Chapter: An Appraiser is Using the Sales Comparison Approach to Estimate the Value of a Property. What is the Most Important Factor the Appraiser Should Consider When Selecting Comparable Properties?

Core Principle: Highest and Best Use

The most critical factor in selecting comparable properties within the sales comparison approach is ensuring they share a similar Highest and Best Use (HABU) as the subject property. HABU represents the reasonably probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. Selecting comparables with a dissimilar HABU introduces fundamental flaws in the valuation process.

I. Understanding Highest and Best Use

• Definition: HABU is not simply the current use, but the optimal use. It dictates the type of buyer a property attracts and thus, comparable sales data must reflect this.

• Four Tests of HABU:

  1. Legally Permissible: The use must comply with all applicable zoning ordinances, building codes, environmental regulations, and other legal restrictions.
  2. Physically Possible: The site’s size, shape, topography, soil conditions, and other physical characteristics must be suitable for the proposed use.
  3. Financially Feasible: The use must generate sufficient income or return to justify the costs of development and operation.
  4. Maximally Productive: Among the feasible uses, the one that maximizes the property’s value. This translates to the most significant present value of future benefits (income, resale value, etc.).

• Impact on Valuation: Mismatched HABU introduces systematic bias. For instance, comparing a property zoned for high-density residential to one zoned for agricultural use yields unreliable results.

II. Why HABU is Paramount in Comparable Selection

Comparable properties serve as benchmarks, providing market-derived indications of value. If the benchmark reflects a different underlying economic driver (HABU), the comparison is invalid. The following illustrates the core issues.

• Market Segmentation: Different HABUs attract different market participants. A property suited for industrial use will be valued by investors with different risk tolerances and return expectations than a property suited for residential development.

• Value Drivers: The attributes that contribute to value vary based on HABU. For residential properties, square footage, number of bedrooms, and proximity to schools are crucial. For commercial properties, factors like traffic counts, visibility, and lease terms become dominant.

• Example: Consider a vacant lot. Its HABU could be:

  1. Single-family residential
  2. Multi-family residential (if zoning allows)
  3. Commercial (if zoning allows)

  If the subject property’s HABU is single-family residential, the appraiser must prioritize comparable sales of vacant lots also suited for single-family residential, even if multi-family or commercial sales are more recent or physically closer.

III. Practical Applications and Related Investigations

• Zoning Analysis: A meticulous zoning analysis is essential. The appraiser must verify permitted uses, setbacks, height restrictions, and other zoning regulations. This analysis dictates the “legally permissible” test of HABU.

• Market Research: Comprehensive market research is vital. This involves analyzing demand and supply for various property types within the subject property’s market area. This helps determine the “financially feasible” and “maximally productive” tests of HABU.

• Site Analysis: A detailed site analysis is necessary to determine the “physically possible” test of HABU. Consider soil conditions, topography, environmental factors, and utility access.

• Sensitivity Analysis: To understand the influence of different HABUs, appraisers use sensitivity analysis. This involves modeling the impact of various potential uses on the property’s value. For instance, discounted cash flow (DCF) analysis can be used to project income streams for different uses and calculate their present value.

  • Formula for Present Value (PV):

    PV = CF / (1 + r)^n

    Where:

    • PV = Present Value
    • CF = Cash Flow in period n
    • r = Discount rate (reflecting risk)
    • n = Number of periods
    • Empirical Studies: Real estate economics provides evidence demonstrating the impact of zoning and land use restrictions on property values. Studies using hedonic pricing models (regressing property prices against various characteristics) often include zoning variables to quantify their effect. The coefficient on the zoning variable represents the marginal impact of that zoning designation on property value.

  • General form of a Hedonic Pricing Model:

    P = β0 + β1X1 + β2X2 + ... + βnXn + ε

    Where:

    • P = Property Price
    • βi = Coefficient representing the marginal impact of variable Xi on price
    • Xi = Property characteristic (e.g., square footage, number of bedrooms, zoning)
    • ε = Error term

IV. Discoveries and Breakthroughs

• Land Use Economics: The development of land use economics has revolutionized appraisal practices. Economists like William Alonso and Richard Muth formalized models explaining urban land rent and land use patterns, providing a theoretical foundation for understanding HABU.

• GIS Technology: Geographic Information Systems (GIS) have transformed site analysis. GIS allows appraisers to overlay zoning maps, flood zone maps, environmental data, and other relevant information, facilitating a more accurate assessment of HABU.

• Automated Valuation Models (AVMs): While AVMs can provide preliminary value indications, they are often limited in their ability to accurately assess HABU. A skilled appraiser is needed to validate AVM outputs and make necessary adjustments based on a thorough HABU analysis. AVMs rely on statistical analysis of past sales. If the data contains properties with different HABUs, the results are questionable.

V. Conclusion

While factors like proximity, date of sale, and physical similarity are important in comparable selection, they are secondary to ensuring a shared Highest and Best Use. A comparable sale that deviates in HABU introduces a fundamental flaw that compromises the integrity of the valuation. Thorough zoning analysis, market research, and site investigation are crucial steps in determining HABU and selecting appropriate comparables.