Land Value via the Income Approach – A Quick Primer

If you’re generally familiar with real estate appraisal, you are no doubt aware that the sales comparison approach is the preferred method of valuing land in most situations.

That said, there are other techniques that can be developed: Market Extraction, Allocation, Land Residual, Ground Rent Capitalization, and Discounted Cash Flow Analysis.

The last three procedures in that list are income capitalization techniques–they are the focus of this article.

Ewa SubdivisionSubdivisions are often valued via the income approach.

Ground Rent Capitalization

Due to the large amount of leasehold land in Hawaii, local appraisers frequently employ this technique to convert ground lease rents into land values.

In appraisal school, one of the first formulas taught is: Income / Rate = Value ( I / R = V )

Here is an example of how it works:

IRV Land Example

As shown, a property’s annual income can be converted to a land value if a capitalization rate, or “rate of return” as it is commonly called in Hawaii, can be derived from the market.  In this example, if an eight percent (8.0%) rate of return was applied to a ground rent of $50,000 per year, the indicated land value would be $625,000.

Land Residual

Similar to the Ground Rent Capitalization technique described above, this method converts the allocated portion of a property’s income that is attributable to the land, and again divides it by a land capitalization rate that is market derived.  Most often, this method is employed when testing the feasibility of alternative uses in highest and best use analyses.

The key difference between this technique and the one above is that income for an improved property is typically the starting point, and it must be segmented (with market support) into the income attributable to land (IL) and income attributable to the building (IB).

The following chart is an example of the Land Residual technique used for Highest and Best Use testing purposes:

H&BU - Land Residual

(Note: In my experience in Hawaii, this method is used so infrequently for market value purposes that the term “Land Residual” is most often meant by appraisers to describe Yield Capitalization/DCF/Subdivision/Development Analyses–described below)

 Discounted Cash Flow Analysis / Subdivision Development Analysis

Yield Capitalization can also be used to value land, it is sometimes referred to as one of the following techniques:

  • Discounted Cash Flow Analysis
  • Subdivision Analysis
  • Development Analysis
  • Subdivision Development Analysis
  • Yield Capitalization
  • Land Residual (Hawaii)

In this technique, gross sale prices are estimated and costs (such as construction, management, or developer’s profit) are deducted to arrive at net income.  This net income is then discounted to a present value estimate for the underlying land.

An example of a Subdivision Development Analysis is shown below:

DCF Example - Subdivision

Comments and/or Questions?  Please leave them in the comments section below–I’d be happy to clarify or expand.

Aloha, Chris

Hawaiki Tower Analysis – An alternative to traditional comps and adjustments.

For many appraisers in Hawaii, a common but challenging assignment is to value a single unit in a high-rise luxury condominium project.

There are dozens of luxury high-rises in Honolulu.  This article takes a look at Hawaiki Tower, a 46-story condominium with 417 residential units. It is situated immediately across the street from Ala Moana Shopping Center and benefits from highly desirable ocean views.

Hawaiki Tower HeroPhoto Credit: Mathew Ngo – REALTOR®

At first, it might seem straightforward to value a unit in this building.  For example, in the past 12 months, 14 residential units at Hawaiki Tower have sold, as shown in the chart below:

Hawaiki Sales - Past 12 MonthsSources:  HiCentral MLS, and Chris Ponsar, MAI

From an appraiser’s point of view, what’s not to love?  We’ve got a bunch of seemingly clean data to work with. This is largely true, but a closer look reveals the following:

  • 10 sales of two-bedroom units in the past year, and 4 sales of one bedroom units.
  • Floor levels range from 8 to 43
  • Unit sizes range from 842 to 1,618 square feet of living area.
  • Sale prices range from $575,000 to $1,616,000
  • Prices per square foot range from $642 to $1,187

In other words, sale prices and unit characteristics fall in a wider range than one might expect, and an appraiser looking at any particular unit will be challenged to provide solid market support for adjustments.  Not impossible, but definitely difficult.

Let’s look at an alternative: The Multiplier Method

The following chart tracks resales at Hawaiki Tower since construction completion in 1999.

Hawaiki Resale as pctSources:  HiCentral MLS, Hawaii Information Service, and Chris Ponsar, MAI

At first, this might appear to be a summary of run-of-the-mill sale prices, but it isn’t.  This chart tracks each sale price at Hawaiki Tower as a percent of its original developer’s sale price.   As shown, the 150 percent threshold was crossed sometime around 2004, with the march past 200 percent taking shape in 2012. (We’re definitely getting into appraiser geek stuff here)

The benefits of this approach are rooted in the idea that when Hawaiki Tower was first completed and sold out in 1999-2001 (a time of relatively stable pricing where almost 75 percent of the project closed in the first 12 months after completion), the developer and more than 400 buyers came to individual agreements on price.  Buyer preferences for items such as ocean view, unit size, floor level, floor plan, etc are “baked in” to the original developer closing prices.

If we take another look at the Hawaiki Tower sales from the previous 12 months, a tighter trend reveals itself in the “% of original price” and “multiplier” columns:

Hawaiki Multiplier Chart

In the prior 12 months, on average, the 10 two-bedroom sales at Hawaiki Tower traded for 2.2x their original sale prices.  One-bedroom units are trailing a bit, selling for about 1.9x the original developer’s price–a possible indication that one-bedroom units are less desirable, in comparison to two-bedroom units, than they were in 1999, a market preference that many real estate agents and appraisers have observed.

What does it all mean?

Based on the sales activity at Hawaiki Tower over the past 12 months, units have closed in the range of 1.6-2.8x original prices, with most activity happening in the 1.9-2.3x range.  As a property owner, real estate agent, or other professional interested in market value, it would seem reasonable to set value expectations in these ranges.

If you’re interested to know what your unit sold for originally in the 1999-2001 sell out period, send me a note and I’ll zip it over to you (the whole 400-unit list seems a bit overwhelming for this article).  Alternatively, you can look up the public record sales activity for any property on Oahu at http://www.honolulupropertytax.com.  Go to the property search tab and enter your address or tax map key if you know it (again, drop me a line if I can help).

Comments and/or Questions?  Please leave them in the comments section below–I’d be happy to clarify or expand.

Aloha, Chris

Resort Homesites – Front Row vs. Second Row – A Big Island Paired Sales Analysis

Hawaii real estate appraisers are often asked to value residential properties that have spectacular ocean views.

Not a bad gig, I admit.

I recently did some appraisal work in Maniniowali, a luxury subdivision in the Kukio membership community on the Big Island of Hawaii.

I was valuing a front row lot, and this time, fortunately, there were several recent sales of similar properties to analyze.  But this is not always the case.  In high-end resort subdivisions, sales occur relatively infrequently–as such, quality comparables are sometimes hard to come by.

When appraising oceanfront or front-row properties, it is common to have no recent front-row sales in the subject subdivision.  But often times, there are timely sales of second row lots that can give an appraiser a better sense of values in the front row market.

Consider these two properties at Maniniowali:

Manini Paired Sale AerialImage Source: Bing Maps  (Click to Enlarge)
Manini Paired Sales Tax MapHawaii County Tax Map  (Click to Enlarge)

The aerial photo and tax map show a front row homesite, Lot 14, and a second row homesite, Lot 6.

For persons interested in real estate analysis, especially appraisers, these transactions are a stroke of analytical luck because they:

  • Closed just six days apart, in early May 2013
  • Both have ocean views
  • Are similar in size
  • Have the ability to purchase a membership in the same exclusive club (Kukio)

In short, a perfect opportunity for a pure paired sales analysis! (An appraiser geek term that speaks to the ability to test the value impact of a single, isolated variable)

The chart below shows a paired sales analysis for this set of comparables:

Manini paired saleSource: Chris Ponsar. MAI  (Click to Enlarge)

As shown, the second row lot at Maniniowali sold for approximately 27 cents on the dollar compared to its front row counterpart.  Said differently, Lot 14 sold for 3.6 times the price of Lot 6.

As an appraiser, I use relationships like this to help me in situations where I am challenged for data.  Obviously, this is only one pairing, and I’ll post similar paired sales of front row and second row lots as I come across them, but to the extent this relationship becomes a consistent trend, an appraiser may be able to check the reasonableness of their value conclusions for a front row lot against sale prices of second row lots, and vice-versa.

Comments and/or Questions?  Please leave them in the comments section below–I’d be happy to clarify or expand.

Aloha, Chris

The Three Approaches To Value: Sales Comparison, Cost, and Income Capitalization

In a nutshell:

Real estate is valued by an appraiser who considers one or more of the three approaches to value:

  • The Sales Comparison Approach evaluates sales of properties that are similar to a subject property.  After differences are accounted for, the comparables should represent a reasonable value range for the subject.
  • The Cost Approach calculates the cost to construct new improvements on a site, less any depreciation due to age or other factors.  This depreciated cost is then added to the value of the underlying land.
  • The Income Capitalization Approach measures the present worth of (a) future income generated by a property and (b) its eventual resale value.

In depth:

In appraisals of real estate, appraisers are most frequently asked to develop an independent and unbiased opinion of market value for a subject property.

Market value is determined by an appraiser who analyzes three types of market data: comparable sales, cost to replace (or reproduce), and income.  The process of analyzing data from these sources is commonly referred to as “The Three Approaches To Value”.

The following discussion explains each approach.

Sales Comparison

“Sales Comparison is King” – Numerous Appraisal Institute Instructors

Sales Comparison is the approach to value that the public is probably most familiar with.  In this approach, real estate appraisers research and analyze sales of similar properties (“comparables” or “comps”) in order to compare them to a subject property.  Sales comparison is usually the most insightful valuation method when numerous timely sales of similar properties are available to study.

To the greatest extent possible, appraisers strive to find comparables that buyers would consider to be acceptable substitutes for the subject property.  When I select comps, I always ask myself the question: “If the subject property was not on the market, what would the most probable buyer purchase instead?”  The goal is to find the most timely sales of properties that an appraiser feels would compete with the subject property in the open market.

After comparables are selected, an appraiser develops his or her opinion of value by considering factors that buyers and sellers consider to be important.  In the case of a single family home, bedrooms, bathrooms, land area, ocean views, and age/quality of construction are among the factors that would typically be considered.  In most cases, mathematical adjustments are made to each comparable sale in order to allow for fair comparisons.  If a comparable has a superior trait, such as an extra bedroom, it is adjusted downward to match the subject.  If a comparable has an inferior trait, like a one car garage (instead of two at the subject), it may be adjusted upward to equate it to the subject property.

Simple Adj ScheduleA Simple Adjustment Schedule

After all adjustments, the comparables should indicate the relevant range of values for the subject property.  The appraiser’s job is then to evaluate the strengths and weaknesses of the comparables and adjustments, and come to a value conclusion via the sales comparison approach.

Cost Approach 

Generally speaking, the cost approach is based on the idea that a rational real estate buyer would not usually pay meaningfully more for a property than it would cost to build new.  The cost approach is most useful in valuing new improvements.  In addition, it is often the best (and sometimes the only) method for valuing properties that are rarely sold and/or generate little or no income (such as schools, churches, parks,or military properties).

The cost approach involves three basic steps:

  1. Estimating the cost to reproduce (or replace) the existing improvements .
  2. Deducting any depreciation that is present.  (The most common form of depreciation is physical deterioration from age, but changing market tastes and external considerations can reveal types of depreciation known as “functional obsolescence” and “external obsolescence“, both of which I can discuss in a later article.)
  3. Adding the value of the depreciated improvements to the value of the land underneath the property.  (The land is valued separately using the sales comparison approach.)

After land value is added to the depreciated value of improvements, the total represents the value of the property via the cost approach.

A side note for a future discussion:  It is common for appraisers to express the idea that the value indicated by the cost approach “sets the upper limit of value”.  Those interested in an in depth refutation of this concept are encouraged to obtain a copy of Nelson Bowes’ new book In Defense of the Cost Approach, published by the Appraisal Institute.

Income Capitalization Approach

The income approach is often summarized as “the present value of future benefits“.  Properties that generate positive cash flow can be appraised using a  “present value” or “time value of money” concept.  The income approach estimates the present value of (a) future income generated by a property and (b) its eventual resale value.

The term “capitalization” refers to the mechanism by which future income can be converted into a present value.  There are two types of capitalization: Direct and Yield.

Direct Capitalization considers one year of income and converts it to a property value.  The direct capitalization technique is often referred to as “Direct Cap” or using a “Cap Rate“.

In my view, the simplest way to understand direct capitalization is using an “income multiplier“.  Consider the following chart:

multiplier image

The three sales generate annual income of $50,000, $25,000 and $100,000 and sold for $500,000, $250,000, and $1,000,000, respectively.  In other words, each of the properties sold for 10 times their annual income.  Using this market data, it would be reasonable to conclude that the market is paying 10 times annual income for properties of this type.  Given this math, a property with annual income of say $75,000 would be valued at $750,000.

A “Cap Rate” is the inverse of an income multiplier.  If an income multiplier is 10x, which is the same thing as 10/1 (10 divided by 1), then the cap rate is 10% (1 divided by 10).

A 10x multiplier and 10% cap rate are too convenient.  Take a look at this chart to see how the relationship between multiplier and cap rate varies:

multiplier vs cap rate

Yield Capitalization differs from Direct Capitalization in one fundamental way:  It considers multiple years of stabilized income and the eventual resale of the property.  The multiple years of income are converted to a present value using a “discount rate”.  The application of this process is sometimes called a “Discounted Cash Flow” or “DCF“.  Yield Capitalization considers multiple variables and can become very complex.  It is most appropriate for properties that are forecast to have uneven future cash flows (perhaps a large tenant is moving out in 3 years).  I’ll write more about this intricate valuation tool in a future article.

Comments and/or Questions?  Please leave them in the comments section below–I’d be happy to clarify or expand.

Aloha, Chris