Land Valuation: Isolation Techniques and Capitalization

Land Valuation: Isolation Techniques and Capitalization

This chapter delves into specific techniques used to isolate land value and apply capitalization methods for valuation. We will explore market extraction, allocation, and various income capitalization procedures, including the land residual method, ground rent capitalization, and the subdivision development method (discounted cash flow analysis).

1. Isolation Techniques: Extracting Land Value

Isolation techniques are crucial when comparable vacant land sales are scarce or unreliable. These methods aim to separate the land’s contribution to the overall value of an improved property.

• Market Extraction (Abstraction): This technique infers land value by deducting the depreciated cost of improvements from the overall sale price of a comparable property. The underlying principle is that the remaining value represents the land’s contribution.

  • Theoretical Basis: The real estate value equation can be expressed as:

    • V_O = V_L + V_B + V_SI

      Where:
      V_O = Overall Property Value
      V_L = Land Value
      V_B = Depreciated Value of Building Improvements
      V_SI = Depreciated Value of Site Improvements

    • Therefore, V_L = V_O - V_B - V_SI

  • Procedure:

    1. Identify comparable improved properties with recent sales.
    2. Estimate the cost of replacing the improvements new (replacement cost or reproduction cost). This includes buildings and site improvements.
    3. Estimate accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence) for the improvements. Accurate depreciation estimates are critical.
    4. Subtract the total depreciation from the total cost of the improvements to derive the depreciated cost of improvements.
    5. Subtract the depreciated cost of improvements (both building and site improvements) from the sale price of the comparable property. The result is the estimated land value.

  • Practical Application & Limitations: Consider the example from the PDF:

    • Gross sale price: $351,000
    • Total cost of building improvements: $253,750
    • Total depreciation (all causes): $30,450
    • Depreciated value of building improvements: $223,300
    • Depreciated value of site improvements: $12,500

    • Estimated land value: $351,000 - $223,300 - $12,500 = $115,200

    • Limitations: This method is most reliable when the improvements are relatively new and depreciation is minimal. It becomes less reliable when:

      • The improvements are old or significantly depreciated, increasing the uncertainty in depreciation estimates.
      • The improvements do not represent the highest and best use of the land. As highlighted in the PDF, if the house is near the “wrecking ball,” the extracted land value will be inaccurate. Inconsistent use issues skew the results.
      • Significant functional or external obsolescence is present, making accurate depreciation estimation challenging.

• Allocation: This method estimates land value by developing a ratio of land value to overall property value based on comparable sales. It relies on the assumption that land value is a consistent proportion of the overall value in a given market area.

  • Theoretical Basis: The method is based on observing the relationship between land value and overall value within a homogenous area.

    • Land-to-Value Ratio = V_L / V_O

      Where:
      V_L = Land Value of comparable sales
      V_O = Overall Value of comparable sales

  • Procedure:

    1. Research comparable improved property sales in the subject’s market area.
    2. Research sales of vacant land in the same market area.
    3. Calculate the ratio of land value to overall property value (V_L/ V_O) from the comparable sales data.
    4. Apply this ratio to the overall value of the subject property to estimate the land value.

  • Practical Application & Limitations: As the PDF example Exhibit 17.5 demonstrates: If comparable sales in an area show an average land-to-value ratio of 20%, and properties in the subject’s neighborhood are valued between $425,000 and $475,000, then the land value can be reasonably estimated to range between $85,000 and $95,000.

    • Limitations: This method’s accuracy depends heavily on:
      • Finding truly comparable properties.
      • Ensuring both the comparables and the subject property are improved to their highest and best use. If not, the ratio will be skewed.
      • The homogeneity of the market area. Variations in zoning, location, or other factors can affect the land-to-value ratio. The PDF notes the difficulty in finding reliable support for the ratio.
      • This technique is less accurate than sales comparison analysis if sufficient data exists for the latter.

2. Capitalization Techniques: Income-Based Land Valuation

These techniques are particularly applicable for valuing leased land, especially when a long-term lease is in place. They rely on the principle of converting future income streams into present value.

• Direct Capitalization: This method converts a single year’s expected income into value using a capitalization rate.

  • The IRV Formula (Income, Rate, Value): The PDF refers to the IRV formula.

    • V = I / R (Value = Income / Capitalization Rate)
    • I = V * R* (Income = Value * Capitalization Rate)

    • R = I / V (Capitalization Rate = Income / Value)

    • This fundamental formula is used throughout income capitalization techniques.

  • Land Residual Method: This technique isolates the income attributable to the land by deducting the income attributable to the building improvements from the overall net operating income (NOI). The remaining income is then capitalized to estimate the land value.

    • Theoretical Basis: This method relies on the principle that the overall NOI represents the combined income generated by the land and the building.

      • I_O = I_L + I_B

        Where:
        I_O = Net Operating Income of the Property
        I_L = Income Attributable to the Land
        I_B = Income Attributable to the Building

    • Procedure:

      1. Estimate the overall Net Operating Income (I_O) of the property.
      2. Estimate the value of the building improvements (V_B).
      3. Determine the capitalization rate applicable to the building (R_B).
      4. Calculate the income attributable to the building: I_B = V_B * R_B.
      5. Calculate the income attributable to the land: I_L = I_O - I_B.
      6. Determine the capitalization rate applicable to the land (R_L).
      7. Estimate the land value: V_L = I_L / R_L.

    • Practical Application & Limitations: As the PDF example Exhibit 17.6 shows: If the NOI is $125,000, the building value is $800,000, the building capitalization rate is 12%, and the land capitalization rate is 10%, then:

      • Income to the building: $800,000 * 0.12 = $96,000
      • Income to the land: $125,000 - $96,000 = $29,000

      • Land value: $29,000 / 0.10 = $290,000

      • Limitations:

        • Requires accurate data, which can be difficult to obtain. Finding reliable building and land capitalization rates in the same market can be challenging.
        • Sensitive to changes in capitalization rates. Small differences in R_B or R_L can significantly impact the estimated land value.
        • As the PDF notes, the separation of land and building is a theoretical division, and the leased fee and leasehold interests are the actual rights transferred.

  • Ground Rent Capitalization: A simpler method that capitalizes the ground rent (lease payments) to estimate land value.

    • Theoretical Basis: The ground rent represents the income stream generated solely by the land.

    • Procedure:

      1. Estimate the annual ground rent income (I_L).
      2. Determine the capitalization rate applicable to the land (R_L).
      3. Estimate the land value: V_L = I_L / R_L.

    • Practical Application & Limitations: The PDF provides an example: If the annual ground rent is $12,000 and the land capitalization rate is 12%, then the estimated land value is $12,000 / 0.12 = $100,000.

      • Limitations:
        • Finding comparable land sales with similar lease rates and terms can be difficult.
        • The capitalization rate must accurately reflect the risk associated with the lease.
        • This method is most reliable when the lease terms are market-based and the lease is long-term.

    • Capitalization Rate Derivation: The PDF mentions combining data sources to establish a capitalization rate (using the sale price of a comparable property that is not leased and the lease rate of a property that has not been sold). This is less desirable than direct market❓ extraction and should be used cautiously and validated with other methods. Differences in upside potential between properties can skew the results.

• Yield Capitalization (Discounted Cash Flow Analysis): Subdivision Development Method: This method is used to value land for subdivision development by projecting future cash flows from lot sales and discounting them back to their present value.

  • Theoretical Basis: The value of development land is derived from the present value of the future income stream generated by the sale of individual lots. This incorporates the time value of money and the risks associated with the development process.

  • Procedure:

    1. Estimate the number of lots that can be developed.
    2. Project the sales price per lot.
    3. Estimate the absorption rate (number of lots sold per period).
    4. Project all development costs (infrastructure, permits, marketing, sales commissions, taxes, etc.).
    5. Determine an appropriate discount rate that reflects the risk of the project, including the developer’s required rate of return or entrepreneurial incentive.
    6. Project the cash flows for each period (lot sales less development costs).
    7. Discount the future cash flows back to their present value using the chosen discount rate. The sum of the present values represents the estimated land value.

    • PV = Σ [CF_t / (1 + r)^t]

      Where:
      PV = Present Value (Land Value)
      CF_t = Cash Flow in period t
      r = Discount Rate
      t = Time period

  • Practical Application & Limitations: As the PDF example Exhibit 17.7 illustrates: A 40-acre parcel can be developed into 60 lots with a sale price of $147,500. Development costs are projected over two years. The application of Discounted Cash Flow analysis yields the land value.

    • Limitations:
      • Complex and requires numerous assumptions, making it more subjective than direct sales comparison (if available).
      • Heavily reliant on accurate projections of sales prices, absorption rates, and development costs.
      • Sensitive to changes in the discount rate.
      • The PDF emphasizes that if truly comparable raw land sales exist, sales comparison analysis is preferable. Subdivision development analysis is more useful when valuing a proposed or existing project at completion. It is also a tool when valuing raw land and completed but unsold project for a lender.

Conclusion:

The techniques discussed in this chapter provide appraisers with a comprehensive toolkit for isolating land value and applying capitalization methods. The selection of the appropriate method depends on the availability of data, the characteristics of the property, and the specific assignment requirements. A thorough understanding of the underlying principles and limitations of each technique is essential for accurate and reliable land valuation. Remember that the most reliable approach is typically to use multiple methods and reconcile the results.