Many first-time homeowners and experienced real estate investors seem to focus on the functionality and style of their proposed purchases, expecting these characteristics to lead to increased property value. Many fail to remember the slogan of the real estate industry — location, location, location — when trying to find the property that will lead to the greatest investment performance.

The reality is that the physical structure actually depreciates over time. It is the land underneath the structure that appreciates in value. This is a significant distinction, considering that the purchase of a home is the single greatest investment that most retail investors will make in their lifetimes. Failing to look at one’s home as an investment and understand the drivers of value, or concentrating on functionality and accommodation, can limit the property’s overall performance and opportunities to maximize wealth. (To go beyond just buying a home and learn how real estate can make you a profit, read Investing In Real Estate .)

Land as an Appreciating Asset

Making the distinction between the improved portion of a property and the land on which it sits may seem trivial. But it is not until the real estate investor focuses on these differences that it becomes easier to find more efficient investments that provide the highest return for the amount of risk or capital invested. Because property prices are a function of local supply and demand. the appearance, functionality and maintenance of the physical structure will certainly impact value, but these factors have less impact than one may think. Understanding how location and the future prospects of land values influence property returns allows investors to make better choices between competing assets. (To learn more, read Five Things Every Real Estate Investor Should Know .)

The reason that land is an appreciating asset is a simple one. It is in limited supply, and no one is producing any more. The demand for land is constantly growing as the population increases, and since its supply is limited, its price must increase over time. Unless something happens to limit demand for a given area or make it unusable, the grounds should be expected to increase in value over time. (For related reading, see Economics Basics: Demand And Supply and Profit With Real Estate Land Speculation .)

The question is how much the land will appreciate and how much the improvements will enhance or degrade overall value. The physical structure on a property is a depreciating asset. As it ages, it requires capital infusions for maintenance, updating to stem functional obsolescence and, depending on its design, updating to prevent it from falling out of style. Even the Internal Revenue Service (IRS) acknowledges this fact by allowing depreciation of the physical structure for tax obligations. The land underneath the structure, however, is not depreciated. (To find out which home improvements are worthwhile and which are a waste of money, read Add Value To Real Estate Investments and Do-It-Yourself Projects To Boost Home Value .)

The degree of depreciation or physical obsolescence will be specific to each property, but it is fair to say that if left alone, a property will continue to lose value until it no longer adds value to the land, or even reduces its value. Some land parcels with inferior structures, as compared to the surrounding properties, will actually be worth more unimproved. Owners will often raze the physical structure in order to maximize the value of the parcel. So why are advisors always suggesting that property owners commit capital to update their homes? The reason is to counteract some or all of the depreciation that is slowly reducing the value of the structure. Experienced real estate investors realize that this asset class is capital intensive, requiring periodic capital input to maximize value. (Learn how to calculate how much your property will need to appreciate to cover the costs of owning it in Will You Break Even On Your Home? )

Implications for Investment

Once an investor understands the impact of land value on total appreciation, the market’s mantra of location, location, location makes more sense. The implication is that home buyers have to look past the physical attributes of the home and focus how its location in the market will affect overall return. This is extremely difficult for home buyers who expect to live in their homes for an extended period of time. However, even the most lackluster of purchases can be improved over time and create significant wealth if located in an area of high demand. The following are some considerations for new home buyers to consider:

• Smaller or less attractive homes can provide greater investment returns.

To understand this point, envision two functionally sound houses on equal land parcels in the same neighborhood, one valued near the maximum for houses in that neighborhood and another trading at half that price. Since local supply and demand factors drive land values, houses in a neighborhood tend to appreciate by approximately the same amount per year. If the more expensive house appreciates by 10% (not including any specific improvement or capital projects), this would be equivalent to a 20% return for the other — a much more efficient use of investment capital.

• Locations within neighborhoods will affect land values.

Locations, such as cul-de-sacs, due their constraint on traffic and implied safety for children, are usually in higher demand than houses on more frequently used roadways.

The appreciation of land values underscores the importance of choosing between neighborhoods. Most middle- and upper-class, single-family-home neighborhoods already limit new construction when developers purchase most of the available land to construct residential neighborhoods and subdivisions. Because of this, most neighborhoods evolve their own social, cultural and demographic characteristics that impact demand for houses there.

• The average age of neighbors can provide clues to appreciation.

Many investors do not consider this when selecting locations. New home buyers with small children will often avoid locations with older homeowners that will not provide playmates for their children. Also, most homeowners are aware of the influence that specific public schools have on the demand for homes in that particular school district. Since homes in the area are not homogeneous, the appreciation is all due to location and the value of land.

• Future development can change your property’s value for better or for worse.

Homeowners must be cognizant not only of the present state of local amenities, but also the future prospects for commercial and governmental development in the area. Government plans concerning schools, hospitals, traffic patterns and other public infrastructure will have as much influence on land values as present and future development of commercial amenities in a particular locale. (For related reading, see Five Mistakes Real Estate Investors Should Avoid .)

Single-family property investors must factor into their purchase offers the potential effect of vacant or developable land on future supply and home prices. This is a continual risk borne by purchasers of condominiums. Condo prices are affected by the same demand factors as single-family homes and the appreciation of the land that their building is on.

A unique issue for condo owners is supply. Unlike most single-family homes, which are built in infill locations, a significant number of condos can be built on small parcels of land and in short periods of time, increasing supply and potentially driving down prices. It is difficult for condo owners to gauge the potential for new development and land values, since multi-unit structures and high rises can easily be built on parcels that were initially home to other types of residential or commercial real estate. (For further reading on the problems facing condo owners, read Buying A Condo .)

Look Beyond Style

The successful real estate investor learns to look beyond style and the physical attributes of prospective purchases and concentrates on the potential for land appreciation. This requires overlooking the most attractive houses in a target location and concentrating on those that provide opportunities for improvement that will enhance the value of the land. Understanding land values will change the investment view of the under-maintained ranch house from unattractive to money maker. Investors interested in tracking appreciation should visit the site of the Office of Federal Housing Enterprise Oversight. which allows you to check the housing appreciation in your area.

Price appreciation is the biggest factor, but it’s not the only thing to consider — learn more in Measuring The Benefits Of Home Ownership .