This section is from the book "Practical Real Estate Methods For Broker, Operator & Owner", by Thirty Experts. Also available from Amazon: Practical Real Estate Methods for Broker, Operator, Owner.
As correct appraisal is necessarily the basis of expert testimony, I desire to call your attention to the fundamental principle of appraising, and that is capitalization. Capitalization is the basic principle of valuing real property. If the land be unimproved, it is a question of the value of the land and the character of the building that the neighborhood justifies, the cost of production, and the income the property will produce when adequately improved. If the property be improved, the first thing to be done in arriving at the value is to fix the value of the land and then capitalize the property on the basis of its rental value. The difference between the value of the land and the gross amount as capitalized from the rental will give you the value of the building. Assuming the land to be worth $25,000 and the building - a tenement - rents for $6,500, I would capitalize the property on a basis of 10%, or $65,000, and deducting $25,000 as the value of the land, leave the value of the building $40,000. Of course, when I make 10% the basis of calculation, I do not mean that this holds in all cases. It would depend on the character, kind and condition of the building, whether it were new or old, whether it were a loft building, a residence, office building or apartment house, its location and surroundings, and as to whether it was an adequate improvement or not.
While I have said that capitalization is the basic principle of valuing real property, I do not wish to be understood as saying that it is the only means of ascertaining values, but in my opinion it is the most accurate way. It is seldom that the structural cost of a building adds that amount to the market value of the land. In other words, the land value being fixed, what will a purchaser pay for the improvement? As an illustration that cost of construction will not add that amount to the value of the land, let us assume that a building similar to the Waldorf-Astoria be erected at the corner of Second Avenue and 34th Street instead of Fifth Avenue and 34th Street. It does not admit of discussion that the market value of the building would be very greatly reduced no matter what may have been the cost of construction.