Real Estate Appraisal Chapter 6 Section 5 pg. 2

The extraction method of estimating land value is very similar to the allocation approach. It attempts to determine the value of the land by separating the land value from the value of the improvements.

In the extraction approach, the appraiser uses the sale of an improved property as a basis for the analysis. The appraiser determines the cost to construct the improvements and then subtracts any applicable depreciation. The sale price in excess of this result would then represent the value of the land.

Again, an example might prove helpful.

Tom Carlson is an appraiser and receives an assignment to appraise a vacant lot. There have been no vacant lots sold in the general area for quite a while. A residence was recently sold for $200,000, however.

Tom finds out that the residence which sold has 1,750 square feet of living space and he estimates that the cost to construct this house would be about $90 per square foot. This would result in construction costs of $157,500. Since the house is relatively new, Tom estimates the depreciation of the property to be 5%, which Tom rounds to $7,500. The depreciated value of the improvements is therefore estimated at $150,000. Since the total sale price was $200,000, Tom estimates the lot to have contributed $50,000 of value to the total property

Land Development

This method is used when appraising a large vacant parcel of land where the highest and best use of the land would be to subdivide the land into smaller lots for development. This development could be for residential, industrial or commercial use.

The process the appraiser would use to appraise this property would be as follows:

  • First, the appraiser must determine the number of lots into which the parcel could be subdivided, as well as  the  size  of  these  lots. The appraiser would have to take into account the applicable zoning ordinances, building codes, setback requirements and other regulatory matters, along with data from any competing developments.

  • The appraiser then determines the most likely selling prices of the improved lots. This is most often done through direct sales comparisons from other developments in the area.

  • The appraiser determines the total gross sales price of all of the lots, as well as estimating the time period needed to build and sell the lots.

  • All costs are then subtracted from this gross selling price to arrive at the net sales proceeds. These costs would include all direct and indirect costs of developing and marketing the properties. The entrepreneurial profit to the developer is also considered a cost for purposes of this analysis.

  • The net sales proceeds are then discounted to their net present value, to account for the fact that these sales proceeds are not received in one lump sum, but rather over the period of development and marketing.

This discounted value would represent the value of the land.  Keep in mind that none of the profit is considered related to the lots, but rather is considered part of the sales price of the improvements.

Land Residual

In the land residual approach, the land is valued as a function of the income it produces. It is related to the capitalization approach to appraisal, which will be discussed in more detail in later chapters.

The land residual technique is used when each of the following conditions exist:

  • There are no recent sales of vacant lots in the area;

  • The value of the building(s) is known or can be accurately estimated;

  • The operating income of the property is known or can be accurately estimated; and

  • A market rate of return (called a capitalization rate) can be determined separately for the land and the building(s).

Suppose, for example, that an appraiser determines that a rental property has net operating income of $125,000 per year. The appraiser has also determined that in this area, buildings have a capitalization rate of 12% and land has a capitalization rate of 10%. The value of the building on this lot is determined to be $400,000.

In this case, first the income attributed to the building must be subtracted from the total operating income. Since the building has been valued at $400,000 and the appropriate rate of return (the capitalization rate) has been determined to be 12%, the income attributed to the building would be $48,000 ($400,000 X 12%).

This would then mean that the income attributed to the land would be $77,000 (the $125,000 operating income less the $48,000 income attributed to the building).

Knowing the income attributable to the land ($77,000) and the capitalization rate for the land, the value of the land can be determined by dividing the income by the capitalization rate, as follows:

                                                      Net income          $77,000
                                               ------------------------- = ------------- =   $770,000
                                                Capitalization Rate      10%

This example can be summarized as follows:

Net Operating Income  $125,000
Less: Income from Building
       ($400,000 X 12%)  - 48,000
Income from Land     $77,000

Value of Land
($77,000/10%)  $770,000

Ground Rent  Capitalization

This approach is used in the case of a ground lease, which is where land is leased to someone else who will have the right to build improvements on that land. These are usually very long-term leases, lasting decades. It would be used in an area where there are many ground leases which can be used as comparable properties.

Once again, the capitalization approach would be used, where the income from the property is divided by a capitalization rate to determine the value of the land.