The Land Residual and Building Residual techniques of real estate valuation allow us to value either only the land (Land Residual) or only the building (Building Residual) of an improved piece of real property. An “improved” property is simply a piece of land with something built on it, typically but not necessarily a building of some sort. It’s easy to mix them up so just remember that the item in the title – land or building – is what that technique derives a value for. The item being valued is referred to as the “residual” since both techniques start with a total value and then subtracts out the value of the land or building.
Without going into too much detail, the Land Residual Technique consists of three (very) general steps: value the property as improved (improvement/building + land); value the depreciated costs of the improvements using the cost approach; subtract the value of the building from the value of the property as improved. It’s easier to see the principle behind the Land Residual technique if you imagine a brand new improvement/building where we know the exact cost of development (keep in mind that the cost of development includes the actual costs of development incurred and a competitive contractor markup/developer return/entrepreneurial profit); for a new building a typical investor/buyer should be willing to buy a piece of land for the total value as improved less the cost to build and less a required return on his investment. This return, by the way, should be a going markup that the typical developer or contractor receives, otherwise we get into Individual Values rather than Market Values. If the building is not new the depreciation needs to be subtracted, and keep in mind this is actual depreciation as opposed to the depreciation calculated for tax purposes.
Why use the Land Residual Technique? The most common reason for using the technique is for valuing the land underneath an improved property in a neighborhood of improved properties; land sales in developed areas tend to be few and far in between. However, it could be that the land is non-conforming in some way that makes finding comparable sales difficult or impossible. Finally, developers contemplating substantial rehabilitation, demolition, or repositioning often utilize the Land Residual technique.
Another important thing to keep in mind is that the value of the improved property as-is and the cost to replace the current improvement should only be used if the current improvement satisfies the Highest & Best Use of the land, otherwise the value of the property improved to its Highest & Best Use and the cost to replace that particular (imagined) improvement should be used. You can imagine an improved piece of property with an outdated/inappropriate improvement; because the total value of the improved piece of property will be artificially low so will the value of the land.
The Building Residual technique is done in a reverse fashion: value the property as improved (improvement/building + land); value the site area using the Sales Comparison Approach; subtract the value of the land from the value of the property as improved. If the land underlying the improved property is similar to the comparable sales and is not adversely affected by the improvement in a fashion dissimilar to that of the comparable sales (soil contamination being a common example), the value of the improvements should be teased out if we subtract the value of the land from that of the improved piece of property. Keep in mind that the resulting value will reflect the actual cost to build – depreciated for time – together with the contractor markup/developer profit.
Why use the Building Residual technique? The technique is often used to value buildings when depreciation is difficult to estimate. Also, for measuring the value loss to an improved property of its improvements, the Building Residual technique can be helpful. Also, if we had no good data on contractor markup/developer profit, the Building Residual technique would allow us to extract market data for such markup/profits.
So, if the Land Residual technique derives a value for the land and the Building Residual technique derives a value for the building, what value does the Property Residual technique render? The value of the entire property, that is the value of the land and its improvements. If you’ve ever estimated the value of a property through Direct Capitalization you have applied the Property Residual technique. Under this technique a single CAP rate is applied to the Net Operating Income (NOI) derived from that property without attempting to segregate income attributable to the land and income attributable to the building.
Using Residual techniques In the Income Approach
The Land Residual and the Building Residual techniques can also include isolating the Net Operating Income attributable to either the land or the building and then deducting that amount from the total Net Operating Income of the entire property; the residual income (the income attributable to the land under the Land Residual technique or the income attributable to the building under the Building Residual technique) is then capitalized with a CAP rate specific to either the land or the building – not the “blended” rate that would be applied to the total NOI under the Property Residual technique. The value resulting by capitalizing the income attributable to that item (land or building) is the value of that residual.