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Land Valuation Techniques: Extraction, Allocation, and Capitalization
Land Valuation Techniques: Extraction, Allocation, and Capitalization
Introduction
Land valuation is a critical aspect of real estate appraisal and investment analysis. This chapter delves into three fundamental techniques used to estimate land value: extraction, allocation, and capitalization. These methods are employed when direct sales comparison is challenging or when additional support for land value estimates is desired.
1. Market Extraction
1.1. Principle of Contribution
The extraction method relies on the principle of contribution, which states that the value of a component of a property is measured by the amount it contributes to the overall property value. In the context of land valuation, this means determining how much the land contributes to the total value of an improved property.
1.2. Methodology
The extraction method involves subtracting the depreciated cost of the improvements from the total sale price of a comparable property. The remaining amount is considered the estimated land value.
- Formula:
Land Value = Sale Price - Depreciated Cost of Improvements
1.3. detailed❓ Steps
- Identify Comparable Sales: Select recent sales of improved properties that are similar to the subject property in terms of location, zoning, and other relevant characteristics.
- Estimate Improvement Costs: Determine the current replacement cost of the improvements (e.g., buildings, site improvements) on the comparable property. This can be done using cost manuals, construction cost data, or consultations with contractors.
- Calculate Depreciation: Estimate the total depreciation of the improvements due to physical deterioration, functional obsolescence, and external obsolescence.
- Determine Depreciated Cost: Subtract the total depreciation from the replacement cost to arrive at the depreciated cost of the improvements.
Depreciated Cost = Replacement Cost - Total Depreciation
- Extract Land Value: Subtract the depreciated cost of the improvements from the sale price of the comparable property. The result is the estimated land value.
1.4. Example
Based on the document provided:
Gross sale price $351,000
Cost of residence 2,800 $75.00 = $210,000
Cost of basement 500 $25.00 = $12,500
Cost of porches, etc. 500 $25.00 = $12,500
Cost of garage 750 $25.00 = $18,750
Total cost of building improvements $253,750
Total depreciation (all causes) 12% − $30,450
Depreciated value of building improvements − $223,300
Depreciated value of site improvements − $12,500
Estimated land value $115,200
1.5. Limitations
- Accuracy of Cost Estimates: The accuracy of the extracted land value depends heavily on the accuracy of the cost estimates and depreciation calculations.
- Depreciation Estimation: Estimating depreciation can be subjective and challenging, especially for older properties.
- Consistent Use Issues: This technique is unreliable when consistent use issues must be addressed. The house does not contribute the same amount of value on both sites, so this extracted land value is incorrect.
2. Allocation
2.1. Ratio Technique
The allocation method is a ratio technique that estimates land value by applying a ratio of land value to total property value observed in comparable sales to the subject property. It is used when there are limited or no vacant land sales available.
2.2. Highest and best❓ Use
The allocation method assumes that both the comparable properties and the subject property are improved to their highest and best use. If this assumption is not met, the analysis can be skewed.
2.3. Methodology
- Research Comparable Sales: Gather data on recent sales of improved properties and vacant land sales in the subject’s area or a competing area.
- Calculate Land-to-Value Ratio: For the improved properties, determine the ratio of land value to total property value.
Land-to-Value Ratio (VL/VO) = Land Value / Total Property Value
- Apply Ratio to Subject Property: Apply the calculated land-to-value ratio to the estimated total value of the subject property to estimate the land value.
2.4. Example
Based on the document provided:
Sale 1, property sold for $400,000 and land is valued at $80,000. The ratio of land value to property value (VL/VO) is 20%. This ratio can then be applied to the subject’s area to estimate a value range there. If property values in the subject’s neighborhood range from $425,000 to $475,000, a reasonable value estimate for the subject’s land would be $85,000 to $95,000.
2.5. Limitations
- Finding Reliable Ratios: It can be difficult to find persuasive and reliable support for the ratio of land value to property value.
- Highest and Best Use Consistency: The method’s accuracy depends on the properties being improved to their highest and best use.
- Market Fluctuations: The ratios may not be stable over time, especially in volatile markets.
3. Capitalization
3.1. Income Capitalization Approach
The income capitalization approach estimates the value of an asset based on the income it generates. In land valuation, this approach is particularly useful for leased land or land with the potential to generate income.
3.2. Direct Capitalization
Direct capitalization converts a single year’s income expectancy into value using a capitalization rate.
- Formula:
Value = Net Operating Income (NOI) / Capitalization Rate (R)
3.3. yield capitalization❓ (Discounted Cash Flow Analysis)
Yield capitalization involves projecting future income streams and discounting them back to present value using a discount rate❓.
3.4. Land Residual Method
The land residual method isolates the income attributable to the land by deducting the income attributable to the improvements from the total net operating income (NOI).
- Formula:
IB = VB × RB, where IB = Income to building, VB = Value of building, RB = Building Capitalization RateIL = IO − IB, where IL = Income to land, IO = Overall Net Operating Income.VL = IL / RL, where VL = Value of land, RL = Land Capitalization Rate.
3.5. Ground Rent Capitalization
Ground rent capitalization directly capitalizes the ground rent income to estimate land value.
- Formula:
Land Value = Income to the Land (IL) / Capitalization Rate for the Land (RL)
3.6. Subdivision Development Method (Discounted Cash Flow Analysis)
This method is used for valuing land with potential for subdivision development. It involves projecting the cash flows from the sale of individual lots, deducting development costs, and discounting the net cash flows back to present value.
3.6.1. Steps Involved
* Estimating lot yield: Determine the number of lots that can be developed from the land parcel.
* Projecting lot sales: Estimate the sale price per lot and the expected absorption rate (number of lots sold per period).
* Estimating development costs: Determine all costs associated with developing the subdivision, including infrastructure, marketing, and sales expenses.
* Discounting cash flows: Discount the net cash flows (lot sales minus development costs) back to present value using an appropriate discount rate that reflects the risk and time value of money.
3.6.2. Discount Rate
The discount rate should include a component for the developer’s profit or entrepreneurial incentive.
3.6.3. Formula:
Present Value of Land = ∑ (Net Cash Flowt / (1 + r)t)
Where:
* Net Cash Flowt is the net cash flow in period t (lot sales minus development costs).
* r is the discount rate.
* t is the time period.
3.7. Example
Based on the document provided, for the land residual method:
The net operating income for the property is $125,000: IO = $125,000
The capitalization rate for the land is 10%: RL = 0.10
The value of the building is $800,000: VB = $800,000
The capitalization rate to the building is 12%: RB = 0.12
Therefore,
The value of the building multiplied by the capitalization rate to the building equals
the income to the building. IB = VB × RB = $800,000 × 0.12 = $96,000
The income to the building is subtracted from the income overall to determine the
income to the land. IL = IO − IB = $125,000 − $96,000 = $29,000
The income to the land is divided by the capitalization rate to the land to estimate land value. VL = $29,000/0.10 = $290,000
Based on the document provided, for the subdivision development method:
Present value of land = sum of the present value amounts = $3,927,561
3.8. Limitations
- Data Requirements: Income capitalization methods require reliable income and expense data, as well as appropriate capitalization or discount rates.
- Subjectivity: Estimating future income streams and capitalization rates can be subjective.
- Market Conditions: The accuracy of the income capitalization approach depends on stable market conditions and predictable income streams.
- Complexity of Subdivision Development Method: The subdivision development method involves numerous calculations and assumptions, making it complex and potentially subjective.
Conclusion
Extraction, allocation, and capitalization are valuable tools for estimating land value, particularly when direct sales comparison is limited or unavailable. Each method has its own strengths and limitations, and the choice of method depends on the specific characteristics of the property and the availability of data. Appraisers should carefully consider these factors and use their professional judgment to select the most appropriate method for each valuation assignment.
Chapter Summary
This chapter, “Land Valuation Techniques: Extraction, Allocation, and capitalization❓,” details methods for appraising land value, particularly when direct sales comparisons are limited. It covers three primary techniques: extraction, allocation, and capitalization.
Extraction involves estimating the depreciated cost of improvements on a property and subtracting that value from the overall sale price to derive the land value. This method is unreliable when there are inconsistencies in use or the improvements are significantly depreciated.
Allocation is a ratio-based approach. It establishes a ratio of land value to property value❓ (or land value to building value) from comparable properties and applies this ratio to the subject property. The accuracy❓ of this method depends on the comparability of the properties and assumes both the subject and comparable properties are improved to their highest and best❓ use.
Capitalization techniques convert income❓ generated by the land into a present value estimate. The chapter explores the land residual method, which partitions the net operating income between the building and the land based on their respective capitalization rates and values. This method requires detailed market data that can be difficult to obtain. Ground rent capitalization, a simpler alternative, directly capitalizes the ground rent income using a market-derived capitalization rate. Combining data sources to derive capitalization rates is possible when market data is limited, but is less reliable than market extraction and requires verification.
Finally, the chapter discusses the subdivision development method, a discounted cash flow (DCF) analysis used for valuing land with a highest and best use as a residential, commercial, or industrial subdivision. This method projects future cash flows from lot sales, subtracts development costs, and discounts the net cash flow to present value. This method requires numerous calculations and can be less persuasive than sales comparison, but is often used when raw land sales data is scarce or when a lender requires a “completed project” valuation. A key element of this analysis is accounting for the developer’s profit through a line item or a higher discount rate.
The chapter emphasizes that the sales comparison approach is generally preferred when sufficient comparable sales data is available. However, extraction, allocation, and capitalization techniques provide alternative valuation methods when market data is limited or complex development scenarios need to be analyzed. The choice of method depends on the specific characteristics of the property, the availability of data, and the intended use of the appraisal.
