If the earning capability of a building should, for any cause, fall below the point where the return upon the invested value is less than market rate, then the only means of rehabilitation of the impaired capital, or provision of security for the investment of further capital in reconstruction or alteration, is to be found in some increase or appreciation in value of the site, or what is commonly referred to as the "unearned" increment of land value.
This is the commonly stated and usually assumed remedy for any anticipation of a decrease in its earning ability, and it is a usually accepted excuse for evading the necessity for a provision in advance for the gradual aging of the structure.
As a solution of either anticipation it is wrong in principle and uncertain in effect.
The rate of appreciation in value of any land is affected by a variety of exterior conditions, but there is always a probability that the same conditions which adversely affect the building may similarly affect the land, while, on the other hand, those that beneficially affect the demand for the land may be adverse to the conditions of the building upon it.
An assumed appreciation is not always realizable as an actual asset, and the most that can be made of it may be to borrow upon its security.
Appreciation of the land may not be realizable unless the building be first removed and a different improvement erected.
The rate at which appreciation proceeds is not independent of other property in the same locality. One site cannot be unduly forced forward in the march of enhancement, in face of the competition of others. The investment of disproportionate capital in an improvement, in the expectation of thereby establishing an enhanced capitalized value of the site, is unsound practice, equivalent to placing gold upon a piece of land in order to increase the value of the combination.
If there be a real appreciation it will be due to a legitimate demand for such a site, or for occupancy of a building upon it. Such a demand will naturally and properly take the form of a higher rate of rental, which will return upon the building and the increased value of the land the established rate of interest.
As has been already pointed out, the appreciation must either be established or capitalized by a commensurate return from the building, or it becomes unproductive, and if interest upon its realizable value be considered, it may become stagnated or discounted to a loss. "Unearned increment" is a favorite phrase with those who have made little study of real estate conditions, but it is often far more correctly to be described as "unearning increment," bringing only an increasing burden of taxation.
The rate at which increment proceeds is usually paralleled by the accumulation of interest charges upon the realizable value and of taxes and assessment, the earning power of which is nil.
If such matters be considered it will be found that some of the large apparent increments in land long held in one possession really represent nothing but past outgoings or the loss of interest on a lesser value which might have been realized at some opportune period of demand for that property.
Take, for instance, a series of figures of values of a plot of land in the Bronx which were published in 1909 by Mr. J. Clarence Davies, which are plotted in Fig. 3. The purchaser of this plot in 1892 could have sold it the following year for a profit of 25%, but thereafter the interest upon that value, and the taxation, kept equal pace with the selling value, so that a sale at a market price during the succeeding eight years would have yielded practically no further profit.
Fig. 3. Increase in Value of lot sold at auction in 1892 showing interest and Taxation on increasing Value over and above the first selling value after purchase.
The general development and improvement of the locality, which began at the end of the eighth year, rapidly advanced the value, but it must be assumed that it also brought with it a parallel advance in taxation, as well as the payment of assessments.
The advance in value continued for five years, and reached the highest point of profit in fourteen years from the original purchase; but there the advance in value ceased, a result due to the settlement of its capitalized value, in company with others, by the development of improvements erected in the vicinity.
The owner or the purchaser who continued to hold such a property at this price without improvement would find that at the end of ten years the ostensible profit would have entirely disappeared in interest charges and taxation, or at an earlier date if assessments should have to be met.
If a commensurate improvement should have been made upon the land at the period of highest profit, then the value of the land would have been established and carried along, relieved by the earnings of the building of the deductions for interest and taxation.
But since the new capital embarked in the building must be released if that building should become ineffective by age or other causes, a new fund must be established to meet this contingency, which the land may not provide and which should therefore be derived from some part of the earnings of the structure.
It must be conceded that the annual setting aside of a proportionate percentage of the value of a building is likely in many cases to be a heavy charge upon net income. Thus, on a property returning a net 5%, the building being two thirds of the whole, the setting aside of a sufficient sum to cover thirty years of life at 4% compound interest involves a reduction of the return upon the investment of 1.068%, reducing a 5% investment to a 4% basis.