rights, or other property rights not present in the subject property? Adjustments reflect the value of these rights.

  • 2. financing terms❓❓: Unusual financing arrangements (e.g., seller-financed with below-market interest rates) can skew the sale price. An adjustment is needed to reflect typical market financing.

    • Let SPc be the sale price of the comparable.
    • Let MTRc be the market interest rate for financing the comparable property.
    • Let ARc be the actual interest rate of the comparable property.
    • Let PMTc be the monthly payment of the comparable property.
    • If ARc < MTRc , then we calculate the adjustment amount using present value techniques to account for the below-market financing.

  • 3. Conditions of Sale: Was the sale “arms-length,” or was there undue pressure (e.g., forced sale due to foreclosure)? Distressed sales are typically excluded or heavily adjusted.

  • 4. Expenditures Immediately After Sale: Did the buyer incur immediate costs (e.g., demolishing an existing structure) to prepare the site? These costs are added to the comparable’s price.

  • 5. Market Conditions (Time Adjustment): Real estate markets fluctuate. An upward or downward adjustment is needed if significant time has elapsed between the comparable sale date and the appraisal date, and the market has changed.

    • This is often modeled using regression analysis, where Price Change = β * Time*, where β is the market trend coefficient.

  • 6. Location Adjustments: Location encompasses factors like neighborhood desirability, access to amenities, and environmental conditions. Proximity to positive (e.g., parks) or negative (e.g., landfills) influences requires careful analysis.

  • 7. Physical Characteristics: Size, shape, topography, soil conditions, and availability of utilities are crucial.

  • 8. Economic Characteristics: Zoning regulations, development restrictions, and potential for future land use significantly influence value.

• C. Dollar vs. Percentage Adjustments: Adjustments can be expressed as either dollar amounts or percentages. Percentage adjustments are typically applied to the comparable sales price.

  • 1. Example: A comparable lot sold for $45,000. Market data indicates the subject lot is 10% less valuable due to market changes since the comparable’s sale. The adjustment is 0.10 * $45,000 = $4,500. The adjusted comparable price is $45,000 - $4,500 = $40,500.

• D. Sequence of Adjustments: The order in which percentage adjustments are applied can influence the final adjusted price. A typical sequence is:

  • 1. Property Rights
  • 2. Financing Terms
  • 3. Conditions of Sale
  • 4. Market Conditions
  • 5. Location
  • 6. Physical Characteristics

  • 1. Mathematical Illustration of Adjustment Sequence:

    • Comparable Sale Price (SPc) = $100,000
    • Financing Adjustment = -10%

    • Utility Adjustment = +$5,000

    • Scenario 1: Financing First

      • Financing Adjustment = $100,000 * 0.10 = $10,000
      • Adjusted Price (Financing) = $100,000 - $10,000 = $90,000
      • Adjusted Price (Utilities) = $90,000 + $5,000 = $95,000

    • Scenario 2: Utilities First

      • Adjusted Price (Utilities) = $100,000 + $5,000 = $105,000
      • Financing Adjustment = $105,000 * 0.10 = $10,500
      • Adjusted Price (Financing) = $105,000 - $10,500 = $94,500

    • This demonstrates the importance of a consistent and market-supported adjustment sequence.

II. Alternative Land Valuation Methods

When sufficient comparable sales data is unavailable, alternative land valuation techniques are employed. These methods are less direct and rely on assumptions, increasing the need for sound judgment and validation.

• A. Allocation Method: This method is used for improved properties. It assumes a typical ratio between the value of the land and the improvements (building).

  • 1. Formula:
    • Land Value = Total Property Value * (% of Value Allocated to Land)

  • 2. Example: If a property is worth $200,000, and the typical building-to-land value ratio in the area is 3:2, then 40% (2/5) of the total value is allocated to the land.

    • Land Value = $200,000 * 0.40 = $80,000

  • 3. Limitations: The method relies on accurate market data to determine the land-to-building value ratio. It also doesn’t account for variations in building size, style, or functionality on similar lots.

  • B. Extraction Method: Also applicable for improved properties when vacant land sales are lacking. It works by subtracting the depreciated cost of the improvements from the total property value.

  • 1. Formula:

    • Land Value = Total Property Value - Depreciated Cost of Improvements

  • 2. Example: A comparable property sold for $650,000, and the appraiser estimates the depreciated value of the improvements is $80,000 - $100,000. The indicated land value is then between $550,000 and $570,000.

  • 3. Limitations: The reliability depends on accurately estimating the depreciation of the improvements. It works best when the improvements represent a relatively small portion of the total value.

• C. Development Method (Subdivision Analysis): Used for valuing large, undeveloped parcels of land suitable for subdivision. This method involves projecting future cash flows from lot sales after deducting development costs and discounting them back to present value. This is a form of Discounted Cash Flow (DCF) analysis.

  • 1. Process:
    • a. Determine the highest and best use (subdivision layout, lot sizes, etc.).
    • b. Develop a detailed development plan, including engineering costs, infrastructure, marketing, and sales costs.
    • c. Project sales prices for each lot, considering market demand and competition.
    • d. Estimate an absorption rate (how quickly the lots will sell).
    • e. Calculate total project revenue and costs over the development period.
    • f. Determine an appropriate discount rate reflecting the risk of the project.
    • g. Discount the net cash flows (revenue - costs) for each year back to present value.
    • h. Sum the present values of all cash flows to arrive at the indicated land value.

  • 2. Formula:

    • PV = ∑ (CFt / (1 + r)^t)

      Where:

      • PV = Present Value (Land Value)
      • CFt = Net Cash Flow in year t
      • r = Discount Rate
      • t = Year

  • 3. Limitations: This method is highly sensitive to the accuracy of the projections. Overestimating lot prices, underestimating costs, or selecting an inappropriate discount rate can lead to significantly inflated land values.

  • D. Land Residual Method: A form of income capitalization. This method isolates the income attributable to the land and capitalizes it to estimate land value.

  • 1. Formula:

    • Land Value = Land Income / Land Capitalization Rate
    • Land Income = Total Net Operating Income - (Improvement Value * Improvement Capitalization Rate)

  • 2. Process:

    • a. Estimate the total net operating income (NOI) the property is expected to generate.
    • b. Estimate the value (or replacement cost) of the improvements.
    • c. Determine appropriate capitalization rates for both the land and improvements, based on market data.
    • d. Calculate the income attributable to the improvements (Improvement Value * Improvement Capitalization Rate).
    • e. Subtract the improvement income from the total NOI to find the income attributable to the land.
    • f. Capitalize the land income using the land capitalization rate to arrive at the indicated land value.

  • 3. Example: If the net income from a property is $208,000, construction cost is $1.2M, the market cap rate for land is 8%, and improvements is 12%: Income attributable to improvements is ($1.2M * 0.12) = $144,000. Therefore income attributable to land = $208,000 - $144,000 = $64,000. So indicated land value = $64,000 / 0.08 = $800,000

  • 4. Limitations: This method relies on accurate income projections and capitalization rate estimates. Errors in either of these inputs can significantly impact the land value conclusion.

• E. Ground Rent Capitalization Method: Another income capitalization approach, this method values land based on the ground rent paid under a long-term ground lease.

  • 1. Formula:

    • Land Value = Ground Rent / Capitalization Rate

  • 2. Example: If a property has a ground rent of $50,000 per year and the market capitalization rate is 10%, then the land value is $50,000 / 0.10 = $500,000.

  • 3. Considerations: This method needs adjustments to reflect the remaining lease term, any provisions for rent escalation, and the creditworthiness of the tenant. It’s critical to assess the stability and reliability of the ground rent.

• F. Depth Tables: These tables are an older technique for approximating the value distribution within a lot based on its depth. They assume that the front portion of a lot has a disproportionately higher value than the rear.

  • 1. Example (The “4-3-2-1 Method”):

    • First 1/4 of the lot: 40% of Value
    • Second 1/4 of the lot: 30% of Value
    • Third 1/4 of the lot: 20% of Value
    • Fourth 1/4 of the lot: 10% of Value

  • 2. Limitations: Depth tables are simplistic and don’t consider the specific needs of potential users. They are rarely used in modern appraisal practice except as a very rough preliminary estimate. They fail to account for the relationship between depth and potential land utilization.

III. Conclusion

Accurate land appraisal is critical for sound financial decision-making. Understanding adjustment techniques for the Sales Comparison Approach and the various alternative valuation methods is essential. While the Sales Comparison Approach is preferred, alternative methods provide valuable tools when comparable sales data is limited. Always remember that sound judgment, thorough market research, and careful analysis are paramount to achieving reliable land value conclusions.

IV. Practice Questions

1. Explain the importance of paired data analysis in the Sales Comparison Approach. Provide an example of how it can be used to determine an appropriate adjustment for location.
2. A comparable property sold for $700,000. The appraiser determines that it has superior access to utilities, worth $25,000, and that the market has increased by 5% since the sale date. Calculate the adjusted sale price, showing each step.
3. Discuss the limitations of the Allocation Method and the Extraction Method. Under what circumstances might each method be most appropriate?
4. Describe the key steps involved in the Development Method (Subdivision Analysis). What are the most critical assumptions that must be carefully considered?
5. A property generates a net operating income of $150,000. The replacement cost of the improvements is estimated at $900,000. Market capitalization rates are 9% for land and 11% for improvements. Use the Land Residual Method to estimate the land value.