Ground Leases, Subdivision Analysis, and Comparative Valuation

Chapter 3: Ground Leases, Subdivision Analysis, and comparative valuation❓❓

3.1 Ground Leases and Valuation

3.1.1 Introduction to Ground Leases
A ground lease is a lease agreement in which the tenant leases land from the landlord. The tenant typically constructs and owns improvements on the land during the lease term. At the end of the lease term, ownership of the improvements may revert to the landowner, depending on the lease agreement terms.

3.1.2 Valuation of Ground Leases: The Income Capitalization Approach
The income capitalization approach is a primary method for valuing ground leases. It focuses on the present value of the expected income stream generated by the ground lease. The key is to accurately estimate the ground rent and select an appropriate capitalization rate.

3.1.2.1 Basic Formula
The fundamental formula is:

Site Value = Income to the Land / Land Capitalization Rate

or

V = IL / RL

Where:
* V = Site Value
* IL = Income to the Land (Ground Rent)
* RL = Land Capitalization Rate

Example: A 2-acre plot is leased for $3.00 per square foot, and the market-derived land capitalization rate is 6.0%.

1. Calculate the Land Area:
   Land Area = 2 acres * 43,560 sq.ft./acre = 87,120 sq.ft.
2. Calculate the Income to the Land:
   IL = $3.00/sq.ft. * 87,120 sq.ft. = $261,360
3. Calculate the Site Value:
   V = $261,360 / 0.06 = $4,356,000

3.1.2.2 Deriving the Land Capitalization Rate
The land capitalization rate (RL) is crucial. It reflects the risk associated with the income stream and the opportunity cost❓ of capital.

Methods for Deriving RL:

1. Market Extraction: Analyze sales of comparable leased land to extract the implied RL. This involves dividing the ground rent by the sale price of the leased fee interest.
2. Band of Investment: This technique considers the required returns of both the land and building components.
3. Surveys: Consult industry surveys (e.g., from real estate research firms) to obtain market data on land capitalization rates.

Mathematical Explanation of Band of Investment:

RL = (LVR * MR) + (BVR * RR)

Where:

RL = Land Capitalization Rate
LVR = Land Value Ratio (Land Value / Total Property Value)
MR = Mortgage Rate
BVR = building value ratio❓❓ (Building Value / Total Property Value)
RR = Required Return on Equity

3.1.2.3 Adjustments for Property Rights (Leased Fee vs. Fee Simple)
It is essential to recognize that capitalization rates derived from leased properties (leased fee) should be applied carefully. Applying a leased fee capitalization rate directly to the market rent of a property can result in a Leased Fee Value❓❓, not a fee simple value. A property rights adjustment may be needed.

• If the current rent and terms correspond to market rent and terms, only a property rights adjustment might be necessary.
• If the current rent deviates from market rent, the value estimate must be adjusted for this difference.

Formula for Property Rights Adjustment:

Adjusted Value = Indicated Leased Fee Value * (Fee Simple Value / Leased Fee Value)

Example: A leased fee sold for $1,300,000, and the same land unleased would be worth $1,000,000.

Property Rights Adjustment = (1 - ($1,000,000 / $1,300,000)) = -0.23 or -23%

3.1.2.4 Lease Terms and Escalation Clauses
Ground leases can have varying terms and escalation clauses that significantly impact the income stream.

• Fixed Rent: The rent remains constant throughout the lease term.
• Graduated Rent: The rent increases at predetermined intervals and amounts.
• Percentage Rent: The rent is a percentage of the tenant’s gross revenue.
• Indexed Rent: The rent is adjusted based on an economic index, such as the Consumer Price Index (CPI).

3.1.3 Practical Applications and Experiments

Experiment 1: Sensitivity Analysis of Capitalization Rates
Objective: To illustrate how changes in the land capitalization rate impact the estimated land value.

Method:

1. Assume a constant ground rent (IL).
2. Vary the land capitalization rate (RL) within a reasonable range (e.g., 5% to 7%).
3. Calculate the corresponding site value (V) for each RL.
4. Plot the results on a graph to visualize the sensitivity.

Expected Result: As the capitalization rate increases, the site value decreases, demonstrating the inverse relationship.

Experiment 2: Impact of Rent Escalation on Present Value
Objective: To demonstrate how rent escalation clauses affect the present value of the income stream.

Method:

1. Create two scenarios:
   • Scenario A: Fixed rent.
   • Scenario B: Rent escalates at 2% annually.
2. Discount both income streams to their present value using an appropriate discount rate.
3. Compare the present values.

Expected Result: The scenario with rent escalation will generally have a higher present value than the fixed rent scenario, provided the discount rate is appropriately considered.

3.2 Subdivision Analysis (Discounted Cash Flow Analysis)

3.2.1 Introduction to Subdivision Analysis
Subdivision analysis, also known as discounted cash flow (DCF) analysis, is a technique used to value land that is suitable for subdivision into smaller lots or parcels. This method projects future cash flows from the sale of the subdivided lots and discounts them back to present value.

3.2.2 Key Steps in Subdivision Analysis

1. Highest and Best Use Analysis: Determine the most profitable, legally permissible, and physically possible use for the land.

2. Subdivision Plan: Create a detailed subdivision plan, including the number, size, and configuration of lots, as well as the allocation of land for streets, utilities, and common areas.

3. Cost Estimation: Estimate all development costs, including:

   • Permitting and Entitlement Costs
   • Construction Costs (infrastructure, utilities, roads)
   • Marketing and Sales Expenses
   • Holding Costs (property taxes, insurance)
   • Administrative and Supervision Costs

4. Revenue Projection: Forecast the retail price of each lot and the anticipated sales volume (absorption rate) over time. market analysis❓❓ is critical here.

5. Discount Rate Selection: Choose a discount rate that reflects the risk associated with the development project. The Weighted Average Cost of Capital (WACC) is often used.

6. Cash Flow Projection: Develop a timeline of cash inflows (lot sales) and cash outflows (development costs) over the project’s life.

7. Discounting: Discount the net cash flow for each period back to the present value using the chosen discount rate.

8. Present Value Calculation: Sum the present values of all cash flows to arrive at the estimated land value.

3.2.3 Mathematical Formulation of Discounted Cash Flow

PV = ∑ (CFt / (1 + r)^t)

Where:
PV = Present Value of the Land
CFt = Net Cash Flow in Period t
r = Discount Rate
t = Time Period
∑ = Summation over all time periods

3.2.4 The Permitting, Construction, and Absorption Phases
Understanding the project lifecycle is critical for accurate cash flow forecasting.

1. Permitting Phase: This involves obtaining the necessary approvals and permits from local authorities. Costs include application fees, engineering studies, and legal expenses.

2. Construction Phase: This includes the physical development of the subdivision, such as grading, installation of utilities, and road construction.

3. Absorption Phase: This involves the sale of lots over time. The absorption rate is the number of lots sold per period (e.g., month, quarter, year). A well-supported market analysis is crucial for estimating the absorption rate.

3.2.5 Considerations for Market Analysis and Absorption Rates
Accurate market analysis is essential for a credible subdivision analysis. Factors to consider include:

• Demand: Population growth, employment trends, housing affordability.
• Supply: Existing and planned subdivisions, competition.
• Market Segmentation: Target market for the lots (e.g., first-time homebuyers, retirees).
• Absorption Rate: Historical sales data for comparable subdivisions.

3.2.6 Banking Regulations and DCF Analysis
Banking regulators often favor subdivision development analysis because it provides transparency into the valuation process. Lenders may require a DCF analysis for bulk lot holdings, especially during economic downturns.

3.2.7 Practical Application and Experimentation

Experiment 3: Sensitivity Analysis of Discount Rate and Absorption Rate
Objective: To illustrate how changes in the discount rate and absorption rate impact the estimated land value.

Method:

1. Create a base-case subdivision analysis with reasonable assumptions for costs, revenues, discount rate, and absorption rate.
2. Vary the discount rate and absorption rate independently within reasonable ranges (e.g., discount rate: 10% to 14%; absorption rate: +/- 20%).
3. Calculate the corresponding land value for each combination of discount rate and absorption rate.
4. Analyze the results to determine the sensitivity of the land value to these key variables.

Expected Result: The land value will be highly sensitive to both the discount rate and the absorption rate. Higher discount rates and lower absorption rates will result in lower land values.

3.3 Comparative Valuation (Sales Comparison Approach)

3.3.1 Introduction to Comparative Valuation
The sales comparison approach is a fundamental valuation technique that relies on analyzing recent sales of comparable properties❓ to estimate the value of the subject property.

3.3.2 The Principle of Substitution
The sales comparison approach is based on the principle of substitution, which states that a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.

3.3.3 Key Steps in the Sales Comparison Approach

1. Identify Comparable Sales: Gather data on recent sales of properties that are similar to the subject property in terms of location, physical characteristics, and use.

2. Verify Information: Confirm the accuracy of the sales data, including the sale price, date of sale, and terms of the transaction.

3. Select Relevant Elements of Comparison: Identify the key characteristics that affect value and differ between the comparable sales and the subject property. Common elements of comparison include:

   • Property Rights Conveyed
   • Financing Terms
   • Conditions of Sale
   • Market Conditions
   • Location
   • Physical Characteristics (size, shape, topography, improvements)

4. Make Adjustments: Adjust the sale prices of the comparable properties to account for the differences in the elements of comparison. Adjustments can be made in dollars or percentages.

5. Reconcile Adjusted Values: Analyze the adjusted sale prices of the comparable properties and arrive at a final value estimate for the subject property. This may involve weighting the comparables based on their similarity to the subject.

3.3.4 Types of Adjustments

1. Quantitative Adjustments: These are based on objective data, such as the cost of adding a feature to a property.

2. Qualitative Adjustments: These are based on subjective judgment and market analysis. They are often used when quantitative data is unavailable. Examples include relative comparisons (“superior,” “inferior,” “similar”).

3. Paired Data Analysis: A technique used to isolate the value impact of a single element of comparison by analyzing pairs of comparable sales that are identical except for that one element.

3.3.5 Mathematical Formulation of Adjustments

Adjusted Sale Price = Sale Price +/- Adjustments

Example:

• Comparable Sale Price: $500,000
• Adjustment for Location (Subject is in a superior location): +$20,000
• Adjustment for Size (Comparable is larger): -$10,000
• Adjusted Sale Price: $500,000 + $20,000 - $10,000 = $510,000

3.3.6 The Importance of Market Analysis
The sales comparison approach requires a thorough understanding of the local market. Factors to consider include:

• Supply and Demand
• Market Trends (price appreciation or depreciation)
• Economic Conditions
• Interest Rates
• Zoning Regulations

3.3.7 Practical Application and Experimentation

Experiment 4: Analyzing Comparable Sales Data
Objective: To practice applying adjustments in the sales comparison approach.

Method:

1. Gather data on at least three comparable sales for a hypothetical subject property.
2. Identify the key elements of comparison.
3. Develop a matrix to organize the data and adjustments.
4. Determine the appropriate adjustments for each comparable sale, justifying each adjustment with market data or reasoning.
5. Calculate the adjusted sale prices for each comparable.
6. Reconcile the adjusted values to arrive at a final value estimate for the subject property.

Expected Result: The adjusted sale prices of the comparable properties should converge around a reasonable range, providing support for the final value estimate.

3.4 Conclusion

This chapter has provided a detailed overview of ground leases, subdivision analysis, and comparative valuation. Understanding these techniques is essential for mastering land valuation. By applying the principles and methods discussed in this chapter, appraisers can develop credible and well-supported opinions of value for a wide range of land types and development scenarios.