When Market Trends Change-What Gets Impacted Land or Improvements?

This is Diana with ABC-The Appraiser’s Business Companion.  I’ve read recently that reliable land to property value ratios for neighborhoods to current median price in the neighborhood can provide a test of reasonableness for site value unless market values are changing.  Its been said that liability increases and assignment results mislead when land value ratios are not also tested during the recognized change.  [1] According to the Internal Revenue Service, you cannot depreciate land. However, if you own a house that you rent out or that you bought as an investor, you can depreciate the building. The reasoning is that the building loses value with wear and tear, whereas land does not. When you own a home that is on land, you must value the home separately from the land. This valuation affects your property taxes and depreciation on the home if it is rental property. Local records do not always reflect a fair valuation of the home vs. the land, so you have to know how to find the separate values yourself.”

I have long been a proponent of the Allocation Method for land value determination when vacant land sales in the most immediate area are lacking or non-existent.  Although your Tax Assessor’s office has a separate assessed value for land and improvements, it is sometimes inconsistent with recent sales that would be considered comparable.  The comparison of the tax assessment for the comparable transactions as well as the subject would be one method of identifying consistency.  I read today an article that challenged the Allocation Method through the use of an example looking at the years 2007 versus 2008.  The quote from the article I read was “Home prices declined at a record pace around the nation in the final three months of 2008, according to an industry report released Tuesday.  The S&P Cas-Shiller National Home Price Index reported that prices sank a record 18.2 percent during the last three months of 2008, compared with the same period in 2007 (Christie, Les, CNN Money, March 6, 2009)”.  The challenge came from a hypothetical property market value of $250,000 in Q4 versus the same Quarter in 2008 indicating a market value of $203,750.  Obviously, the loss of 18.2% would be realized.  The author asks for a consideration of how that could be correlated into a lost land value citing that from a deprecation standpoint the cost of construction declines at a different rate.  While I concur the rates of construction decline at different rates than overall property value, I have to call for the question.  On existing housing, in declining markets, doesn’t the demand for new housing also decline?  Given that truism, isn’t it also reasonable to believe that regardless of the decline the purpose of land is its physical utility and legal ability to be improved?  The value has never actually been in the physical holding; rather, it is in the legal privileges associated with the holding.

I often state, that its been my experience, land “as if vacant”, is worth more than “land as vacant”.  The basis of my finding is supported from two perspectives.  Consider impact fees (the charges to develop land), the lot purchase in some developments cannot be improved unless an additional “impact fee” is charged.  This is over and beyond any permitting fees.  Once developed those fees never have to be paid again.  If the improvement burns to the ground or is blown away in a tornado, the legal allowance of zoning and deed restrictions allow the subject to be rebuilt, the impact fees are not an issue, only permitting.    That impact fee, once paid, expands the legal allowance of the vacant lot to be improved, hence there is a value enhancement due to the expanded utility.  For existing parcels that have no impact fee history, there is a history of demand for the location.  The existing improvement exhibits the demand of the market for the lot to be improved.  This means there are now utilities that are connected to the site and over time the demand will generally cycle into a growth where the improvement, even maintained, will lose some of its “long-lived” remaining life but the value of the lot will incrementally increase.  In fact, as the life cycle of the neighborhood progresses the demand will eventually peak, (remember your economic principle of the neighborhood life cycle integration, growth, stabilization, decline)?  When the decline begins one of two directions will be identifiable, 1) continued decline or 2) renewal.  In some cases, there is actually such a peaked interest in the location the improvements are a negative to the land, properties are purchased with the intent to “tear down” or “raise” and then a different residential dwelling is developed on the site.  Any one of these stages makes identifying the land value difficult.  In the raising of the improvements, the land value is the price paid is considerate of the removal of the improvements.  We could get technical and chase down all types of stages and scenarios, but for the purpose of this article, I won’t.

If overall prices are increasing, both the land value is increasing and the depreciated value of the improvements are often increasing (the loss of value due to any depreciation is often off-set by the cost new which is still higher than to purchase “as is” and make improvements.  It is this stage when renovation costs are the interest of the buyer.  But what about a market that has been identified to be in a state of decline?  How do land ratios work in those cases?

Here’s the point, methodologies are just that, methods to develop conclusions.  A property being appraised will be viewed for 1) the effective date of the analyses and conclusions, and 2) the age/condition of the property in that location on that effective date.  There are different stages of the life cycle occurring when properties are observed as of the effective date.  Using the decline of 18.2% in one year consider the $250,000 property that declined in value in one year to $204,500.  If the land to value ratio is 30%, what if any reason would that percentage of contribution change during the period of decline?  In the hypothetical scenario 30% land contribution of a $250,000 property value, the land value would be $75,000.  If a decline such as the national housing crisis were in motion and a year later overall property value was down by 18.2%, would that be attributable to because the land was worth less or the improvements?  Could it be both?

The answer to that question has to incorporate more than we have time to discuss in this “tip of the week”, but if nothing else changes, then the national impact is an external influence which isn’t just to the land or just to the improvements.  Its an overall property value decline.  Under this circumstance, the normal physical depreciation incurable rate continues (unless the property has undergone some type of physical maintenance/renovation, etc.).  If the property was, prior to the external cause, suffering on average a 1.5% incurable loss (1 ÷ 0.015 = 67 say 70-year economic life), the change in the overall property value is a strong indicator that both land and improvements changed.  Here’s the math of it under this assumption, $250,000 – $75,000 = $175,000 – 1.5% incurable or $2,625 = $172,375.  Because of the decline of 18.2% overall property loss, the math shows, $250,000 – 18.2% = $204,500.  That conclusion of value overall indicates:

$204,500                                                                                                              $204,500

X       30% Land to Value Ratio                                                                     –    61,350  Land Value

$  61,350 Land Value 1 year after decline                                               $143,150   Improvement Contribution

 

Prior to the Decline forecast of Physical  $172,375

After the Decline Improvement                 $143,150

External Loss to the Improvement            $   29,225

 

Change in Land Value resulting from decline        -$13,650

Change in Improvement                                                               -$29,225

Total impact of changed market conditions          -$42,875 which shows a -17.2% down from $250,000

 

What has occurred is there was no upward increase in the land value which was steady or slightly increasing prior to the national decline, but the wasting asset continued to lose at 1.5%.  If you consider the logic its easy to see that a natural loss of physical long-lived cannot be denied or stopped unless it would be addressed by the replacement of certain long-lived components.  However, in the event of a recovery, both land value will recapture its loss due to market conditions and demand for existing housing will return with particular attention being paid to the cost for renovation versus raising the dwelling and beginning again to build.  When there are vacant lot sales or sales that have a price representing the land value “as vacant” rather than “as if vacant”, clearly those sales would puritanically support a more credible land value than the Allocation method.  Absent of sufficient quantity, it is difficult to understand why some would see the Allocation method as lacking in credible results.

 

The real key lies in the appraiser’s support for what they’ve done.  It’s not about the methodology, its about the credibility of the results.  When there are erratic indicators of land ratios, the Allocation Method would be a difficult method to support the land value.  But, when there is a close agreement and the market history is studied, its also difficult for this appraiser to understand why it wouldn’t be a viable indicator of the land value “as if vacant”.  This is Diana Jacob with ABC-The Appraiser’s Business Companion, and you’ve just had a “Tip of the Week” from ABC.

 

[1] https://homeguides.sfgate.com/land-value-vs-home-value-46832.html