Land Valuation: Using what remains

Why is the Land Residual method needed?

I suspect this increased interest from appraisers is because the need for reliable land value estimates is increasing all over Russia as the number of new building projects are increasing. The lending institutions and investors are also participating at an earlier stage in the development process. This, combined with progress in legal ways for the land rights to serve as security for the loan, has increased the need to understand the market value of the land parcel.
In most parts of Russia there still are not sufficient free-market exchanges of specific types of rights to land parcels to provide enough data to estimate value by comparison, so other methods of valuation are needed to indicate the potential desire of the market to pay for rights to a particular site. Available methods include subdivision analysis, allocation between known relationships of land value to total property sale prices, and the land residual techniques. The first two methods also require significant specific data that is not yet available in our still developing Russian market. But the land residual method, properly developed, can be useful when the conditions of the appraisal problem are appropriate.

So, how to do it?
The land residual method starts with the improved property, which is made up of two basic components: the land, and the improvements. If estimating market value, then the improved property is the theoretical highest and best use in stabilized operation, just as a typical developer would create it. Use value, or investment value of land rights may be developed when the specified use is not the most profitable allowed.
The principle then is to separate the contribution of the land, from the total value of the completed project. There are actually two ways to do this; one is to analyze and allocate income, and the other is to analyze cost components. The income variant requires estimation of the income and rate of return specific to land, and requires much more market-based transaction information than is now available in the Russian market. So, I will focus on the cost analysis method which is more practical for use in our markets.
By definition, the value of the completed project is the result of contributions from the four basic factors of production: land, labor, capital, and management. Properly estimating and subtracting the value of the three non-land factors from the total, will leave the residual amount as the land value. The cost analysis version of the land residual method starts with estimating value for the hypothetically improved property (total project value. The formula for this technique is the following:

Principle: Project Value = Land Value + [ Values of Labor + Capital + Management ]

Therefore: Land Value = Project Value – [ Values of Labor + Capital + Management ]

The references to labor, capital, and management may be summed up as the costs necessary to plan, design, and construct the project buildings. The premise for this type of analysis is that market costs of these components are equal to their market value. Thus, this technique is most useful for new buildings or those still to be built, where value loss from age does not have to be estimated. The process might be summarized as follows for a market value estimate.

1. Estimate the stabilized net operating income and operating expenses related to the completed project as of the date of the appraisal.
2. Estimate the market value of the subject property complex based on appropriate discount and capitalization rates applicable for comparable properties. This usually implies use of the discounted cash flow (DCF) technique.
3. Estimate the gross construction cost as new (including the developer’s profit), as of the effective date of the appraisal. This will represent the value contribution of labor, materials, and capital.
4. If the building is existing, estimate and deduct any value loss due to the structure’s age or condition.
5. Subtract the adjusted construction cost of the complex from the market value of the subject total complex. Deduct the cost of marketing the property if not included in the DCF analysis.
6. The remainder represents the maximum amount which an investor would pay for the land on the date of appraisal.

Useful details
Cash Flow Estimates. Net cash flows used in the DCF should reflect all operating revenues and expenses from the projected operations. Calculated cash flow should not include income tax or potential debt service, because such expenses are related to the owner and not to the property. If the project is a theoretical one not yet developed, the DCF may take into account cash flow timing that is realistic for planning, permitting, construction and leasing of the project; as well as its operation after completion for a holding period that is typical of market investors. In this case, the first several years may be periods of negative income, with significant outflows during the construction period, and only after a lease-up period does positive cash flow start. Negative cash flows are usually discounted at a lower rate than the more risky positive cash flows.
Discount and capitalization rates. The discount rate should be appropriate for funds being invested in the construction of an income producing property planned for commercial use. The capitalization rate, typically used in the estimation of the residual project value at the end of the DCF analysis period, will be the forecasted operating property discount rate adjusted for the expected annual change in value of the property beyond the DCF analysis period.
Dates involved. The effective date of your appraisal will likely be the present time, although banks sometimes want estimates of future value. In any case, all analysis should be reconciled to the effective date and include market perceptions of future costs, developer’s profit, the time required for construction, and the operational discount rates for the project.

The accompanying table outlines this process.
Note that the same steps may relate to projects that do not represent the highest and best use (such as an existing building, or a planned project that does not match the market). In this case, the result will be investment value (to the developer), or use value (for the particular project).

Residual conclusions
The above analysis can represent the value of any set of rights to the development of the project analyzed, including ownership, long-term lease, or development rights with permits in place. As we have noted, the residual approach to estimate value of rights to land is dependent on the future value of the complete project and the required construction costs, each developed from separate analysis and involving certain assumptions and estimations. The analysis is particularly sensitive to the discount rate, the net income and construction cost inputs. Care must be taken to make these estimations as accurately as possible, as small errors will greatly affect the final conclusion.