Valuing residential land in today’s U.S. real estate market for GAAP financial reporting purposes is increasingly complex – especially when long-term use restrictions, whether zoning-related or municipally imposed for affordable housing, are involved. Because there is no single consistent valuation method, investors, lenders, and appraisers encounter a variety of approaches – creating challenges in development, financing, and determining the market value of land, whether as-is or as-if encumbered.  

Use restrictions

Sometimes it is clear that land acquired in an asset acquisition transaction is restricted; it was restricted before the transaction, and it remains restricted after the transaction. However, it is also possible for unrestricted apartment properties to be subject to use restrictions shortly after acquisition.

The facts and circumstances need to be carefully considered to determine if the use restrictions placed on the assets by the acquirer are an inherent part of any transaction, or if the post-transaction restrictions represent a subsequent event occurring after the transaction date that should not impact the asset values being measured as of the transaction date.

Do the land use restrictions impact the value of the overall property?

The overall property is considered to consist of a group of similar assets, including land, buildings, site improvements, personal property, and property-level intangibles.

The impact on the overall property is best measured by comparing the as-is fair value of the achievable restricted rents for the property with the hypothetical as-is fair value of achievable market rents. Depending on the nature of the land use restrictions, there may be significant or negligible differences between these two rent sets.

Further, there may be a large difference for an early-stage Low Income Housing Tax Credit (LIHTC) property and very little difference for a property with project-based vouchers or Section 8 rents. Occasionally, a property with project-based vouchers or Section 8 rents and property tax abatements may have a fair value that exceeds the hypothetical fair value of the same property assuming market rents.

If there is little difference in the fair values between the as-restricted rent and the at-market rent scenarios, and without other extended analysis or extenuating circumstances, it is difficult to assert that the land value is simply lower because of the affordable-based use restrictions.

Additional analysis might include an operational (cash flow) expense comparison between a stabilized market rate and a stabilized affordable rate. Extenuating circumstances that should be evaluated may include, but are not limited to, incentives provided to the property owner or developer in the form of a tax abatement or below-market long-term (75-plus years) ground lease. These incentives may create additional value for the improved property or land that may offset differences between the market rent and restricted rent.

Obsolescence and valuation theory

If there is a material difference between the fair value with restricted rents and the fair value with hypothetical market rents, this difference is obsolescence. Obsolescence is a form of economic depreciation. Valuation theory traditionally attributes depreciation to depreciable assets – and not to land.

In practice, we have seen a variety of alternative practices:

• Obsolescence attributed to the land 
• Obsolescence allocated pro rata to all of the assembled assets (including land, building, and property-level intangibles) 
• Obsolescence attributed only to the depreciable assets

Valuers need to be careful when evaluating land as a result. Reducing the value of the land alone, rather than allocating obsolescence across the asset group, is not consistent with valuation theory (and it could imply a precarious increase in the value of the building asset).

Common errors

A professional may assert that all identified obsolescence should be attributed to the land. The justification is often semantic. The restrictions are described in a Land Use Regulatory Agreement (LURA), and the LURA is recorded against the land. The error lies in assuming the LURA applies only to land. In reality, it limits rents across the entire property – including improvements – and therefore affects the assembled group of assets.

Note: A LURA describes the set of potential renters that may rent the apartment units and limits the rent that may be charged for the apartment units.  

A more extreme error assumes that land only has value at the expiration of the land use restrictions, requiring a discounted cash flow (DCF) analysis to determine its as-is value. Proponents of this theory claim that land only has market value when it is available for development and free of any use restriction.

The DCF technique demonstrates the valuation theory of the return ON an asset and the return OF an asset. The model reflects a series of cash flow projections over the holding period (return ON the asset), followed by the hypothetical sale of the property (return OF the asset).

When using DCF to value land with use restrictions, we often see models that estimate the return OF the land at the expiration of the restriction but attribute zero value for the return ON the land during the restriction period – which could span decades. This undervalues the land’s contribution to ongoing cash flows and leads to a significantly understated market value. Buildings require land – either owned or ground leased – and for owned land assets, failing to capture the return ON concept results in a valuation gap. This is the essence of the return ON problem.

Example: Land analysis considering zoning

Common in urban areas seeking more affordable housing units, a land site could be improved with a 200-unit apartment building, but a zoning modification approved by the municipality may permit 300 buildable units on the same site area. As such, the highest and best use of the land, as-if vacant, would likely be to develop the land to the maximum density permitted, or 300 units in this example. With the exception of a few real estate markets where the custom is to analyze land based upon its buildable area, the most common unit of comparison for apartment land is the price per developable unit. The result of the above, which increases available density, would likely result in a higher value to the land. This same scenario would more than likely be vice versa if the example zoning modification above had become more restrictive and reduced available density; i.e., this would likely lower the value of the land, as-if vacant.

Example (continued): Land analysis considering zoning, under value in-use”

However, if the example above was altered and the land value is now being developed specific to an affordable housing property, as an example, for value in-use, the highest and best use of each of the individual assets should be the same as the highest and best use for the asset group. If the highest and best use for the group is for continued use as a 200-unit apartment building, it would be inappropriate to value the underlying land based on an alternative highest and best use as a site for industrial development.

Note: Value in-use, is the highest and best use the land asset would provide based on its maximum value to market participants principally through its use in combination with other assets as a group. Specific to the example above, other assets in this scenario would reflect the improvements that were an existing 200-unit apartment building.

Is there a consensus valuation methodology for affordable housing land?

The fair value of the land should be derived based upon a consideration of recent, competitive land sale transactions. For affordable housing land, it is common to analyze the market evidence using a price per dwelling unit metric.  For an asset acquisition, all other identifiable acquired assets should also be separately measured (using the relative fair value method to apportion the acquired assets to the purchase consideration). If, for some reason, the valuer elects not to directly estimate the fair values of the other assets, the specialist should determine if there is obsolescence related to the land use restrictions.

Example: Land fair value estimated at $20,000 per dwelling unit, or $2,000,000. Hypothetical as-is property value with market rents is $10,000,000. Estimated as-is property value with restricted rents is $8,000,000. Obsolescence = ($10,000,000 less $8,000,000) / $10,000,000 = $2,000,000, or 20%. Given the facts in this example, we would expect the valuer to conclude to a land fair value, as restricted of $1,600,000. $2,000,000 less 20%.

However, if the fair value specialist is using best practices and estimating the values for each acquired asset, we would expect a similar result if the purchase consideration is close to the estimated as-is property value as restricted of $8,000,000. In this case, the valuer should obtain a similar result regardless of whether the land fair value is being estimated in combination with fair value estimates of the other acquired assets, or similarly in the scenario where only the land fair value is estimated.

Final considerations

Valuing residential land for GAAP financial reporting in the context of affordable housing demands a nuanced understanding of use restrictions, asset grouping, and obsolescence. Missteps – such as attributing all depreciation to land or undervaluing its contribution during restriction periods – can lead to significant valuation gaps. By applying best practices like analyzing price per dwelling unit and allocating obsolescence across the asset group, professionals can achieve more accurate and defensible valuations.

For any and all questions related to affordable housing, land, and/or financial reporting, please seek our CohnReznick specialists.