§APPRAISAL OF LAND VALUE §Please download the powerpoint file : §From my website

§A Market Economic View of Land Value : § §The basic theme of this approach is to look at value from an individual's point of view of various commodities in the market. It tells how an individual makes decisions in allocating his limited resources among various commodities while trying to maximise his total utilities from the ownership of these commodities. § §In the simplest form, the utility a person derives from the ownership of a particular commodity such as land determines the value of this commodity. When this process is amplified to the whole market, the overall market's utility derived from a particular commodity determines the market value of it.

§In essence, when the economy is still at its very primitive stage, and there is abundant supply of land no monetary charge will be laid on land because it is a free good, just like air or water and it has no production function. Hence, the use of land does not demand any form of payment or rent. This is obvious when the supply of natural resources far exceeds than the demand for them and there is basically no opportunity costs for their application in the production process. Economic activities will naturally take place in the most accessible and fertile land because that would minimise production costs. § §However, as human economic activities increase due to increases in real income and hence increases in real demand, utilisation of the most accessible and fertile land will soon be saturated. Land starts to be distinguished by site specific factors, especially productivity. § §Incoming new economic activities will have to utilise the fringe area or less productive land (e.g. grade two land), which will increase production costs, e.g. due to higher transportation and delivery as well as land improvement capital. §

§Because of these increases, product prices on this marginal land will also have to increase for the firm to survive. Assuming the demand for this product is relatively inelastic and a rise in price will not jeopardize the original increase in demand, this increase in product price will also be received by the producers on grade one land and a surplus profit will accrue to these land users. § §Land rent under such a situation represents the differences in productivity between grade one and grade two land or the surplus profit. Further, because of private land-ownership, this difference will be transferred to the landlord as land rent on this grade one land. This is because if the existing producers on grade one land do not pay this amount, the producers on the grade two land or other would-be producers would. In so doing, they will out-bid the existing producers. § §Eventually, all producers will have to pay that rent for grade one land in order to stay on business.

§Accordingly, when in the future demand increases constantly, grades 3,4,5,6, land will be brought to use respectively and land rent will be charged in accordance with the differential productivity between different grades of land. This concept paves the way for the development of two important concepts, the residual concept of land value and Marx's conception of differential rent §Under the Ricardian school, land value is solely a residual element and therefore marginal land where soil productivity is the least or even nil commands no rent at all. This however does not stand when private property rights are taken into account. Because of private property ownership, a landlord can and will charge a minimum rent (value) for their land even for the worst and least productive land or let their land vacant. As Evans points out, this absolute rent (or the minimum price or rent a landlord insists on charging even for the worst land) may be demanded by a landlord due to various types of transaction costs

§Residual valuation : § §Land value is regarded as a residual value. This originates from the concept in land economics. This means that land is a fixed element, and payment for which would be made when a residual value is obtained after all the costs and liabilities are deducted from the total revenue. Land value therefore depends very much on the nature of the economic activities undertaken on the land and the costs to produce them. § §The model seems so logical and justified. But in the UK., the Lands Tribunal has denounced this method as far from a certain guide to values. This is mainly due to the fact that there are so many variables in the model, and they are inter-related. Hence, a change in any one or some of these variables will invariably exert a greater effect on the final residual value. Because of this risk, there is a high possibility of fluctuation in the land value. §

§On the other hand, if we look at this problem from other angle it is not that pessimistic. §It is just because there are so many elements in the model that it requires the analyst an even more careful approach to identify the assumptions behind each element. Of course, land value can be obtained by strict comparison of market land prices of previous transaction. §The rationale behind the residual valuation model is to assess the residual process. There must be an ideal 'economic activity' to be carried out on the land. There is no way to compare the prices of two pieces of land without any reference to the different elements in the residual model unless these two pieces of land are absolutely identical in size, use, design layout ;and development and management team. § §When we are applying the residual valuation method, it should be the rationale of the model we are looking for instead of the mechanical process of calculation. §

§By residual valuation, we start from looking at the income to be generated from land, or the Gross Development Value (GDV in short). The GDV is normally the unit price of property multiplied by the gross floor area is the property units are to be sold. §If the development is meant to be income-producing property, then investment method can be applied to find the capital value of the development. §The GDV represents what we can earn from developing the site. However, in realizing this income we need to spend on certain items as costs. These items need to be deducted from the GDV before we can arrive at the residual figure.

§The following represents the flow of events : § § §Gross Development Value : §GDV = Unit price HK$ x Gross Floor Area (GFA) or §GDV = Market rent p.a. divided by market yield x GFA §LESS §1) Construction Costs = Unit cost x GFA §2) Professional Fees eg. Architects, QSs = % x item (1) §3) Marketing and Agency Fees = % x GDV §4) Bank Interest on Costs §5) Contingency = % x ( items (1) and (2) ) §6) Developer’s Profit §EQUAL TO §Residual Amount = Land value + Acquisition /Legal Fees + Bank interest §By simple algebra, we can find the final residual land value. §

§We can note from the above that after the deduction of the costs and profit items from the GDV figure, we are left with a residual amount that includes not only land value itself but also acquisition fees and bank interests accrued during the development period. §There is therefore a need for a conversion process to further derive the residual land value from this residual amount. This process will be explained in details in the examples below. First of all, let’s discuss the various items in the flowchart above. §The residual valuation model is one of the traditional valuation models developed long time ago. Similar to the term and reversion model in the appraisal of real estate, there are certain assumptions to be made in the valuation process. §The first one is the assumption that all expenditure and income occur as a single sum at the specific point of time. Hence, we pay our contractor and architect a lump sum at the beginning of the construction.

§This however, is not a standard practice in the construction industry. As a result, if cash inflow and outflow are made equally through a certain number of installment, the present value of the first installment will be quite different from the present value of the last installment especially if the development period is long and inflation during the period is high. §In this respect, the model itself has a “self-adjusting” mechanism to try to offset this trouble. It is carried out through the peculiar calculation of the bank interest on cost. §In the traditional residual valuation model, the bank interest payment, although still assumed to be paid out in a lump sum, is calculated through one of the following three ways : § §1)Full Cost x (1+i%) n minus Full Cost § 2 2 § 2) Full Cost x (1+i%/2) n minus Full Cost § §3) Full Cost x (1+i%) n/2 minus Full Cost §

§The main of objective of these three interest payment calculation methods is to average out the amount of interest payment so as to offset the effect of assuming interest is paid out as a lump sum which will be greater than the summation of the present value of all the installment payment of bank interest. The first method is the assumption of only half of the full cost is being borrowed. The second method is the assumption that only half of the current interest rate is being charged and finally the last method is to assume that only half of the development period carries the burden of bank interest payment. § §Furthermore, we assume all the market information on property prices and rentals will remain the same at the date of completion of the project. Again, this is not realistic. The following simple example shows the mechanism of estimating land value by this residual model : § §

§Traditional Residual Valuation : § November 97, Hung Hom § Unit price$7, § GFA sq.ft. 67, § GDV Residential $503,250, § Total GDV : $503,250, § § LESS COSTS and PROFIT § Building Costs Two years $ psf for residential $1000 $67,100, § Professional Fees 5.00% $3,355, § Interest on Above 13.00% $9,754, Agency+Marketing fees (on GDV) 1.00% $5,032, § Contingency on Costs 0.5% $352, § Development Profit on GDV 15% $75,487, § Total Costs + Profit = $161,081, § Amount Available for Land; Acquisition and Interest : $342,168, § § Let "X" be the Land Value § Acquisition cost = 0.03X § Interest On Land for 2 Years =1.03X* = X = $342,168, § § Residual Land Value = $260,163, § AV : $3,877.24

§. A standard government residual valuation model will look like this one : § §GDV (for existing use) : $__ / sq.ft. for development period ___ §Less costs and profits : §1. construction costs$___ /sq.ft. §2. professional fees6% on (1) §3. developer’s profit on cost20% on (1) + (2) for half of the development period §Equals to residual sum for land and profit______ §Deduct 20% profit on land divide by 1.2 § Land Value : ___________