Extraction???? How Can that Be Done without First Knowing Depreciation?

This is Diana with ABC-The Appraiser’s Business Companion.  Recently I’ve been in the process of rewriting some old favorites, and the subject of land value of course always challenges us when the assignment involves existing houses or new construction in older markets.  The review of the methodologies includes extraction.  For many years I wrestled with this methodology.    Not in how it was to be developed but in how I could credibly obtain the data.

As a simple review the simple formula for the Extraction Method is:

Sale Price

Minus  Dwelling and other Improvements

Equals  Land Value

 

Seems simple but, when the dwelling and other improvements have varied ages and lives remaining how can the improvements depreciation be credibly developed.  Suddenly,

 

[1]“When out on the lawn there arose such a clatter,

I sprang from the bed to see what was the matter.

Away to the window I flew like a flash,

Tore open the shutters and threw up the sash.”

 

It came as a gift of many years searching for a credible reasoning of how this formula could be working (couldn’t resist, just had to add the rhyme).  All of us who have been doing this for several years has documentation of various builder’s plans and costs on various qualities of dwellings in the locations we work as well as styles and sizes.  Even when we’re in those existing neighborhoods we recognize houses that will call to our minds “today’s version”.  Going back into those assignments we can identify local costs new that are superior often even to our cost’s manuals from services such as “Marshall and Swift” or “The Blue Book” (there are more these are the two that seem to be the most popular).

 

For a case scenario, think about a comparable house that’s 11 years old in a neighborhood that is built-up.  The neighborhood nearest the subject comparable that still has some new construction is about 5 miles out but the locational amenities are similar.  The tax district is the same, the school district is the same, proximity to major transportation arties is similar, it’s just a newer development.  The subject comparable measured by the appraiser results in a 1700 sq. ft. main dwelling, with a covered porch and rear covered patio.  Five years ago, an inground pool was added and the fence was recently replaced within the past year.  The MLS states fence costs about $5,800 with another $29,000 for the pool.  Now find the nearest neighborhood of similar quality of construction homes and identify the ranges of costs new for houses of 1,500 to 2,000 sq. ft. of GLA.  The cost ranges were from $95 – $102 per sq. ft. including the covered porches and garage.  Using this breakdown, you can analyze the components of the comparable 11-year old house.  Based on the cost new there is $37,000 connected in the higher per sq. ft. for the 1,500 sq. ft. dwelling versus the 2,000 sq. ft. dwelling in the competing newly constructed neighborhood.  This works out to be $74.00 per sq. ft incrementally between those two points.  The land values in the newer neighborhood don’t seem appropriate as they represent a time period of integration (the first stage of the life cycle of the neighborhood), but the cost of the construction is credible and can be applied to the comparable being analyzed.

 

Subject                                 Comparable

1,700     Sq. Ft.                   1500 Sq. Ft.

200 sq. ft. difference

 

$74.00 x 200 sq. ft. =  $   14,800                  $95.00 x 2,000 sq. ft. = $190,000

$102 x 1,500 sq. ft. = +$153,000                 (300 sq. ft. x $74 p sf) +$  22,200

Subject cost              =    $167,800                 Subject cost                        $167,800

 

Cost New of Subject is reconciled at $167,800

+ Cost New of Pool                                  $  29,000     (sources quote prices unchanged for 5 years)

+ Cost New of Fence                               $    5,800      (prices paid have

Total Cost New                                         $202,600

 

 

Where will the economic life come from?  We know from cost services what the projected physical lives are.  We also know houses are torn down before they wear down so what would a reasonable economic life projection be?  Look at your market, what’s the oldest house in the neighborhood and how long have the owners occupied the residence?  If you look at those factors you can make certain projections based on assumptions of economic indicators.  For example, if the oldest house is 20 years and the last transaction of the dwelling was 5 years ago, the loan term being 30 years means at this point 50 years would be the minimum expected time but the quality indicates a life expectancy of 70 years.  If you consider the area is building up and houses are not being raised to construct new the expectation of economic investors is reasonable at 50-70 years.  That equates to a spread of 2.0%-1.4% per year, round to 1.5% that means an economic life of 67 years (1÷ 0.015).  For simplicity and support of the projection being an estimate, you can conservatively project 65 years or 70 years.  Let’s go with 65 and take a look at this subject.

 

Cost New of Main Dwelling (including garage and porches)           $167,800

1.5% x 11 Years = depreciation of 16.5 %                                               –   27,687

Plus depreciated value of the pool (20 years spent 5 = 25%)          +  21,750

Plus depreciated contribution of the fence (15-year life 1 yr.)       +    5,394

Total Depreciated Contribution of all Improvements                        $167,257

 

The Sale Price of the Comparable was                                  $187,000

Extracting Depreciation Contribution                                     – 167,257

Land Value                                                                              $  19,743

Rounded to                                                                             $   20,000

 

Land to Value Ratio                                                                10.7% round to 11%

 

Did I make assumptions?  Yes, I did, I considered costs paid and studied cost changes for the site improvements.   I looked at the age of the neighborhood where houses, similar to the subject and the comparable were built.  I considered as well cost services that projected lives.  I studied the local costs to derive the cost new of the main improvements.  Was reasoning involved?  It was, and that means I need to disclose and report the results of my assignment, the analyses I conducted and how those conclusions came to be.  I’ve exampled for you a methodology with alternatives to data gathering and shown you reconciliation of the reasoning.  That’s what we do, we’re appraisers who have learned to use methodologies and reasoning to conclude a reasonable basis for identifying a land value from a comparable sale.  When you conduct these types of analyses and use an excel spread sheet and document how and what the basis was of your entries you can explain the process in your report very simply.  Land value was derived by the extraction method through comparable improved sales analyzed for their depreciated contribution of improvements to identify the extracted range of land values.

 

Hope your Christmas Shoppers aren’t causing you too much of a delay this week between your appointments.  I also send you good wishes ABC appraisers.  This is Diana Jacob and you’ve just had a tip of the week from ABC-The Appraiser’s Business Companion

 

 

[1] Excerpt from “Twas the Night Before Christmas”, Author CLEMENT CLARKE MOORE A biblical scholar, he was professor of Asian and Greek literature at the Episcopal General Theological Seminary, erected in New York City on land that he had donated. He is remembered for the well-known poem A Visit from St. Nicholas, which begins ‘Twas the night before Christmas’ it was first published anonymously in the Troy Sentinel in 1823