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REAL ESTATE IS MADE UP of two distinct parts – land and improvements. Land value is based on its highest and best use as if it were vacant and available for development. The value of the improvements is based on how they contribute to (or detract from) the value of the land.
Improvements are any man-made objects that are permanently attached to the land, such as buildings. Anything that isn’t permanently attached is personal rather than “real” property. Personal property can include furniture, fixtures, commercial equipment, appliances and even entire manufactured homes which are not installed on a permanent foundation.
Land value is determined by the dynamics of the local real estate market. When supply exceeds demand, this causes land values to rise very slowly, remain the same or even decline. This is called an oversupplied or “buyers” market. When demand exceeds supply, this causes land values to rise. This is called an undersupplied or “sellers” market.
However, market dynamics are not quite that simple. For example, ocean front land can increase in value at the same time that nearby commercial land is declining in value, because the two types of property have different supply and demand characteristics. Also, land values can rise while improvement values decrease.
It used to be an old real estate adage that land always increased in value “because they aren’t making any more of it.” The California economic downturn (1992-1997) debunked this myth. Overall real estate values, including land values, declined significantly throughout the state. Some real estate advisors now caution against buying land unless you plan to build on it within six months.
Another real estate maxim is that land does not depreciate. Technically, this is true. Land can decrease in value, but it’s not called depreciation. Improvements depreciate, but land loses value.
The Adjusted Sales Comparison Approach
In rural areas where vacant land sales are common, the adjusted sales comparison approach is a simple way to estimate land value. This is also the most widely-used method for appraising improved residential property.
The first step in this approach is to select three or more land sales which most closely resemble the property being evaluated. Comparable sales are difficult to find. The local multiple listing service usually has the best data, but this information is available only to licensed real estate agents and associated trades (appraisers, lenders, title companies, etc.).
Private real estate information services such as Experian, Metroscan and Dataquick focus their efforts on urban areas and don’t serve rural counties very well. But even this information is not always complete or accurate. However, real estate data is improving rapidly as consumers with personal computers demand more information to help them with buying, selling, investing and borrowing.
It’s important to find actual confirmed land sales and not be confused by asking prices. The two can be very different. The comparable sales should be similar in size, location and zoning. If the property has a premium view, a special frontage (ocean, river, lake, busy street) or merchantable timber, the comps should have these features too. The comps should also be relatively recent.
Unfortunately, even the best comparable land sales may be very different from the property being evaluated. This is especially true in rural areas, which have a low volume and wide variety of real estate sales. Therefore, you need to adjust the comps to make them more resemble the subject. You do this by making upward adjustments for inferior features and downward adjustments for superior features. These adjustments are supposed to represent “market reactions” rather than the actual cost of a particular feature.
How do appraisers, real estate agents, and informed buyers and sellers make these adjustments? This is a controversial subject, because human behavior is complex, often illogical and always difficult to model. The best adjustments are based on informed opinions and experienced guesses. Appraisals prepared for litigation purposes often eliminate these subjective adjustments because they are easily challenged in a court of law.
Rank Analysis
A more simple form of sales comparison approach is called rank (or array) analysis. The first step in this approach is to select a group of comparable land sales and rank them by their selling price. The next step is to label each comp as inferior, similar or superior to the property being evaluated. This establishes a range of value for the property in question. You can estimate the value more precisely by placing it in the lower, middle or upper part of this value range.
This is what real estate agents do when they conduct a free “comparative market analysis” or CMA. This is also the way most buyers and sellers compare different properties.
Merchantable Timber
What if the property has a significant amount of merchantable timber? How does this affect land value? The simplest way to account for timber is to compare the land with the sales of other land which was similarly forested at the time of sale. If this is not possible, a professional forester should estimate the standing timber volume. This can be an expensive and time-consuming process, but well worth the effort if there are a lot of saleable trees.
Many people make the mistake of assuming you can simply add the total timber value to the unforested land value. Not true. Trees contribute only a portion of their total value to the market value of the land, depending on the size of the property, the topography, location and other factors.
Extraction and Allocation
How do you estimate land value when there have been no vacant land sales? This is a typical problem in urban and built-up areas. The solution is to select comparable improved sales and subtract the value of the improvements. You can do this by extracting the depreciated replacement cost of the improvements, which is called extraction. An easier method is to simply allocate a percentage of the total real estate value to the land, which is called allocation.
The County Assessor does this for every property on the tax roll, distributing the assessed value between the land and the improvements. However, the Assessor’s allocation may not always be accurate, especially as the real estate market changes and properties age.
Graphic Analysis
How do you compare land sales which are different in size? What sort of adjustments do you make? Making any kind of adjustments to comparable sales is difficult to support, but adjusting for differences in lot size is almost impossible. The best way to analyze different-sized land sales is by graphic analysis. The familiar “diminishing returns” curve (also called a logarithmic curve) best describes the relationship between sale price and lot size. Prices tend to rise more steeply when lot sizes are small, with the price curve flattening out as the lots become larger.
Through the magic of computers, even the mathematically challenged can create impressive graphs from simple spreadsheets. This type of graph is called a scatter chart, which I generated from actual land sales. I inserted a trend line derived by a statistical method called regression analysis. Because of the small sample size, this is not a true statistical analysis. However, if the comparables are selected carefully, even a small number of sales will show a consistent pattern of value related to size.
In this chart, some of the dots aren’t close to the trend line at all. These wayward blips are called “outliers” by statisticians. Close examination of these outlying sales usually reveals something unusual about them. The property may have a better ocean view, it may be dividable, or it may be in a remote location. The sale could have occurred many years ago, or it may not have been an arm’s length transaction. When these outliers are adjusted or eliminated, the dots will lie much closer to the trend line.
Based on this chart, I would estimate the most probable value for a typical 4-acre ocean view lot to be about $180,000, even though I could find no actual sales of any 4-acre acre lots. The chart also shows that a 4-acre lot would probably not sell for twice as much as a 2-acre acre lot.
The chart shows an abundance of sales of one-acre lots with a wide range of prices. If I were appraising a one-acre lot, I would probably use the adjusted sales comparison approach or rank analysis rather than graphic analysis.
Estimating land value is both a science and an art. It helps to have a computer and good access to comparable sale information. But it also helps to have a “feel” for land and the behavior of buyers and sellers in the local real estate market.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
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Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor“ and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
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