BUILDING RESIDUAL TECHNIQUE USING COST AND SALES COMPARISON
The major drawback to using the above direct capitalization method to extract the land value is that it requires knowledge of both the land capitalization rate and the improvements capitalization rate. In urban, highly developed areas, there may not be enough unimproved land sales to accurately establish a market land capitalization rate. In reality, it is typically a blended capitalization rate that is observed in the market. Market value is a function of cash flows generated by the land and improvements together, and the capitalization rate reflects that combined value. To account for this, there is another method commonly used that does not require individual capitalization rates. It is the land residual technique using cost and sales comparison.
The first step of this technique involves finding the market value of the total property (both the land and improvements). Typically, either the sales comparison or income capitalization approach is used to find the property value. Next, the cost approach is applied in order to find the depreciated value of the improvements. Finally, subtracting the depreciated value of the improvements from the total property value leaves the market value of the land.
For example, suppose that when using the sales comparison approach, a property is valued at Rs.1,400,000. Using the cost approach, replacement cost new of the improvements is calculated to be Rs.1,260,000. Using straight-line depreciation over 31.5 years yields a total accumulated depreciation of Rs.320,000 over eight years. Therefore, the depreciated value of the improvements is Rs.940,000, which is the difference between the replacement cost new of the improvements and the accumulated depreciation. The residual value of Rs.460,000 can be attributed to the land.
|Improvements Value New||1,260,000|
|Depreciated Improvements Value||940,000|
Building Residual Technique Using Cost and Sales Comparison
The value of the improvements can also be extracted from the total property value using a similar technique. The income capitalization or sales comparison techniques can again be used to find the market value of the total property (land and improvements). Next, find the market value of the land using the sales comparison approach with recently sold, unimproved lots. Subtracting the land value from the total property value gives an estimate of the building value. Using this technique to find the building value is helpful when estimating depreciation is difficult or adequate data on developer profit and overhead is not available.
For example, suppose the income valuation approach suggests that the subject property’s market value is Rs.2,200,000. Sales of unimproved lots in the area indicate that the underlying land value is estimated to be Rs.250,000. The difference between the total property market value and the land value is the depreciated value of the improvements.
|Depreciated Building Value||1,950,000|
Therefore, the depreciated building value is Rs.1,950,000. It is important to note that this estimates the value of the improvements after accounting for accumulated depreciation and is not replacement cost new.