At a high level there are two components to the value of a house. There’s the value of the land and there’s the value of all the improvements. That is, the bricks, wood, and other stuff that form the actual house. When a media outlet runs a sensational headline about some shack in Toronto selling for, oh I don’t know, a million dollars, what it actually means is that the land in this particular area was just valued by somebody at this number. In fact, if the property is very clearly a “knock down” the improvements sitting on the land become a liability/cost rather than anything of value. Because whoever buys the land will almost certainly need to remove the improvements before they can build whatever it is they want to build.
This distinction between land and improvements is a valuable one for many reasons. Here’s one example. In cases where the improvements aren’t some shack, you may be faced with a scenario where a property can be valued in two different ways. You can value it based on the development potential of the underlying land or you can value it based on the income (either in-place or potential) that the improvements are generating, or could be generating with some hard work on your part. If the development value is greater than the value of the improvements, then there will be pressure to redevelop. Conversely, if the opposite is true, it is likely that not much will happen other than maybe capital expenditures applied to the existing building(s).
Of course, you could also run into a scenario where there’s little development potential and there’s zero ability to invest in the existing improvements, either because the market rents are too low in the area or because they’re capped and/or controlled in some way. In this scenario, it’s likely that not much will happen other than the normal and expected depreciation of the improvements. Maybe one day the development/investment math will work. But in the interim, you probably won’t be seeing any of those sensational media headlines.
Photo by Andre Gaulin on Unsplash
I wonder what ESG considerations will do when ESG filters down to smaller scale residential development.
Let’s look at E -environmental- in relation to my own home. Aside from the bromide that it is better to renovate than start from scratch, that guidance often produces less than optimal use of a site. Then there is the question of depreciation being theoretically being affected by the quality of construction or quality of design itself. I live in a mid-century modern home constructed of glu-lam beams and inline supporting structure that gives the impression of an impossibly skinny roof and windows that go all the way up to the underside of the ceiling. The effect is breathtaking- it never gets dull. My insurer disagrees; if my home were to burn down, they would rebuild it but without the structural gymnastics. Let’s say that I would like to rebuild my house exactly as it is. That might be a $1.5 M touch. My insurance company will go a more conventional route and get it rebuilt for $1M. That $500 000 gap is probably only supported by architects, engineers and fans of the mid-century style. Nevertheless, for purchasers with environmental consciousness and aficionados of gravity defying design, the determination of a supposedly depreciating physical asset will become more nuanced and complicated.