A property has a life cycle—it is created, ages, depreciates, and is eventually redeveloped. Because of this, investors view real estate as comprising two parts: land value and building value. This type of analysis provides significant insights into evaluating property value and rent growth rates.

Let me explain this intriguing diagram:

  • R: The point where redevelopment occurs (typically every 50 years).
  • Usage Value: Reflects how property value can increase due to the rising importance of a location. The dotted line shows the trajectory of how property value would increase if depreciation didn’t occur. Hypothetically, if the city expands or population density increases, the location’s importance and value should rise (although this is not always the case).
  • P: The total property value (land + building), which decreases over time and necessitates redevelopment.
  • L and C: Both represent land value. L is the traditional valuation—what the land would cost as undeveloped. C, on the other hand, represents the modern financial perspective, factoring in real options. As the value of the existing building decreases, the value of the option to demolish and build anew increases.

Key Findings from This Analysis:

  1. The location value (Usage Value) represents the upper limit for capital gains in real estate. Due to depreciation, the importance of the location always grows at a higher rate than the property value, which catches up periodically through redevelopment.
  2. Assuming rent correlates with property value, the growth rate of a location’s importance will always outpace the growth rate of rents.
  3. The increase in location importance is the most significant driver of real estate profitability.

Some Illustrative Numbers:

If redevelopment occurs every 50 years, with land value accounting for 20% of the total property value at each stage, and the total location value grows at 5% annually, the property value growth rate would be 1.67%. This is 3.33% lower than the growth rate of location value. The difference in growth rates, 3.33%/5%, amounts to 67%.

Now, let’s examine how this 67% gap changes depending on varying building lifespans and the land/building value ratio (Excel File):

The table clearly shows that the higher the building’s durability (resistance to depreciation) and the greater the land’s share in the project’s budget, the more likely both property value and rent growth will increase. This difference can be substantial.

P.S.

It’s essential to note that depreciation doesn’t only refer to the physical aspect. Building depreciation can also be functional (e.g., changes in energy efficiency standards) and economic (e.g., shifts in neighborhood development or surrounding area trends making the building no longer suitable for the location’s highest and best use).

Adapted from:
Commercial Real Estate Analysis and Investments by D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz.