RESIDUAL TECHNIQUES

RESIDUAL TECHNIQUES

An income property may have components of known value, or of value that can be determined by another
technique, and a component of unknown value referred to as the “residual”. These components may be
physical (land and improvements) or financial (mortgage and equity). Residual techniques employ Direct
capitalization to separate the net income for the entire property into the net income necessary to support
each property component. Direct capitalization may then be used to value the residual (unknown
component) by dividing the net income necessary to support that component, by an appropriate market
derived capitalization rate. The different components may, and often do, have different capitalization rates.
One then adds the value of the known component and the residual component for the indication of total
property value. Residual techniques have very limited use and only for special valuation problems. The
examples below outline the process.

Building Residual Technique

If the value of the land is known and the value of the building (the residual) is unknown, the property’s value
may be determined by the building residual technique. This technique allocates the net income of the property
to both land and building. The procedure is:

1. Multiply the known land value by the applicable Land capitalization rate to determine the income
attributable to land only.

2. Deduct income to the land from total net income to determine the income attributable to the building.

3. Capitalize the building’s income at the applicable Building Capitalization rate to derive the value of the
building.

4. Add the capitalized value of the building to the land value to arrive at the value of the whole property.

Example. An appraiser forecasts the net annual income of a 60 unit apartment building at $216,000. On the
basis of several comparable sales, an appraiser estimates that the land value is $60,000 and that the applicable
Land capitalization rate and the Building capitalization rate are 8% and 12%, respectively. What is the indicated

value of the property by the income approach?

Annual net income of property .................................... $216,000

Less the income attributable to the land ($60,000 x 8% )....... 4,800

Net income attributable to building .............................. $211,200

Indicated building value ($211,200 ÷ .12) ...................... $1,760,000

Plus Land value (by Sale Comparison) ............................... 60,000

Indicated property value ....................................... $1,820,000

Land Residual Technique

If the building value is known and the land value is unknown and cannot be determined by another method, the
value of the property as a whole may be estimated by using the land residual technique. The land residual
technique is similar to the building residual technique except that the appraiser must first find the income
attributable to the improvements and the residual balance of the income is then attributable to the land. The
procedure is:

1. Multiply the known improvement value by the applicable Building capitalization rate to determine the
income attributable to the building only.

2. Deduct income to the building from the total net income to determine the residual balance of the net
income attributable to/earned by the land.

3. Capitalize the land’s income at the Land capitalization rate to derive the value of the land.

4. Add the capitalized value of the land to the building value to arrive at the value of the whole property by
the land residual technique.

Example. Same facts as the building residual technique example above.

Annual net income of property ........................................ $216,000

Less income attributable to building ($1,760,000 x .12) .......... 211,200

Net income attributable to land ......................................... 4,800

Indicated land value ($4,800 ÷ .08) .................................... 60,000

Building value ...................................................... 1,760,000

Property value indicated by land residual technique ................ $1,820,000

Finding the Building Capitalization Rate - Example

A property sells for $250,000. Building value is $190,000. Remaining economic life is 25 years. Annual net
income from building is $28,000. What is the interest rate on the land and the building investment? What is the

Building capitalization rate?

Recapture rate is 4% (100% ÷ 25).

Building’s net income ............................................... $28,000

Recapture of building (.04 x $190,000) ............................... $7,600

Net income after recapture .......................................... $20,400

Interest rate on land and building = $20,400 ÷ $190,000 = .1074 or 10.74%

The overall cap rate is the sum of the interest rate (return on) and recapture rate (return of):
Interest Rate = 10.74%

Recapture Rate = 4%

Therefore, the Building capitalization rate = 14.74%

Or: The Building capitalization rate equals the net income to the building divided by the value of the building:

$28,000/$190,000 = 14.74%