English
Land Valuation: Extraction, Allocation, and Capitalization Techniques
Land Valuation: Extraction, Allocation, and Capitalization Techniques❓❓
Introduction
Land valuation is a critical aspect of real estate appraisal, involving the estimation of the economic worth of land. This chapter explores three fundamental techniques used in land valuation: extraction, allocation, and capitalization. These methods are employed when direct sales comparison data for vacant land is scarce or when valuing leased land. We will delve into the scientific principles underlying each technique, provide practical examples, and discuss their limitations.
1. Market Extraction
1.1. Principle
The market extraction technique, also known as abstraction, isolates the land value from the overall sale price of an improved property. The underlying principle is that the value of an improved property is the sum of the values of its land and improvements. By estimating the value of the improvements and subtracting it from the overall sale price, the residual value is attributed to the land.
1.2. Procedure
The process involves:
1. Identifying Comparable Improved Sales: Select recent sales of properties similar to the subject property in terms of location, size, and use.
2. Estimating Improvement Value: Determine the current value of the building and other site improvements. This can be done using the cost approach (reproduction cost new less depreciation) or by analyzing comparable sales of similar improvements.
3. Calculating Land Value: Subtract the estimated depreciated value of the improvements from the overall sale price of the improved property.
1.3. Formula
Land Value (VL) = Sale Price (SP) – Depreciated Value of Improvements (VI)
VL = SP - VI
Where:
VL = Estimated Land Value
SP = Gross Sale Price of the improved property
VI = Depreciated value of all improvements (building, site improvements)
1.4. Example
Consider an improved property that sold for $350,000. The estimated cost to reproduce the building improvements is $200,000, and the estimated depreciation is $30,000. Site improvements are valued at $10,000 with depreciation of $2,000.
VI = $200,000 - $30,000 + $10,000 - $2,000 = $178,000
VL = $350,000 - $178,000 = $172,000
Therefore, the extracted land value is $172,000.
1.5. Limitations
- Accuracy of Improvement Valuation: The accuracy of the extracted land value heavily relies on the accuracy of the improvement valuation. Errors in estimating reproduction costs or depreciation will directly impact the land value estimate.
- Depreciation Estimation: Accurately estimating depreciation (physical deterioration, functional obsolescence, and external obsolescence) can be challenging and subjective.
- Consistent Use Issues: The technique is unreliable when the improvements do not represent the highest and best use of the land. If a building is nearing the end of its economic life, its contribution to the overall property value may❓ be disproportionately low, leading to an inaccurate land value extraction. As highlighted in the provided text, a house nearing demolition will not accurately reflect true land value.
1.6. Practical Application and Experiment
A practical experiment involves analyzing several comparable sales in a homogenous neighborhood. For each sale, carefully estimate the improvement value using multiple cost manuals and depreciation schedules. Compare the resulting extracted land values. Observe the range of values and analyze the sensitivity of the land value to changes in depreciation estimates. This experiment demonstrates the impact of depreciation accuracy on the overall outcome.
2. Allocation
2.1. Principle
The allocation method estimates land value by determining the typical ratio of land value to total property value in a comparable market area. This technique is based on the principle that land value is a function of the overall property value.
2.2. Procedure
- Identify Comparable Improved and Vacant Land Sales: Research sales of both improved properties and vacant land in a competitive area.
- Calculate Land-to-Property Value Ratio (VL/VO): For the improved property sales, determine the land value (either through extraction or other means). Divide the land value by the overall sale price of the improved property to derive the land-to-property value ratio.
- Apply Ratio to Subject Property: Apply the derived ratio to the value of the subject property to estimate its land value.
2.3. Formula
Land-to-Property Value Ratio:
VL/VO = Land Value / Overall Property Value
Estimated Land Value for Subject:
VL_subject = (VL/VO) * VO_subject
Where:
VL/VO = Land to property value ratio
VL_subject = Estimated land value of subject property
VO_subject = Overall Property Value of subject property
2.4. Example
In a comparable neighborhood, similar improved properties are selling for between $425,000 and $475,000. Analysis of recent sales indicates that the ratio of land value to overall property value is approximately 20%. Applying this ratio to the subject property’s area:
Lower Land Value Estimate: $425,000 * 0.20 = $85,000
Upper Land Value Estimate: $475,000 * 0.20 = $95,000
Therefore, the estimated land value for the subject property ranges from $85,000 to $95,000.
2.5. Limitations
- Highest and Best Use Consistency: The accuracy of the allocation method depends on the assumption that both the comparable properties and the subject property are improved to their highest and best use. Inconsistent uses can skew the land-to-property value ratio.
- Market Conditions: The land-to-property value ratio can vary significantly depending on market conditions, such as supply and demand for land and improvements.
- Data Reliability: The reliability of the land value estimate depends on the availability of persuasive and reliable data to support the land-to-property value ratio.
2.6. Practical Application and Experiment
Compile sales data from assessor’s records in a given area. Calculate the land to building value ratio, and the land to total value❓ ratio. Apply those ratio to different sales in the area and analyze the variation in the estimated values. Identify outliers and determine potential causes for these discrepancies (e.g., differing highest and best uses, unusual property features). This illustrates the importance of ensuring comparable properties are truly comparable and improves understanding of how the method is applied.
3. Capitalization Techniques
Income capitalization techniques are most appropriate for valuing leased land, especially under long-term leases. They are based on the principle that the value of an asset is the present value of its expected future income stream.
3.1. Direct Capitalization: Land Residual Method
3.1.1. Principle
The land residual method isolates the income attributable to the land and capitalizes it to estimate land value. It requires separating the net operating income (NOI) into components attributable to the building and the land.
3.1.2. Procedure
- Estimate Net Operating Income (NOI): Determine the overall NOI of the property.
- Estimate Building Value (VB): Determine the current value of the building improvements.
- Estimate Building Capitalization Rate (RB): Determine the appropriate capitalization rate for the building improvements.
- Calculate Income to Building (IB): Multiply the building value by the building capitalization rate (IB = VB * RB).
- Calculate Income to Land (IL): Subtract the income to the building from the overall NOI (IL = NOI - IB).
- Estimate Land Capitalization Rate (RL): Determine the appropriate capitalization rate for the land.
- Calculate Land Value (VL): Divide the income to the land by the land capitalization rate (VL = IL / RL).
3.1.3. Formulas
- IB = VB * RB
- IL = NOI - IB
- VL = IL / RL
- RO = NOI / Property Value (Overall Cap Rate)
Where:
VB = Value of the building
RB = Building capitalization rate
IB = Income to the building
NOI = Net Operating Income
IL = Income to the land
RL = Land capitalization rate
VL = Value of the land
RO = Overall Capitalization Rate
3.1.4. Example
A property has a NOI of $100,000. The building value is estimated at $700,000, and the building capitalization rate is 10%. The land capitalization rate is 8%.
IB = $700,000 * 0.10 = $70,000
IL = $100,000 - $70,000 = $30,000
VL = $30,000 / 0.08 = $375,000
Therefore, the estimated land value is $375,000.
3.1.5. Limitations
- Data Requirements: This method requires substantial data, including building value, building capitalization rate, overall NOI, and land capitalization rate, which can be difficult to obtain in many markets.
- Capitalization Rate Differences: Differences in risk associated with leases can complicate the land and building capitalization rates.
- Theoretical Division: The separation of land and building components is a theoretical division for analysis purposes, as the actual rights transferred are the leased fee and leasehold interests.
3.2. Direct Capitalization: Ground Rent Capitalization
3.2.1. Principle
Ground rent capitalization directly capitalizes the income generated from a land lease to estimate land value. This is simpler and more commonly used than the land residual technique.
3.2.2. Procedure
- Determine Annual Ground Rent (IL): Identify the annual rent generated from the land lease.
- Estimate Land Capitalization Rate (RL): Determine the appropriate capitalization rate for the land, based on comparable leased land sales or market data.
- Calculate Land Value (VL): Divide the annual ground rent by the land capitalization rate (VL = IL / RL).
3.2.3. Formula
VL = IL / RL
Where:
VL = Land Value
IL = Annual Ground Rent (Income to the land)
RL = Land Capitalization Rate
3.2.4. Example
A parcel of land is leased for $15,000 per year. The appropriate land capitalization rate is determined to be 10%.
VL = $15,000 / 0.10 = $150,000
Therefore, the estimated land value is $150,000.
3.2.5. Limitations
- Comparable Lease Data: Finding comparable land sales with similar lease rates and terms can be difficult.
- Capitalization Rate Selection: The accuracy of the method depends on selecting an appropriate and supportable capitalization rate.
3.3. Yield Capitalization: Subdivision Development Method (Discounted Cash Flow Analysis)
3.3.1. Principle
The subdivision development method, also known as discounted cash flow (DCF) analysis, values land based on its potential for subdivision development. It projects the expected cash flows from the sale of individual lots over a specified period and discounts those cash flows back to their present value.
3.3.2. Procedure
- Determine Development Potential: Estimate the number of lots that can be developed on the land.
- Estimate Lot Sales Price: Determine the expected sales price of each lot.
- Project Sales Volume and Revenue: Project the number of lots to be sold in each period (e.g., quarterly or annually) and calculate the associated revenue.
- Estimate Development Costs: Estimate all costs associated with developing the subdivision, including infrastructure, utilities, marketing, and sales expenses.
- Project Cash Flows: Calculate the net cash flow for each period by subtracting development costs from revenue.
- Determine Discount Rate: Select an appropriate discount rate that reflects the risk associated with the development project. This rate should include developer’s profit (entrepreneurial incentive).
- Discount Cash Flows: Discount each period’s cash flow back to its present value using the selected discount rate.
- Calculate Present Value of Land: Sum the present values of all cash flows to arrive at the estimated land value.
3.3.3. Formula
Present Value = CF / (1 + r)^n
Where:
CF = Cash Flow in period n
r = Discount rate
n = Period number
Land Value = Sum of all discounted cash flows
3.3.4. Example
A 40-acre parcel can be developed into 60 residential lots, each selling for $100,000. The projected sales period is two years (8 quarters), with 7.5 lots sold per quarter. Development costs are $1,000,000, real estate taxes total $20,000, sales commission 6%, advertising is 4% and Entrepreneurial incentive is 20%.
Total Revenue: 60 * $100,000 = $6,000,000
Real estate taxes $2,500 a quarter.
Sales commission (6%) 6% of the sales, $6,000 x 7.5 lots = $45,000
Advertising, etc. (4%) 4% of the sales, $4,000 x 7.5 lots = $30,000
Entrepreneurial incentive (20%) 20% of the sales, $20,000 x 7.5 lots = $150,000
Assuming development costs are $125,000 per quarter and the developer’s entrepreneurial incentive is 20%, and using a 12% discount rate, the present value of the land is calculated by discounting each periods net revenue.
Calculations for one quarter only:
Revenue: $750,000
Development costs: $125,000
Real estate taxes: $2,500
Sales commission: $45,000
Advertising: $30,000
Entrepreneurial incentive: $150,000
Cash Flow: $397,500
Discounted Cash Flow (period 1): 397,500 / (1+0.12/4)^1 = $385,922.33
Discounted Cash Flow (period 2): 397,500 / (1+0.12/4)^2 = $372,740.98
Discounted Cash Flow (period 3): 397,500 / (1+0.12/4)^3 = $359,934.55
Discounted Cash Flow (period 4): 397,500 / (1+0.12/4)^4 = $347,485.55
Discounted Cash Flow (period 5): 397,500 / (1+0.12/4)^5 = $335,376.59
Discounted Cash Flow (period 6): 397,500 / (1+0.12/4)^6 = $323,590.39
Discounted Cash Flow (period 7): 397,500 / (1+0.12/4)^7 = $312,110.72
Discounted Cash Flow (period 8): 397,500 / (1+0.12/4)^8 = $300,921.48
Total discounted value: $2,737,082.6
3.3.5. Limitations
- Complexity: This method is complex and requires a large number of calculations, making it more cumbersome than other methods.
- Subjectivity: The accuracy of the method depends on several subjective inputs, including lot sales prices, development costs, sales absorption rates, and discount rates.
- Market Volatility: Market conditions can significantly impact the accuracy of the projected cash flows.
Conclusion
The extraction, allocation, and capitalization techniques provide valuable tools for estimating land value when direct sales comparison data is limited or unavailable. Each method relies on distinct scientific principles and requires careful consideration of its underlying assumptions and limitations. Understanding these techniques and their appropriate applications is essential for accurate and reliable land valuation. While sales comparison analysis is usually favored, it may not always be possible to implement as the primary valuation technique.
Chapter Summary
This chapter provides an overview of three primary techniques used in land valuation when direct sales comparison data is limited: extraction, allocation, and capitalization.
Extraction: This technique estimates land value❓ by subtracting the depreciated cost of improvements from the overall sale price of an improved property. The accuracy of this method is highly dependent on accurate cost estimation and depreciation calculations for the improvements. It’s least reliable when consistent use issues are present or when the improvements are near the end of their economic life, as the contribution of the house to the site value may be skewed and incorrect, particularly when the improvements may warrant demolition.
Allocation: This method derives a land-to-property value ratio by analyzing comparable improved property sales and vacant land❓ sales in a competing area. This ratio is then applied to the subject property’s overall value to estimate land value. The method’s accuracy hinges on the assumption that land value is a function of overall property value and that both the subject and comparables are improved to their highest and best use. Inconsistent use between the subject and comparables can lead to skewed results. Like extraction, allocation’s reliability is tied to the quality of data and the validity of the land value to property value ratio.
capitalization techniques❓: These methods are appropriate for valuing leased land, especially under long-term leases, and utilize the income the land generates.
-
Direct Capitalization (Land Residual Method): This technique separates the property’s net operating income (NOI) into income attributable to the building and income attributable to the land. This method requires determining the building value, building capitalization rate, the property’s NOI, and the land capitalization rate, which may be difficult to obtain. The income to the building is calculated by multiplying the building’s value by its capitalization rate. This income is then subtracted from the overall NOI to determine the income attributable to the land. The land value is then calculated by dividing the income to the land by the land’s capitalization rate.
-
Direct Capitalization (Ground Rent Capitalization): This is a simpler and more common method that directly capitalizes the ground rent (lease income) to estimate land value. This method is particularly useful when comparable land sales❓ are scarce and lease income is the land’s primary attribute. Land value is calculated by dividing the income to the land by the capitalization rate for the land. Combining data sources to establish a capitalization rate may be necessary but less desirable and should be checked for accuracy.
-
Yield Capitalization (Subdivision Development Method): This method, also known as Discounted Cash Flow (DCF) analysis, is used for valuing land with development potential, particularly for residential, commercial, or industrial subdivisions. It involves projecting future cash flows from lot sales, subtracting development costs, and discounting these cash flows back to their present value to arrive at an indicated land value. This technique is complex, requires many calculations, and relies on accurate estimations of lot prices, absorption rates, development costs, discount rates (including developer’s profit), and projection periods. While powerful, it is more subjective than direct sales comparison and is typically used when comparable sales data is limited or when valuing a proposed project at completion. Topographical considerations and zoning ordinances may necessitate adjustments.
In summary, while sales comparison is the preferred method for land valuation, extraction, allocation, and capitalization techniques provide alternative approaches when comparable sales data is limited. Each technique has its own set of assumptions, data requirements, and limitations, making it crucial to carefully consider their applicability to the specific valuation scenario.
