Residual Techniques When Evaluating Real Estate

Residual techniques in commercial real estate valuation are sometimes used to value a property, but these residual techniques are also often misunderstood. The income capitalization approach to valuation utilizes a cap rate that represents the value created by all of the real property. It incorporates the capitalization of income from both the underlying land and the improvements built upon the land. There are, however, ways to estimate the value of a property when one of the components of total value is known and the other component is estimated.

These methods are known as residual techniques and can be used to estimate property value when either the value of the land or the value of the improvements is known. In this article, we’ll walk through several examples that will show you how the residual technique is used in commercial real estate valuation.

Land Residual Technique Using Direct Capitalization

The land residual technique using direct capitalization was developed in order to evaluate the highest and best use for a particular piece of land. According to this technique, if the proposed use of the property is its highest and best use, the value of the building should equal the cost of construction. The value of the building is based on the construction costs.

For example, consider a problem where the construction costs are known as well as the market capitalization rates for land and improvements. The land capitalization rate is 9.5%, and the improvements capitalization rate is 10%. The cost of constructing the improvements is $1,400,000. Multiplying the value of the improvements by the appropriate capitalization rate suggests that the improvements are responsible for generating $140,000 in annual income. If the property generates $200,000 in annual net operating income (NOI), the remaining $60,000 is attributed to the land. Then, the value of the land can be estimated by considering the following:

Land Value = Cash flow generated by land / Land capitalization rate

Land Value = $60,000 / .095

Land Value = $631,579

Finally, the total property value is the sum of the land value and the improvements value. So, the total property value is $2,031,579, which is the sum of the $1,400,000 improvements value and the $631,579 land value.

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Building Residual Technique Using Direct Capitalization

On the other hand, there may be a case where the underlying land value is known but the improvements value is not. Suppose market estimates indicate that the land capitalization rate is 9.5% and the improvements capitalization rate is 10%. The land value is $450,000. Multiplying the land value by the land capitalization rate indicates that the underlying land can generate $42,750 of operating income annually. If the property has annual net operating income of $200,000, that means the remaining $157,250 in annual NOI can be attributed to the improvements. Dividing this cash flow by the building capitalization rate provides the estimate of the building value.

Building Value = Cash flow generated by building /Building capitalization rate

Building Value = $157,250 / .010

Building Value = $1,572,500

Adding together the building value and the land value provides an estimate of the total property value. So, a land value of $450,000 and building value of $1,572,500 would create a total property valued at $2,022,500.

Land 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 $1,400,000. Using the cost approach, replacement cost new of the improvements is calculated to be $1,260,000. Using straight-line depreciation over 31.5 years yields a total accumulated depreciation of $320,000 over eight years. Therefore, the depreciated value of the improvements is $940,000, which is the difference between the replacement cost new of the improvements and the accumulated depreciation. The residual value of $460,000 can be attributed to the land.

Property Value1,400,000
Improvements Value New1,260,000
Accumulated Depreciation320,000
Depreciated Improvements Value940,000
Land Value460,000

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 $2,200,000. Sales of unimproved lots in the area indicate that the underlying land value is estimated to be $250,000. The difference between the total property market value and the land value is the depreciated value of the improvements.

Property Value2,200,000
Land Value250,000
Depreciated building Value1,950,000

Therefore, the depreciated building value is $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.

Conclusion

In this article, we discussed land residual techniques and building residual techniques commonly used in commercial real estate valuation. We started with land and building residual techniques based on both land and building capitalization rates. The drawback to this method is that cap rate data is usually not detailed enough to be split between land and buildings in many areas. We then discussed land and building residual techniques using the cost approach and the sales comparison approach. The benefit of this method is that it allows you to use a blended cap rate for both the land and the building, which is what is typically observed in the market.

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