How property is valued for tax purposes is important. Methods have improved signficantly in recent years, as computer-aided mass appraisal has become possible. The process of assessment is done somewhat differently from the appraisals that are done for mortgage underwriting and for insurance underwriting purposes. The goal is to estimate the value of each property, residential or commercial, relative to other properties in the municipality, so that the tax burden is shared justly among them. To do this correctly, the land and the building need to be valued separately.

A properly done assessment measures two things: the total value of each property, as it exists at a particular time, and the value of the land alone. The difference between the two is the current value of the existing buildings. Depending on their age, the quality of the original materials and the construction, and the amount of updating and expansion that has taken place over the years, not to mention regular maintenance of systems, the building may exhibit very little obsolescense or be almost totally without value in today's marketplace.

For residential property, valuations are fairly straightforward, as long as a reasonable number of houses change hand each year. And in places where vacant lots change hands or teardowns are occurring, valuing land is straightforward. For commercial property, there is a tendency to underassess the properties, perhaps because of the perception that large landholders also have deep pockets and might sue to get their assessments lowered. Because fewer properties change hands each year, there is a tendency to rely not on transactions, but on some valuation based on the net income the property enjoys. This, however, turns the property tax into an income tax, with all the perverse incentives associated with income taxes, and does nothing to encourage the owners of underused land to redevelop it. The building residual method is far more desirable. Value the land first, then look at the depreciated value of the existing buildings, which in the case of obsolete buildings, may be quite close to zero (and could even be negative, since it costs to tear them down and clean up the site).

The widening spread in the ratio between what a property sells for and how much it rents for is in part the difference between the right of its owner to tear it down and build something else more suitable (usually a more intense use of the site) and the fact that all the tenant is getting is the right to use, from month to month, the existing building on that site. When property taxes are low, the landlord can afford to receive only that low level of rent on the property, while he waits for the land to appreciate due to factors he can take no credit for; when taxes on land values are somewhat higher, the landlord becomes motivated to replace the obsolete building which draws little rent with a more appropriate building which will provide him cash flow with which to pay the land tax. The land gets moved toward its highest and best use. Everyone benefits: those who need a place to live, those who want more jobs to choose from, those who want to start a business and need a centrally located site, those who want more vendors to choose from, those who seek the lower prices that competition and an active marketplace creates.

And then, of course, there are states where assessment is not related to market value, but is primarily a function of how long one has owned one's property. In California, those who have owned a choice property for 25 or more years have assessments that are a tiny fraction of what identical neighboring properties which are owned by new owners carry. It doesn't matter what the property is worth in the marketplace. One's land can only appreciate at 2% per year, no matter what one builds on it. The incentives for using it well are minimal. And, since one's potential competitors will face a very different cost structure, one faces less competition, allowing one to charge higher prices. This is known as land monopoly capitalism. How does one fix that? Don't cap the assessment artificially, and don't cap the property tax. Let the property tax fall largely or entirely on land value. The land can take it, and we'll all benefit!

Mason Gaffney:  Sounding the Revenue Potential of Land: Fifteen Lost Elements

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.

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.

• The land-residual approach subtracts the value of buildings from this overall value, designating the remainder as the value of land. Building values may be estimated in terms of their replacement cost (which usually produces a very high estimate, leaving little land value) or their depreciated value (which gives an unrealistically low building estimate, inasmuch as maintenance and repairs save most buildings from deteriorating through wear and tear). Using the depreciated value method leaves a higher residual land value. The Federal Reserve Board recently has experimented with a hybrid intermediate method that values buildings on the basis of their "historical costs".
• The building-residual approach starts by valuing the land, and treats the difference as representing the building's value. The first step in this approach is to construct a land-value map for the district or city. This displays fairly smooth contours for land values. Overlays would show zoning variations. Most of the variations in property prices around this normalized map will be for structures, along with a sizable component of "errors and omissions." This approach rarely is used, and most assessed land values vary drastically from one parcel to the next. The problem is especially apparent in the case of parking lots or one-story "taxpayers," that is, inexpensive buildings in neighbourhoods that are heavily built up. Their purpose is simply to be rented out at enough to carry the property's tax bill, not to maximise the site's current economic 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.

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 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

see also:
The Land-Residual vs. Building-Residual Methods of Real Estate Valuation, http://www.michael-hudson.com/articles/realestate/0110LandBuildingResidual.html

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