Many first-time home buyers believe the physical characteristics of a house will lead to increased property value. But in reality, a property's physical structure tends to depreciate over time, while the land it sits on typically appreciates in value. Although this distinction may seem trivial, understanding how prospective land values influence property returns lets investors make better choices.
Quite simply, land appreciates because it's in limited supply. After all, no one is producing any more earth. Consequently, as the population increases, so does the demand for land, driving its price up over time. Therefore, investors should consider how land appreciation can offset the depreciation of a home, which requires capital infusion for maintenance, as it ages. The Internal Revenue Service (IRS) even acknowledges this inevitability by allowing the depreciation of a physical structure to reduce a homeowner's tax obligations.
The degree of depreciation and/or physical obsolescence varies from one property to another, but if left alone, properties continue to depreciate until they no longer add any value to the land. Some owners even raze physical structures to maximize the value of their parcels.
- Many first-time home buyers believe the physical characteristics of a house will lead to increased property value. But in reality, a property's physical structure tends to depreciate over time, while the land it sits on typically appreciates in value.
- Understanding how prospective land values influence property returns allows investors to make better choices.
- Land appreciates because it is limited in supply, consequently, as the population increases, so does the demand for land, driving its price up over time.
Implications for Investment
Once an investor understands the impact of land value on total appreciation, the time-honored real estate mantra of "location, location, location" takes on even greater meaning. Savvy home buyers look past the physical attributes of a home and focus on its physical site, taking the following elements into consideration:
Locations within neighborhoods will affect land values.
Not all spots within a given area are considered equal. A home by a cul-de-sac is usually in higher demand than a home situated near a busy roadway because the former has less traffic and is safer for young children. Also, most middle- and upper-class, single-family-home neighborhoods have new construction limits that are set when developers purchase most of the available land, on which to construct the subdivisions. Consequently, most neighborhoods evolve their own social, cultural and demographic characteristics that impact demand for houses.
The average age of neighbors can provide clues to appreciation.
New home buyers with small children often avoid locations with older homeowners who will not provide playmates for their little ones. Also, specific public schools can influence the demand for homes in particular school districts.
Future development can change the value of a property for better or for worse.
Homeowners should not only be cognizant of current local amenities, but they should also be aware of the prospective commercial and municipal developments in the area, such as plans for new schools, hospitals, and public infrastructure, that may impact land values.
Single-family property investors should also consider the possible development of condominiums in their neighborhoods. Because condo complexes may contain multiple units on small parcels of land, the increased supply could potentially drive down prices for all area homes.
The Bottom Line
Successful real estate investors look beyond the stylistic attributes of prospective home purchases and concentrate on a property's potential for land appreciation. This requires overlooking the most attractive houses in a target location and concentrating on those that provide opportunities for improvement, which may enhance the value of the land. Investors may track appreciation by visiting the Federal Housing Finance Agency (FHFA).