Site Valuation Adjustments and Methods

Chapter 6: Site Valuation Adjustments and Methods

This chapter delves into the crucial aspect of site valuation, providing a comprehensive understanding of various adjustment techniques and valuation methods essential for accurate property appraisal. We will explore the scientific principles underlying these methods and their practical application in real-world scenarios.

I. sales comparison❓ Adjustments

The Sales Comparison Approach relies heavily on analyzing comparable sales data. However, no two properties are exactly alike. Adjustments are necessary to reconcile the differences between comparable sales and the subject property, thereby deriving a reliable indication of the subject’s value. The fundamental principle is that every adjustment is applied to the comparable property’s sale price, not the subject.

• Theoretical Basis: The concept of substitution is paramount. A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. Adjustments quantify the price difference a rational buyer would demand (or concede) due to specific differences.

• Types of Adjustments:

  1. Property Rights: Adjust for differences in the bundle of rights conveyed (e.g., fee simple vs. leased fee).
  2. Financing Terms: Adjust for non-market financing that may have influenced the comparable’s sale price. This includes items such as below-market interest rates or seller-paid points.
  3. Conditions of Sale: Account for motivations influencing the transaction (e.g., a forced sale due to foreclosure may result in a lower price).
  4. Market Conditions (Time): Adjust for changes in the market between the date of the comparable sale and the date of the appraisal. This accounts for appreciation or depreciation in market value.
  5. Location: Adjust for locational advantages or disadvantages (e.g., proximity to amenities, traffic noise, school district).
  6. Physical Characteristics: Adjust for differences in site size, shape, topography, views, and other physical attributes.
  7. Economic Characteristics: Adjustments for income production, operating expenses, and other income-related features.

• Direction of Adjustment:

  • If the comparable is superior to the subject, the comparable’s price is adjusted downward (a negative adjustment).
  • If the comparable is inferior to the subject, the comparable’s price is adjusted upward (a positive adjustment).

  Example: A comparable lot sold for $100,000. It has a superior view worth $10,000 more than the subject lot. The adjusted sale price of the comparable is:

  $100,000 (Comparable Sale Price) - $10,000 (View Adjustment) = $90,000

  The indicated value of the subject lot is $90,000.

• Magnitude of Adjustments: Determining the appropriate size of the adjustment is crucial. This often relies on paired sales analysis, cost analysis, or statistical analysis of market data.

  • Paired Sales Analysis: Identifying two comparable sales that are identical except for one key difference. The price difference between these sales provides an indication of the value of that difference.
  • Cost Analysis: Estimating the cost to cure a deficiency or the cost to add a feature to the subject property.

  • Regression Analysis: A statistical method used to isolate the impact of a specific variable (e.g., lot size) on sale price. This can be done using simple linear regression (SLR) or multiple regression (MLR), but it requires a large dataset.

    For simple linear regression, the model is represented as:

    Y = a + bX

    Where:

    • Y is the dependent variable (e.g., sale price)
    • X is the independent variable (e.g., lot size)
    • a is the intercept
    • b is the slope, representing the change in Y for each unit change in X. This is the adjustment amount.

• Dollar vs. Percentage Adjustments: Adjustments can be expressed as dollar amounts or percentages of the comparable’s sale price. Both methods are valid, and the choice often depends on the market data available and the appraiser’s judgment.

  Example: A comparable lot sold for $50,000. Market data suggests the subject lot is worth 5% less due to its location. The adjustment is:

  Adjustment = 5% of $50,000 = 0.05 * $50,000 = $2,500

  Adjusted Sale Price = $50,000 - $2,500 = $47,500

• Order of Adjustments: The sequence in which adjustments are applied can significantly impact the final adjusted sale price, especially when using percentage adjustments. A general guideline is to prioritize adjustments that address the transaction itself (e.g., property rights, financing, conditions of sale, and market conditions) before adjustments related to the property’s characteristics (e.g., location and physical characteristics).

  Example:
  Comparable Sale Price: $150,000
  Financing Concessions: -5%
  Superior Location of Subject: +$8,000

  • Scenario 1: Financing First

    • Financing Adjustment: $150,000 * 0.05 = $7,500
    • Adjusted Price: $150,000 - $7,500 = $142,500
    • Location Adjustment: $142,500 + $8,000 = $150,500

  • Scenario 2: Location First

    • Location Adjustment: $150,000 + $8,000 = $158,000
    • Financing Adjustment: $158,000 * 0.05 = $7,900
    • Adjusted Price: $158,000 - $7,900 = $150,100

  As shown, the order of adjustments results in different indicated values. The appraiser’s market analysis should dictate the most appropriate sequence.

II. Allocation Method

The Allocation Method estimates land value by assuming a typical ratio between land value and total property value within a specific market segment.

• Theoretical Basis: This method is based on the principle of contribution. The land contributes a certain percentage to the overall❓ value of the improved property. The ratio is derived from analyzing similar properties and estimating the typical land-to-building value relationship.

• Formula:

  Land Value = Total Property Value * Allocation Percentage

• Application:

  1. Determine the total property value, typically through the Sales Comparison Approach applied to improved comparable properties.
  2. Research and establish the typical land-to-building value ratio for the relevant property type (e.g., residential, commercial).
  3. Calculate the allocation percentage based on the ratio. For example, a 3:1 building-to-land ratio implies a 25% allocation to land (1 / (3 + 1)).
  4. Multiply the total property value by the allocation percentage to estimate land value.

  Example: A property is valued at $500,000. The typical building-to-land ratio in the area is 4:1.

  Allocation Percentage = 1 / (4 + 1) = 0.20 (20%)

  Land Value = $500,000 * 0.20 = $100,000

• Limitations:

  • Reliance on Market Data: Accurate ratios depend on reliable market data. Obtaining representative ratios can be difficult, especially in heterogeneous markets.
  • Inherent Inaccuracy: Allocation percentages are averages and do not account for specific variations in improvement quality, size, or functionality on individual properties.
  • Not a Primary Method: This method is generally considered a secondary approach, used to support or check the results obtained through more direct methods like the Sales Comparison Approach.

III. Extraction Method

The Extraction Method estimates land value by subtracting the depreciated cost of improvements from the total property value. It’s essentially the Cost Approach in reverse.

• Theoretical Basis: Based on the principle of contribution and the idea that the total property value represents the sum of the value of the land and the value of the improvements.

• Formula:

  Land Value = Total Property Value - Depreciated Cost of Improvements

• Application:

  1. Determine the total property value using the Sales Comparison Approach applied to improved comparable properties.

  2. Estimate the depreciated cost of the improvements. This involves estimating the cost of replacing the improvements new and then deducting accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence). (Refer to the Cost Approach chapter).

     • Cost New: Cost New = Area x Cost Per Area Unit

     • Accrued Depreciation: Accrued Depreciation = Physical Deterioration + Functional Obsolescence + External Obsolescence

     • **Depreciated Cost = Cost New - Accrued Depreciation`

  3. Subtract the depreciated cost from the total property value to arrive at the estimated land value.

  Example: A comparable property sold for $800,000. The depreciated cost of the improvements is estimated at $300,000.

  Land Value = $800,000 - $300,000 = $500,000

• Reliability Considerations: The Extraction Method is most reliable when:

  1. The depreciated cost of improvements can be reliably estimated.
  2. The value of the improvements is relatively small compared to the total property value (e.g., in areas with high land values and older, less valuable buildings). This minimizes the impact of potential errors in estimating depreciation.

IV. Development Method (Subdivision Analysis)

The Development Method, also known as subdivision analysis, estimates the value of raw land suitable for subdivision and development by projecting future cash flows from the sale of finished lots and discounting those cash flows back to a present value.

• Theoretical Basis: Based on the principle of anticipation. The value of the land is based on the present value of the future income stream it is expected to generate through development and sale. It utilizes discounted cash flow (DCF) analysis.

• Process:

  1. Highest and Best Use Analysis: Determine the most profitable and legally permissible use for the land (e.g., single-family residential subdivision, commercial development).
  2. Development Plan: Create a detailed development plan, including the number of lots, lot sizes, infrastructure requirements (roads, utilities), and amenities.
  3. Market Study: Conduct a market study to project sales prices for finished lots, considering factors such as market demand, competition, and absorption rates (the rate at which lots are expected to be sold).
  4. Cost Estimates: Estimate all development costs, including:
     • Site preparation (grading, clearing)
     • Infrastructure installation (roads, utilities)
     • Marketing and sales expenses
     • Legal and administrative fees
     • Taxes
     • Financing costs
     • Developer’s profit

  5. Cash Flow Projection: Project annual cash flows, considering revenues from lot sales and expenses associated with development.

     Net Cash Flow (Year i) = (Number of Lots Sold (Year i) * Sale Price per Lot) - Development Costs (Year i) - Operating Expenses (Year i)

  6. Discount Rate Selection: Choose an appropriate discount rate that reflects the risk and opportunity cost associated with the development project. The discount rate should be based on market data and consider the investor’s required rate of return.

  7. Discounting: Discount each year’s net cash flow back to its present value using the selected discount rate.

     Present Value (Year i) = Net Cash Flow (Year i) / (1 + Discount Rate)^i

  8. Land Value Estimation: Sum the present values of all projected cash flows to arrive at the estimated land value.

     Land Value = Σ [Net Cash Flow (Year i) / (1 + Discount Rate)^i] from i = 1 to n (where n is the total number of years)

  Example: A developer plans to subdivide a 20-acre parcel into 10 residential lots. The projected sale price per lot is $200,000. Development costs are estimated at $50,000 per lot. The expected absorption rate is 2 lots per year. The discount rate is 10%.

  Simplified Cash Flow (Ignoring other costs like marketing, taxes, etc):

  • Year 1: Revenue ($400,000), Costs ($500,000), Net Cash Flow (-$100,000)
  • Year 2-5: Revenue ($400,000), Costs ($100,000), Net Cash Flow ($300,000)

  Present Value Calculation:

  • PV (Year 1) = -$100,000 / (1.10)^1 = -$90,909.09
  • PV (Year 2) = $300,000 / (1.10)^2 = $247,933.88
  • PV (Year 3) = $300,000 / (1.10)^3 = $225,394.44
  • PV (Year 4) = $300,000 / (1.10)^4 = $204,904.04
  • PV (Year 5) = $300,000 / (1.10)^5 = $186,276.40

  Land Value = -$90,909.09 + $247,933.88 + $225,394.44 + $204,904.04 + $186,276.40 = $773,599.67

• Challenges:

  • Complexity: The Development Method is complex and requires extensive market research, cost estimation, and financial analysis.
  • Sensitivity to Assumptions: The results are highly sensitive to the accuracy of the underlying assumptions (e.g., sale prices, absorption rates, discount rate).
  • Risk Assessment: Accurately assessing and incorporating risk into the discount rate is crucial.

V. Land Residual Method

The Land Residual Method isolates the income attributable to the land and capitalizes it to determine land value. It’s a variation of the income capitalization approach.

• Theoretical Basis: It relies on the income capitalization principle and the principle of surplus productivity. The land receives the residual income remaining after deducting a return on and of the building (improvements).

• Formulas:

  • V = I / R (Basic Income Capitalization Formula)
  • <a data-bs-toggle="modal" data-bs-target="#questionModal-385875" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">land income</span><span class="flag-trigger">❓</span></a> = Total Property Income - Building Income
  • Land Value = Land Income / Land Capitalization Rate

• Application:

  1. Determine Property’s Net Operating Income (NOI): This requires estimating the potential gross income (PGI) of the property, deducting vacancy and collection losses (VC), and then subtracting operating expenses (OE).

     NOI = PGI - VC - OE
     2. Estimate the Value of the Improvements: This can be based on the cost approach or other valuation methods.
     3. Determine the Building Capitalization Rate (R_b): This rate represents the return required on the building investment. It should be based on market data for similar properties.
     4. Calculate the Building Income (I_b): Multiply the value of the improvements by the building capitalization rate.

     I_b = Improvement Value * R_b
     5. Calculate Land Income (I_l): Subtract the building income from the total property NOI.

     I_l = NOI - I_b
     6. Determine the Land Capitalization Rate (R_l): This rate reflects the return required on the land investment. It may differ from the building capitalization rate due to differences in risk and liquidity.
     7. Calculate Land Value (V_l): Divide the land income by the land capitalization rate.

     V_l = I_l / R_l

  Example: A property generates a net operating income of $200,000. The value of the improvements is estimated at $1,000,000. The building capitalization rate is 10%. The land capitalization rate is 8%.

  • Building Income: $1,000,000 * 0.10 = $100,000
  • Land Income: $200,000 - $100,000 = $100,000
  • Land Value: $100,000 / 0.08 = $1,250,000

• Challenges:

  • Accuracy of Income Projections: Accurate income projections are critical.
  • Capitalization Rate Selection: Appropriate selection of building and land capitalization rates is crucial and requires careful market analysis.
  • Estimating Improvement Value: Estimating the value of the improvements accurately is necessary.

VI. Ground Rent Capitalization Method

The Ground Rent Capitalization Method values land based on the capitalized value of ground rent payments. Ground rent is the rent paid for the use of land under a ground lease.

• Theoretical Basis: Based on the income capitalization principle. The value of the land is equal to the present value of the future stream of ground rent payments.

• Formula:

  Land Value = Annual Ground Rent / Land Capitalization Rate

• Application:

  1. Determine the annual ground rent payment.
  2. Select an appropriate land capitalization rate based on market data for ground leases.
  3. Divide the annual ground rent by the capitalization rate to estimate land value.

  Example: A property is subject to a ground lease with an annual ground rent of $60,000. The appropriate land capitalization rate is 6%.

  Land Value = $60,000 / 0.06 = $1,000,000

• Complexities: The capitalization process becomes more complex if the ground lease includes:

  • Varying Rent Payments: The ground rent may increase over time according to a predetermined schedule or based on an index (e.g., CPI). DCF analysis is needed.

    Present Value = Σ [Ground Rent (Year i) / (1 + Discount Rate)^i]

  • Lease Term: Remaining lease term must be considered.

  • Reversionary Interest: At the end of the lease term, ownership of the improvements may revert to the landowner. This reversionary interest needs to be considered in the valuation if its value is substantial.

VII. Depth Tables

Depth tables are percentage tables used to estimate the relative value of different portions of a lot based on its depth. They reflect the principle that the front portion of a lot typically has higher value due to its greater accessibility and visibility.

• Theoretical Basis: Based on the principle of contribution. The front portion of the lot contributes more to the overall value due to its higher utility.

• Example: “4-3-2-1 Method”

  This is a simplified depth table:

  • First 1/4 of depth: 40% of value
  • Second 1/4 of depth: 30% of value
  • Third 1/4 of depth: 20% of value
  • Last 1/4 of depth: 10% of value

  Example: A lot is valued at $200,000. If the rear 25% of the lot is lost due to an easement, the value loss would be:

  Loss in Value = 10% of $200,000 = $20,000

• Limitations:

  • Oversimplification: Depth tables are a simplified tool and may not accurately reflect the specific characteristics of a particular property or market.
  • Does not consider the need for depth. Certain uses require more depth than others (e.g., industrial property).
  • Best as a rough estimate only. They are best used as a preliminary estimate, to give an idea of value differences in relation to depth.

Conclusion

Accurate site valuation is a cornerstone of sound appraisal practice. Mastering the adjustments techniques and valuation methods discussed in this chapter empowers appraisers to make informed judgments and provide reliable estimates of land value. Remember to consider the principles and limitations associated with each method, and always support your analysis with thorough market research and sound reasoning.