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Building Residual Method
The Land Fraction of Real Estate Value (LFREV) is much higher than standard modern sources show. On most assessment rolls the value of old “junker” buildings, on the eve of demolition, is listed as higher than the land under them. This betrays the erroneous use of the “land-residual” method of separating land from building values. It should be obvious that the old junker has no residual value: that is why it is being junked. Junking is continuous in enclaves of high value like Kenilworth, Illinois, or Beverly Hills, California. “Locational obsolescence” is the key concept. The high and growing value of the underlying site cannibalizes the residual building value. Read the whole article
Michael Hudson: The Lies of the Land: How and why land gets undervalued
Turning land-value gains into capital gains
YOU MAY THINK the largest category of assets in this countrly is industrial plant and machinery. In fact the US Federal Reserve Board's annual balance sheet shows real estate to be the economy's largest asset, two-thirds of America's wealth and more than 60 percent of that in land, depending on the assessment method.
Most capital gains are land-value gains. The big players do not want their profits in rent, which is taxed as ordinary income, but in capital gains, taxed at a lower rate. To benefit as much as possible from today's real estate bubble of fast rising land values they pledge a property's rent income to pay interest on the debt for as much property as they can buy with as little of their own money as possible. After paying off the mortgage lender they sell the property and get to keep the "capital gain".
This price appreciation is actually a "land gain", that is, it's not from providing start-up capital for new enterprises, but from sitting on a rising asset already in place, the land. Its value rises because neighbourhoods are upgraded, mortgage money is ample, and rezoning is favorable from farmland on the outskirts of cities to gentrification of the core to create high-income residential developments. The potential capital gain can be huge. That's why developers are willing to pay their mortgage lenders so much of their rent income, often all of it.
Of course, investing most surplus income and wealth in land has been going on ever since antiquity, and also pledging one's land for debt ("mortgaging the homestead") that often led to its forfeiture to creditors or to forced sale under distress conditions. Today borrowing against land is a path to getting rich -- before the land bubble bursts. As economies have grown richer, most of their surplus is still being spent acquiring real property, both for prestige and because its flow of rental income grows as society's prosperity grows. That's why lenders find real estate to be the collateral of choice.
Most new entries into the Forbes or Fortune lists of the richest men consist of real estate billionaires, or individuals coming from the fuels and minerals industries or natural monopolies. Those who have not inherited family fortunes have gained their wealth by borrowing money to buy assets that have soared in value. Land may not be a factor of production, but it enables its owners to assert claims of ownership and obligation, i.e., rentier income in the forms of rent and interest.
Hiding the free lunch
BAUDELAIRE OBSERVED that the devil wins at the point where he convinces humanity that he does not exist. The Financial, Insurance and Real Estate (FIRE) sectors seem to have adopted a kindred philosophy that what is not quantified and reported will be invisible to the tax collector, leaving more to be pledged for mortgage credit and paid out as interest. It appears to have worked. To academic theorists as well., breathlessly focused on their own particular hypothetical world, the magnitude of land rent and land-price gains has become invisible. But not to investors. They are out to pick a property whose location value increases faster rate than the interest charges, and they want to stay away from earnings on man-made capital -- like improvements. That's earned income, not the "free lunch" they get from land value increases.
Chicago School economists insist that no free lunch exists. But when one begins to look beneath the surface of national income statistics and the national balance sheet of assets and liabilities, one can see that modern economies are all about obtaining a free lunch. However, to make this free ride go all the faster, it helps if the rest of the world does not see that anyone is getting the proverbial something for nothing - what classical economists called unearned income, most characteristically in the form of land rent. You start by using a method of appraising that undervalues the real income producer, land. Here's how it's done.
Two appraisal methods
PROPERTY IS APPRAISED in two ways. Both start by estimating its market value.
Note that the Fed's land-residual appraisal methods do not acknowledge the possibility that the land itself may be rising in price. Site values appear as the passive derivative, not as the driving force. Yet low-rise or vacant land sites tend to appreciate as much as (or in many cases, even more than) the improved properties around them. Hence this price appreciation cannot be attributed to rising construction costs. If every property in the country were built last year, the problem would be simple enough. The land acquisition prices and construction costs would be recorded, adding up to the property's value. But many structures were erected as long ago as the 19th century. How do we decide how much their value has changed in comparison to the property's overall value?
The Federal Reserve multiplies the building's original cost by the rise in the construction price index since its completion. The implication is that when a property is sold at a higher price (which usually happens), it is because the building itself has risen in value, not the land site. However, if the property must be sold at a lower price, falling land prices are blamed.
If it is agreed that any explanation of land/building relations should be symmetrical through boom and bust periods alike, then the same appraisal methodology should be able to explain the decline of property values as well as their rise. The methodology should be as uniform and homogeneous as possible. By that, I mean that similar land should be valued at a homogeneous price, and buildings of equivalent worth should be valued accordingly.
If these two criteria are accepted, then I believe that economists would treat buildings as the residual, not the land. Yet just the opposite usually is done.
How land gets a negative value!
THE DRIVING FORCE behind the anomalies is the political lobbying eager to depict real estate gains simply as "protecting capital from inflation." In reality, it helps land owners and their creditors get a free ride out of land asset-price inflation -- that is, The Bubble. ...
This leaves in limbo the macro-economists and business analysts whose business is to explain the finance, insurance and real estate (FIRE) sector's dominant role in the economy. According to the land-residual appraisal technique, high-rise buildings seem to have the lowest land values. Real estate interests argue that this is realistic, because at least in New York City the higher a building is, the more of a subsidy its developers need, given the economics of space involved for elevators, surrounding air space and so forth. The land itself is assigned a negative value as a statistically balancing residual reflecting the difference between the building's high construction costs and its lower market value.
One obvious problem with the land-residual approach is that many buildings would not be rebuilt in their existing form. ...
The land-residual approach appears to work as long as a fairly constant proportion of land to buildings is maintained. Statistically, this can occur only when property prices are rising at about the same rate as commodity prices and wages. But business cycles snake around the economy's basic trends, rising steadily and then plunging sharply. This fluctuation is what causes the most serious problems for statisticians.
In a thriving real estate market appraisers typically use a rule of thumb in allocating resale prices as between land and buildings to reflect their pre-existing proportions. Buildings typically are assumed to account for between 40 percent and 60 percent of the property's value. As a result, building values are estimated to grow along with a property's overall sales value. This appraisal practice is made to appear plausible as the pace of asset-price inflation tends to go hand in hand with rising construction costs, and hence in the theoretical replacement cost of buildings.
As noted, the anomaly occurs when real estate prices fall. Real estate prices are volatile, while construction costs rarely dip more than slightly, if at all. When real estate prices turn down, they often plunge below the reproduction cost of buildings. Hence, the residual ("land") rises and falls much more sharply than do building replacement costs (which are estimated as rising at a fairly steady pace) and overall property values.
The result is a curious asymmetry. Building prices seem to be responsible for the rise in real estate prices, while land prices are held responsible for their decline. When the fall in property values intersects the rising reproduction-cost trend, the land residual turns negative.
Because this land value often represents the owner's equity, this decline may prompt heavily indebted owners to default on their loans or even to walk away from their property, which reverts to the bank or other mortgage holder. In this sense the financial system itself is based largely on real estate, as the economy learned in the savings and loan (S&L) deposit insurance crisis of the late 1980s. Real estate prices reflect the supply of property (including a fixed supply of land) as compared with the fluctuating supply of mortgage credit, which tends to be a function of the economy's overall liquidity. ...
Real estate industry's priorities
REAL ESTATE LOBBIES recognize that what is not seen is less likely to be taxed. What is not quantified for public policy-makers to see clearly may avoid taxes, leaving property owners with a larger after-tax return. They prefer land-residual's capital gains statistics at the national level, even as individual investors seek site-value gains at the local level.
This explains the seeming irony
that investors in an industry
dealing primarily with the development of land sites have campaigned
to minimize the statistical treatment of land. Relegating land to
merely secondary status enables the real estate industry to depict
its "capital" gains as resulting from cost inflation and hence the
reproduction costs of buildings -- whose value is allowed to be
depreciated and re-depreciated at rising values over time. The free
lunch of land-price gains is unseen as attention is diverted from the
real estate bubble and land-price inflation to building costs. These
fiscal considerations help to explain why it has been so hard to get
Washington to produce national land value statistics. Read the whole article
The Methodology of Real Estate Appraisal: Land-Residual or Building-Residual, and their Social Implications http://www.michael-hudson.com/articles/realestate/0010NYURealEstate.html
How to lie with real estate statistics: The Illusion that Makes Land Values Look Negative; How Land-Value Gains are Mis-attributed to Capital http://www.michael-hudson.com/articles/realestate/01LieRealEstateStatistics.html
Where Did All the Land Go? - The Fed’s New Balance Sheet Calculations: A Critique of Land Value Statistics http://www.michael-hudson.com/articles/realestate/01FedsBalanceSheet.html
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Wealth and Want
... because democracy alone hasn't yet led to a society in which all can prosper