Highest and Best Use: Nonconforming, Interim, and Mixed Uses

Chapter Title: Highest and Best Use: Nonconforming, Interim, and Mixed Uses

Introduction:

This chapter delves into the complexities of highest and best use (HBU) analysis when dealing with properties exhibiting nonconforming, interim, or mixed uses. Understanding these scenarios is crucial for accurate real estate appraisal. We’ll explore the legal, economic, and practical considerations involved in determining the HBU under these circumstances.

1. Legally Nonconforming Uses

1.1 Definition and Origins:

A legally nonconforming use is a use that was lawfully established and maintained but no longer conforms to the current zoning regulations. This situation arises primarily from two causes:

• Governmental Action: Eminent domain (partial takings), or changes in zoning ordinances.
• Zoning Changes: An existing use that met the zoning requirements at the time of establishment, but no longer conforms due to subsequent changes in zoning laws (e.g., minimum lot size increases).

It is important to remember that a nonconforming use that is allowed to continue is not illegal. An illegal use is one that was never permitted in the first place, or that violates current zoning or other regulations.

1.2 Legal Framework and Restrictions:

• Zoning Ordinances: Most jurisdictions have specific sections within their zoning ordinances that address nonconforming uses. These ordinances typically permit the continuation of the nonconforming use but often restrict:

  • Expansion: Expanding the size or scope of the nonconforming use.
  • Major Alterations: Making significant structural changes to the improvements supporting the nonconforming use.
  • Rebuilding: In many jurisdictions, if the improvements are destroyed (e.g., by fire), they cannot be rebuilt as a nonconforming use. Some areas permit rebuilding to the prior intensity, given no increased negative impact on the surrounding area.

• Amortization: Some jurisdictions specify a timeframe for phasing out nonconforming uses.

• Abandonment: If a nonconforming use is abandoned for a statutory period, it may not be re-established.

1.3 Variances:

• Area Variance (Less Commonly “Use Variance”): A variance may be granted when strict application of zoning codes would deprive a property owner of privileges commonly held by other properties in the same zone, due to special circumstances specific to the property.

• Transferability: It is critical to determine if a variance is specific to the current owner and use, or if it transfers with the property. A non-transferable variance becomes invalid upon property transfer.

1.4 Valuation Implications of Nonconforming Uses:

• Sales Comparison Approach:

  • Higher Income Potential: The nonconforming use may generate higher income than a conforming use would.
  • Risk Assessment: Consider the risk associated with the nonconformity. If the improvements cannot be rebuilt, the income stream is less secure.
  • Comparable Selection: Select comparable properties carefully. Ideally, use comparable sales of properties with similar nonconforming uses. Adjustments are necessary if comparable sales are conforming.

• Income Capitalization Approach:

  • Capitalization Rate Adjustment: Increase capitalization or discount rates to reflect the increased risk associated with the nonconforming use (e.g., risk of not being able to rebuild).

• Cost Approach:

  • Any incremental value associated with the nonconforming use is attributed to the improvements, not the land. This is because the improvements are what enable the higher-value nonconforming use. If the improvements could be rebuilt, the increment would be attributed to the land.

• Zoning and Market Demand: A change in zoning does not automatically increase property value. Market demand for the new zoning must exist. The current nonconforming use may generate more income than a conforming use would.

1.5 Mathematical Considerations:

* **Income Capitalization:**
    * *V = I / R*
    * Where:
        * *V* = Value
        * *I* = Net Operating Income (NOI)
        * *R* = Capitalization Rate

    An increase in the risk associated with the nonconforming use would increase *R*, leading to a lower *V*.

* **Discounted Cash Flow (DCF) Analysis:**  DCF can be used to analyze the potential income stream from the nonconforming use versus the potential income stream from a conforming use, considering the risks associated with each.
    * *PV = Σ [CFt / (1 + r)^t]*
    * Where:
        * *PV* = Present Value
        * *CFt* = Cash Flow in period *t*
        * *r* = Discount Rate
        * *t* = Time period

    A higher discount rate *r* would be applied to the cash flows of the nonconforming use if it is perceived as riskier.

1.6 Practical Application & Experiment:

* **Scenario:**  A property with a legally nonconforming commercial use in a residentially zoned area. The building is old and needs significant repairs.

* **Experiment:**
    1. **Market Research:** Conduct a survey of potential tenants for both the existing commercial use and potential residential uses (if the property were brought into conformance).
    2. **Financial Modeling:** Create pro forma income statements for both the nonconforming commercial use (with necessary repairs) and a conforming residential redevelopment.  Project cash flows over a 10-year period.
    3. **Sensitivity Analysis:**  Vary key assumptions, such as rental rates, vacancy rates, and discount rates, to assess the impact on the present value of each option. Include a sensitivity analysis for increased costs that might be required to meet current environmental regulations, which may not have been a requirement when the nonconforming use was established.
    4. **Highest and Best Use Conclusion:**  Based on the financial modeling and market research, determine which use (nonconforming commercial or conforming residential) yields the highest present value, considering the associated risks.

2. Interim Uses

2.1 Definition and Characteristics:

An interim use is a temporary use of a property until a more profitable or suitable use becomes financially feasible. The current use of the property is considered an interim use because it is not the most productive and profitable use of the property.

2.2 Triggers for Interim Uses:

• Delayed Development: Legal or financial reasons may delay the implementation of the optimal use. This might include zoning restrictions, environmental remediation requirements, or lack of financing.
• Market Conditions: The market may not yet be ready for the ultimate use. This could be due to insufficient demand, oversupply, or unfavorable economic conditions. For example, a property may be used for parking until the surrounding area develops sufficiently to support a high-rise office building.

2.3 Valuation Implications:

• Dual Highest and Best Use: The HBU analysis must consider both the interim use and the future use.
• Contribution to Value: The interim use contributes value to the extent that it generates income or defrays carrying costs (e.g., property taxes).
• Negative Contribution: If the interim improvements do not generate enough revenue to cover operating expenses and demolition costs, they may detract from the overall property value. In such cases, the value of the property as improved may be less than the land as though vacant.

2.4 Forecasting Feasibility:

• Market Analysis: A thorough market analysis is essential to forecast when the ultimate use will become financially feasible. This includes analyzing supply and demand, market rents, and development costs.
• Residual Demand Analysis: This analysis helps determine when market rents will reach the level necessary to justify new construction (feasibility rent).
• Discounted Cash Flow Analysis: Compare the potential returns of the interim use and the ultimate use using DCF analysis.

2.5 Mathematical Considerations:

* **Feasibility Rent Calculation:**

   * *Feasibility Rent = (Operating Expenses + Debt Service + Required Return on Investment) / Rentable Area*

   This formula estimates the minimum rent required to make a development project financially viable.
* **Present Value of Interim Income Stream:**
   *  Calculate the present value of the income generated by the interim use during the period before the ultimate use is implemented.
* **Land Value Appreciation:**
   * Forecast the future land value at the time when the ultimate use is expected to be implemented. This forecast will need to account for anticipated growth in demand, and the time value of money (discount rate).
* **Optimal Timing:**  The decision to transition from the interim use to the ultimate use should be based on maximizing the present value of the combined income streams.

2.6 Practical Application & Experiment:

* **Scenario:** Vacant land in a rapidly growing suburban area, currently zoned for agricultural use, but expected to be rezoned for commercial development within 5-7 years.

* **Experiment:**
    1. **Interim Use Options:** Explore potential interim uses, such as a Christmas tree farm, a pumpkin patch, or leased grazing land for cattle.
    2. **Cost-Benefit Analysis:**  Evaluate the costs associated with establishing each interim use (e.g., planting, fencing, irrigation) and the potential income they can generate. Consider any remediation costs that might be needed to prepare for the future use.
    3. **Discounted Cash Flow:** Calculate the present value of the income streams from each interim use option.
    4. **Land Value Projection:**  Project the land value at the expected rezoning date, considering market trends and comparable land sales.
    5. **Decision:** Select the interim use that maximizes the overall present value of the property, considering both the interim income and the future land value.

3. Mixed Uses

3.1 Definition and Types:

Mixed-use properties involve more than one distinct use on the same parcel of land or within the same building. Examples include:

• Horizontal Mixed-Use: Different uses on different portions of the same land parcel (e.g., a shopping center in front of residential housing).
• Vertical Mixed-Use: Different uses within the same building (e.g., retail on the ground floor and offices or apartments above).

3.2 Highest and Best Use Analysis for Mixed-Use Properties:

• Individual Component Analysis: Analyze the HBU of each component of the mixed-use property separately. This involves conducting market studies, feasibility analyses, and financial modeling for each use.
• Contributory Value: Determine the contributory value of each use to the overall property value. The contributory value reflects each use’s market demand, income potential, and expenses.
• Synergy and Interdependence: Consider the potential synergies between the different uses. For instance, retail shops may benefit from the foot traffic generated by the residential component. There could also be adverse impacts, such as increased traffic that impacts residential tenants.
• Marketability Analysis: Repeat marketability analysis for each use, to determine the timing and economic contribution of each use, and determine the optimal mix of uses for the property.

3.3 Valuation Techniques:

• Allocation of Value: Allocate the overall property value among the different uses based on their contributory values.
• Income Capitalization: Develop separate income statements and capitalization rates for each use.
• Sales Comparison: Identify comparable sales of similar mixed-use properties and adjust for differences in use mix, location, and other factors.
• Cost Approach: This approach is more challenging for mixed-use properties as it requires estimating the cost of each component separately and then summing the values.

3.4 Mathematical Considerations:

* **Weighted Average Capitalization Rate:**  If using the income capitalization approach, calculate a weighted average capitalization rate based on the relative income contribution of each use.

   * *R_weighted = (I_1 / I_total) * R_1 + (I_2 / I_total) * R_2 + ... + (I_n / I_total) * R_n*

   Where:
       * *R_weighted* = Weighted average capitalization rate
       * *I_i* = Net Operating Income for use *i*
       * *I_total* = Total Net Operating Income for the property
       * *R_i* = Capitalization rate for use *i*
* **Gross Rent Multiplier (GRM):** Calculate a blended Gross Rent Multiplier based on the rents from each use.

3.5 Practical Application & Experiment:

* **Scenario:** A mixed-use building with retail on the ground floor and apartments above.

* **Experiment:**
    1. **Market Segmentation:** Conduct separate market studies for the retail and residential components.
    2. **Income Projections:** Develop separate income statements for the retail and residential units, estimating rental rates, vacancy rates, and operating expenses.
    3. **Capitalization Rate Analysis:** Research capitalization rates for comparable retail and residential properties in the area.
    4. **Valuation:** Value each component separately using the income capitalization approach. Sum the values to arrive at an overall property value.

Conclusion:

Determining the highest and best use of properties with nonconforming, interim, or mixed uses requires a thorough understanding of legal regulations, market dynamics, and valuation principles. Appraisers must carefully analyze the unique characteristics of each property, consider the risks and opportunities associated with each use, and apply appropriate valuation techniques to arrive at a credible opinion of value.