Lesson 15 – Land Valuation: Direct Land Capitalization (The Income Approach to Value)
Appraisal Training: Self-Paced Online Learning Session
The property tax appraiser may appraise land separately for many reasons; foremost are the following three:
- Most obvious, the subject of an appraisal may be vacant land, rather than an improved property.
- The property tax appraiser is required to allocate the total property value between land and improvements, which may be accomplished through a separate estimate of land value.
- An estimate of land value under its highest and best use, as though vacant, is required in other appraisal approaches or techniques – for instance, both the cost approach and the building residual technique (which will be discussed in the next Lesson) require separate land value estimates.
Methods of Land Valuation – Comparative Sales
The most reliable method of estimating land value is through the comparison of the subject property with recent sales of comparable, similarly located, properties. This is consistent with Property Tax Rule 4, which starts out,
When reliable market data are available with respect to a given real property, the preferred method of valuation is by reference to sales prices.…
The value of all land is based on its productivity, or income-producing ability, when utilized at its highest and best use – the student may want to refer back to Lesson 2, “Basic Economic Principles of Real Property Value”, and the Concept of (1) Highest and Best Use and the Principles of (2) Consistent Use, (3) Conformity, and Balance.
Whenever the comparative sales approach is inapplicable, either because of the absence of market transactions or because of the nonexistence of comparable unimproved land, the appraiser may need to turn to the income approach. Property Tax Rule 8 was previously covered in Lesson 5, “Definition of the Income Approach and Property Tax Rule 8”. Subsection (a), regarding the income approach to value, states:
…It is the preferred approach for the appraisal of land when reliable sales data for comparable properties are not available.…
In subsection (b)(3) this topic is expanded:
(b) Using the income approach, an appraiser values an income property by computing the present worth of a future income stream. …In practical application, the stream is usually either
(3) projected as a level perpetual flow.
It is this level perpetual flow that we will primarily discuss in this Lesson; in Lessons 16, 17, and 18 we will learn about the two income streams described in subsections (b)(1) and (b)(2).
The appropriate capitalization rate for land, assuming a constant perpetual income stream, is a combination of a yield rate (Yo) and an effective tax rate (ETR). [The appropriate capitalization rate for improvements must also make an allowance for recapture (return OF the investment), in addition to the allowances for yield (return ON the investment) and property taxes.]
This lesson discusses the Direct Land Capitalization; the next lesson will cover the land residual technique, as well as the building residual technique.
Three Other Methods of Land Valuation
Land or site value is also estimated by (1) allocation – allocating a portion of total property value to the site based on analyzing ratio of site value to total property value from sales of vacant and improved properties in the neighborhood or in a comparable neighborhood, (2) extraction – extracting the depreciated value of the improvements from the total property value, and (3) subdivision development, also known as land development or anticipated use method – costing the hypothetical development of vacant land that is ready for development to a higher use, and subtracting those costs from projected selling price of the developed lots. As these three methods do not involve income capitalization, they will not be further discussed in this Self-Paced Online Learning Session.
Direct Capitalization of Income to the Land
The direct capitalization of land income, or ground rents, involves two steps; first processing the land’s income stream down to Net Income Before deducting for property Taxes [NIBT]; and second, capitalizing that Net Income Before Taxes into an estimate of value, using a capitalization rate that provides both for (1) taxes, the Effective Tax Rate, and (2) Yield, the return on investment. Since the income stream is perpetual, there is no need to provide for the recapture of capital — land is considered to be a non wasting asset, and therefore the capitalization rate does not have to provide for return of investment – theoretically, the land does not lose value. The capitalization rate only needs to provide for Yield and Property Taxes. In real estate valuation, capitalization in perpetuity is typically applied only to land.
For ad valorem property tax purposes, not including certain statutory or regulatory provided exceptions, land is always valued at its highest and best use. In determining the income the land could earn, the appraiser considers uses that are (1) legally permissible, (2) physically possible, (3) financially feasible, and (4) maximally productive. Highest and best use was discussed in Lesson 2; we will not repeat that discussion here. (Note: An example of a regulatory exception is Property Tax Rule 8, Subdivision (f), which excludes open space land, as defined in Revenue and Taxation Code Section 421 from the provisions of Rule 8, and also states that not all provisions of Rule 8 apply to taxable possessory interests.)
Typically, the yield rate will be derived from market sales of comparable properties – properties that have the same highest and best use as the subject. You would not want to derive a yield rate from the sale of an office building, and apply it in the appraisal of a parking lot. Yield rates derived for Level Perpetuity Capitalization should be derived from properties exhibiting the characteristics of a Level Perpetual Income Stream.
To capitalize income into perpetuity, the net income is divided by a capitalization rate composed of an overall yield rate plus the effective ad valorem tax rate. Thus:
PV = NIBT ÷ (Yo + ETR)
EXAMPLE 15–1: Capitalization of Level Perpetual Income Stream
What is the capitalized value of a perpetual net income before recapture and property taxes of $100,000, given an overall yield rate of 8%, and an effective ad valorem property tax rate of 1%?
- Ad valorem property taxes are not deducted as an expense from the income stream because they are based on the value being sought. This requires that a before-tax discount rate be used; hence, a property tax component equal to the ad valorem property tax rate must be included in the capitalization rate.
The lesson you just read reviewed different methods of appraising land, and discussed direct land capitalization. The next lesson will address the appraisal of improved property and of land using different residual techniques.
Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.