Fortunately, the theory of real estate valuation is not as difficult to comprehend as the theory of value, over which economists continue to fight endlessly.
Real estate valuation concerns the assessment of particular parcels’ market price. It is not about some abstract or philosophical theory of value. Maybe to save confusion though, real estate valuation ought to have been termed ‘real estate pricing’.
It is sometimes difficult to price a parcel of real estate where little sales evidence exists, but there are ways of overcoming this by establishing its net rental relative to surrounding properties and capitalising this at a rate reflected by current market conditions.
Capitalising the current market rental is the essence of the theory of valuation. Sir William Petty used it to assess Britain’s land and capital stock at 250 million pounds (15 million pounds annual income capitalised at 6%) one hundred and fifty years before David Ricardo ‘discovered’ the Law of Rent.
Neoclassical economists and some real estate valuers (‘appraisers’ in the US) claim there are ‘positive economics’ and theory-of-value implications which make the theory of real estate valuation uncertain. They are correct in one sense only, but the problem is theirs, because they confound land and capital.
We know that money and allotments of company shares have a value, but they are not in themselves created wealth. Nor is land. Theirs are values from obligation or legal arrangements between parties which do not constitute created wealth which is more easily assessed. In the economics sense land is all natural resources: land, sea and air. These are not created wealth, as they are obviously pre-existing.
The difficulties which economists have with the theory of valuation arise because of their confusion of the value of land from legal obligation, to pay a price or some or all of its rent, with the created capital of the improvements which are constructed upon it.
It should be clear that an improved parcel of real estate consists of two distinct parts – the added price of the improvements (the capital works on the site) and the value of the land itself. But what is the price of this ‘value by obligation’ of the land?
This will depend on whether the land is leasehold or freehold, and how much of its rent remains in private hands. If the land is leased from the Crown at its full market rental, it will have no price. That’s correct, little or no price, because the tenant is paying its full market rental for leasehold possession. There remains little or no private rent to be capitalised into a price.
However, if the site is not leased but is in exclusive possession as freehold land, the price of the land will depend upon the quantum of rates and taxes paid annually on the site. These are notionally deducted from the gross rent of the land, and the net rent remaining in the occupier’s hands then capitalised, as early conducted by William Petty.
That’s the theory, but we will usually have sales of freehold land which allows us to forego all the mathematics of capitalising the land’s net market rent in order to assess its price. If there are no sales of vacant land, there will usually be sales of improved land on which the improvements have been demolished, which will allow us to assess the actual price paid for the land by adding net demolition costs to the sale price.
But the significance of what constitutes land price should be understood. It is the private capitalisation of the publicly-generated rent that goes uncaptured on a site, not simply a matter of supply or demand, as for commodities.
Discuss in our Forums
See what other readers are saying about this article!
Click here to read & post comments.
3 posts so far.