To an average person, land value and building value might sound like the same – for isn’t every building situated on some sort of land? That, however, isn’t the case, and this article is here to clear up the possible confusion.
The structure below will follow the topic.
The topic is a clear distinction between land value and building value. So, first, the terms land value and building value themselves will be defined. Understanding the terminology that will be used in the rest of the article is important, which is why this takes the first two sections.
The next three sections will be ridden with we, focusing on the topics of how to calculate the land value and building value as well as how to separate these two from the total property value. Furthermore, the next couple of sections offer a twist.
If you’re already familiar with the definitions and the calculating aspect, skip that and land directly on more advanced topics related to property investors and developers. Such as which one is better to invest in short-term and for long-term, and how to perfectly balance out the land-to-asset ratio.
And, if you don’t have the time to read through all of that, jump straight to the last section, where everything is summed up and concluded.
Let’s start rolling by defining building value first…
What Is A Building Value Of An Investment Property?
Just like land value is the value of a land, building value is the value of a building.
Building value, of course, needs to be separated from the land value, but more about land value in the next section, and how to separate them in the section after that. And on ways how to calculate building as well as land value in a couple of sections.
First, let’s define what’s an investment property. If we’re starting with the basics, we might as well start with bare basics too. Don’t you agree?
An investment property is a property bought with the intention of earning more profit from it over time. It can be through rents, resale of the property, or both. These three options then help differentiate the main three types of investment properties:
- Residential,
- Commercial, and
- Mixed-use.
A residential investment property returns income after being rented out – the landlord rents out a place to live and earns income by collecting rent from tenants.
Commercial properties work similarly; however, in this case, investor rents their space out to be a shop, a café, or other businesses and earns a monthly income.
Mixed-use investment property is exactly what the name suggests; the single property is used both to live in and to lead a business, which is most commonly done by leading a business on the ground floor and living on the upper floors.
To be able to rent out a building properly, the landlord needs to know the exact value of the said building. There are multiple factors to take into consideration; from the type of the building, its structure and durability, the quality and prices of materials used in the construction and even the cost of construction, everything at a present-day rate.
OK, now let’s turn on the land value… What is it?
What Is A Land Value Of An Investment Property?
Land value is defined as the value a piece of land has, and it includes both the value of the land itself as well as the value of everything done to the land. This is especially important when investing in a property.
All the hard work and money put into improving it won’t waste if you have calculated the land value accurately. But, more about how to calculate land value a little later in the article.
Land value increases when the demand for land is higher than the land supply, or if the intrinsic value of a certain piece of land is bigger than the neighboring lands. For example, if there’s oil found on the property. Just joking…
In reality, the land value is driven by the opportunity that land gives to an investor or developer. For example, can you add value to that land by subdividing?
Land value is a great tool to determine how much to charge others to use that said piece of land, which is the main motivation behind determining land value. That is often conducted by third parties, an appraiser will look at both flaws and advantages of the piece of land to determine its objective value.
What’s also important to note is that land value isn’t the same as site value, and the two shouldn’t be mixed up. In contrast, land value is the value of a piece of land with all of the investments made to it. The site value is the reasonable value of a piece of land without counting anything that might’ve changed the value, such as mortgages or investments.
Remember, the market value of a property is ideally the combination of its land value and building value. The following video explains the marketing value.
How to Separate Land Value vs. Building Value From Total Property Value?
Now that distinction between land value and building value has been made, and all three of the most important terms for this article have been defined, it’s time to move onto some more important topics for an advanced property investor.
Firstly, that is how to separate land value and building value from total property value, an investment property value in this case. This distinction is important, especially for tax reasons and before you make an offer to purchase a property.
And, while there’s not one single set formula to make the allocation, there are a couple of different ways to approach it.
- Closing documents
When reviewing closing documents from the purchase of the land and the building, make sure that the entire purchase is accounted for. Closing costs consist of title fees, recording fees and attorney fees, which you will need to discount, though.
- Land value vs building value
The difference between the two must be visible. The best way to do this properly is to hire the already mentioned third party (Property Valuer). This independent appraiser will be objective while doing their calculations.
- Land to building cost ratio
The land to building cost ratio is determined by looking into tax assessments. They provide not only the total assessed value of the property, land and building, but also the value of the building and the land alone.
- ü Verify the ratio
Make sure to test it and make sure it’s reasonable. Don’t forget that a building is built on some land, so at least some portion of the price belongs to the land and not the building alone.
Let’s go further into calculating the land value now. There are two main ways of doing that…
How Is Land Value Calculated? Pt. 1
Land valuation is a process in which the fair value of a certain piece of land is determined.
As mentioned previously, this is often conducted by an independent third party (Land Valuer) who can evaluate it objectively, taking into account both the good sides and bad sides of the property.
Land valuation is important not only for taxes – for you might’ve not even know that you might be eligible for some tax benefits, make sure to research further on that – as well as to properly price your investment property.
There are multiple factors to take into consideration when calculating land value.
- Location
The location of the land is the biggest factor that every real estate business should master in.
For example, a piece of land in an urban area will be worth more than a piece of land in a rural area (e.g. farm land).
- Usage
This is yet another important factor, as not every land is worth the same.
For instance, similarly to the previous point, a piece of land used for commercial and residential purposes will be worth more than a piece of land used for agriculture.
- Size
Smaller pieces of land in an urban area are most of the better to invest in for residential usage than a larger rural block, as they’re more affordable to tenants and thus bring more income to the landlord in the long run.
On the other hand, larger lots are better to invest in for property developers, who know how to multiply their value by creating small land parcels, or used it/them for industrial or commercial purposes.
- Shape
This may be a silly one, but it is worthy of keeping in mind. Regular shaped lots such as square and rectangle are generally worth more than irregularly shaped pieces of land.
- Level
Generally, the higher the piece of land is from the road, the harder it will be for water and drainage pipes to reach it. With that, its value drops as well. Similarly, if the land is lower than the road, some costs will have to go to landfills.
Both extremes have their downs, so, generally speaking, leveled lands are headache-free and cheaper to develop than high or low level land acquire lots of infrastructure cots.
- Accessibility
The value of land also depends on how close to the main road. Similarly, the value drops if the main road isn’t nearby, if the lot is blocked in some way, the access road isn’t wide enough, etc.
However, this can go in both ways, especially in Australia. For example, a block in an inner suburb can be much for valuable than a similar block on a main arterial road. In this case, the dropped value it due to the exposure, and direct impact from pollution from the busy road.
- Infrastructure
Like the previous point, the closer the piece of land is to the city center, schools, hospitals, supermarkets, etc. the higher the land value will be.
- FSI, or floor space index
In short, this index determines the total floor area of the building that can be built on that piece of land. In other words, this defines the opportunity it provides as a potential development site.
- Soil
The type and quality of the soil of the designated piece of land also affect its value. The better the soil, the higher the land value and, thus, the higher the price of land.
Similarly, suppose the land is on a rock. In that case, the value goes down as the rock may hinder its potential for construction, or any construction will be costly due to special engineering requirements.
Now, let’s turn on to the second method of calculating the land value.
How Is Land Value Calculated? Pt. 2
Now that we’ve broken down the relevant factors used when the calculating value of a piece of land, now let’s move on to the possible methods that can be used.
A professional Land or Property Valuer will generally do the evaluation. Still, it does not harm being aware of the methods that they use.
- Comparative method
This is the most popular method used, in which prices of recently sold pieces of land close are analyzed in order to estimate the value of the land.
This analysis must be done in the course of at least 1 year or ideally over several years. Otherwise, it won’t be accurate.
- Development method
This method considers the full potential of the land that it can be developed into so it can be sold for a fair price.
- Allocation method
This method assumes a relationship between the land value and the total value of the property, and it only works if there’s enough statistical proof to back it up.
This method is most commonly used in times when land sales are scarce, but built-up properties are available.
- Income capitalization method
There are two sub-categories to this method: capitalization of ground rent and land residual technique.
The first method uses a market-derived land capitalization rate to estimate the most objective land value possible. Whereas, the latter method utilizes the net operating income to isolate the land and estimate the land’s total property value.
- Belting method
This method takes the frontage and depth of the piece of land into account while estimating its value. Higher frontage means more value, while the depth of frontage decreases the plot’s value too.
- Guideline value
In some areas, the government publishes relevant guidelines to estimate the value of a certain property, so in this method, only these guidelines are followed.
In Australia, the Council Rates are based on the perceived land value. However, in most cases, this value is a very conservative underestimation.
How is Building Value Calculated?
Building valuation is a method of calculating the current marketable cost of a building. There are many factors on which the value depends, including building type, its structure, location, size, shape, building age, durability, the width of roads, quality, and the cost of building materials, and many more.
There are a few methods to calculate the building value.
- Rental method
This method determines the building value by deducting all the outgoings from rent. This, however, is only possible if the rent is know and consistent.
- Direct comparison with the capital value
When the rent isn’t know, this method is used. This method estimates the value of the building by comparing values of similar buildings nearby.
- Profit-based valuation
This method is used for buildings such as cinemas, restaurants, and other similar buildings where value depends on their profit.
The value is determined by deducing all the expenses from the gross income. Such annual income is used as a basis for the building valuation. This might result in the value is much higher than the construction value.
- Cost-based valuation
This method uses the cost of construction or the cost obtained by owning the building as the basis upon which the true value of the building is determined.
- Development method
This method is commonly used for underdeveloped or partially developed properties, and it focuses mainly on the divided parts of a larger piece of land. The value of these divided lots should be know, and this method then helps.
It’s also used for lots that need to be renovated, and the way the building value in these cases is received by calculating the worth of the building after the renovations. But, to prove the renovations are justified, it’s important to compare the cost of the property with the total cost of renovation.
- Depreciation method
This method bases the value of a building on four categories: walls, roofs, floors, and doors and windows.
The cost of each category as well as the value of the land and water supply, electric and sanitary fittings, etc. is then incorporated into the final building value.
What Short-Term Investments Should Focus On? – Land Value or Building Value?
Short-term investments, or also called marketable securities or temporary investments, are investments that can be converted into cash in a short period of time. Typically, within 5 years when speaking about assets and commodities, and less than 10 years when it comes to real estate. Most commonly, they’re anticipated to convert into cash in less than a year, actually.
Short-time investments usually offer a small return rate, meaning there isn’t a lot of income. Still, they offer flexibility and quick conversion from assets to cash.
Alongside that lovely advantage, short-term investments generally bring lower risk than long-term investments, which will be discussed in the next section. And, since the asset isn’t meant to be held onto for a long time, it makes no difference if the investor is investing in land or building.
Therefore, there’s no difference between land value and building value to the investor when it comes to short-term investments. This, however, is different from the long-term investments, but more about that in the next section.
What Long-Term Investments Should Focus On? – Land Value or Building Value?
Long-term investments are defined as investments that will be held onto for more than a year, though when speaking about real estate, it is for decades.
While short-term investments will be sold within a few years, or within a few months at times, long-term investments are held onto for a long time before they’re sold. Some may even never be sold for generations.
Furthermore, unlike the typically ‘risk-free’ short-term investment, a long-term investor needs to be willing to accept certain risks when pursuing a higher income from their investment properties. Those risks are high in the short-term, but will disappear as the property help for the longer.
The investor also needs to be able to afford such patience, as the potential losses need to be accounted for.
In a long-term investment, losses are marked as a loss (in accounting), while any possible gains aren’t marked as such until the sale has been made. This is another risk connected to long-term investments.
Taking that risk into consideration, the question is whether to invest in land or buildings. Which one is better, which will bring more income? The answer is that long-term investors should prioritize land value over building value. The risk is lower when investing in a land.
What is the Right Balance? – The Ideal Land-To-Asset Ratio
The land-to-asset ratio is one of the key factors that determine the property value. It’s defined as the proportion of the property value overall made up of the land component.
The first step to determining the right land-to-asset ratio is to determine the land value. This topic has been covered in one of the previous sections, so there’s no need to repeat it.
Once the land value has been calculated, one can determine the per cent (%) of the estimated purchase price made up by land.
From an investor’s perspective, the optimal land-to-asset ratio is when land makes up 70% of the property’s value.
In the previous section, we’ve said that land value and building value make no difference to short-term investors. However, to the majority of investors who are long-time investors, the land value should be the priority. 50% of the property value going to land value should be the absolute minimum.
The highest land-to-asset ratios have properties in popular locations, typically ones close to the city center and with lots of commodities nearby. An investor can buy a smaller piece of land there, but still have sufficient income due to the high land-to-asset ratio. Already established properties are generally the best ones to go for to add some safety net to your property portfolio.
Conclusion
An investment property is a property bought with the intention of earning more profit from it over time. This article focused on two types of investment property values: land value and building value.
Building value is the value of a building, which lies on numerous properties of the said building, from its structure, materials, size, and shape. There are six methods of calculating a building’s value mentioned, but the calculation of this sort is commonly left to the professionals who can do it objectively.
On the other side, land value is the value a piece of land has, and it includes both the value of the land itself and the value of everything done (or could be done) to the piece of land.
Land value increases when the demand for land is higher than the land supply, or if the intrinsic value of a certain piece of land is bigger than the neighboring lands.
There are multiple factors to consider when calculating land value, from the shape, size, levels and even to the soil itself, as well as the number of methods used to reach that value. But, just like building value, land value is oftentimes left to an independent individual to calculate.
Short-time investments are typically sold in under a decade, sometimes even in under a year. When it comes to land or buildings, it makes no difference to a short-time investor. This is, however, different with long-time investments, which will be held onto for decades, if not forever.
Long-term, it is less risky to invest in the land than it is to invest in buildings. But it’s all about finding the right land-to-asset ratio. The optimal land-to-asset ratio is when land makes up 70% of the property’s value or at least 50%.
Let us know your questions…
