• Adjustments and Methods for Site Valuation

    Adjustments and Methods for Site Valuation

    Chapter 6: Adjustments and Methods for Site Valuation

    This chapter delves into the methodologies employed to determine the value of land, often referred to as site valuation. We will explore various techniques used by appraisers, focusing on their theoretical underpinnings, practical applications, and limitations. A thorough understanding of these methods is crucial for accurate real estate appraisal.

    I. The Importance of Site Valuation

    Site valuation is a critical step in real estate appraisal because:

    • Land is Immutable: Unlike improvements, land is a permanent resource.
    • Foundation of Value: The value of any improved property is inherently tied to the underlying land value.
    • Highest and Best Use: Accurate site valuation helps determine the highest and best use of the property, maximizing its economic potential.

    II. Sales Comparison Method: The Preferred Approach

    The Sales Comparison Method (SCM) is the most reliable and widely accepted method for site valuation when sufficient data is available. It involves analyzing recent sales of comparable vacant land parcels and adjusting their prices to reflect the differences between them and the subject property.

    A. Scientific Basis: The SCM is rooted in 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.

    B. The Adjustment Process: Adjustments are made to the comparable sales prices, not to the subject property. This is crucial for maintaining objectivity.

    *   **Comparable Superior:** If the comparable is superior to the subject property in a particular characteristic (e.g., better location), the comparable's price is *adjusted downward*.
*   **Comparable Inferior:** If the comparable is inferior to the subject property, the comparable's price is *adjusted upward*.

    C. Types of Adjustments:

    1.  **Property Rights:** Differences in the legal rights conveyed (e.g., fee simple vs. leasehold).
2.  **Financing Terms:** Favorable financing terms offered in the comparable sale.
3.  **Conditions of Sale:** Unusual circumstances that may have affected the sale price (e.g., forced sale).
4.  **Expenditures Immediately After Sale:** Costs incurred by the buyer shortly after purchase (e.g., demolition).
5.  **Market Conditions:** Changes in the market since the date of the comparable sale.
6.  **Location:** Differences in location attributes (e.g., proximity to amenities, traffic patterns).
7.  **Physical Characteristics:** Differences in site size, shape, topography, soil conditions, etc.
8.  **Economic Characteristics:** Differences affecting site's economic potential.

    D. Adjustment Order and Sequence
    Adjustments are calculated in a sequence (order) which will depend on the appraiser’s analysis of the market.

    *   Adjustments for property rights, financing and sale terms, and market conditions are made first, before adjustments for location and physical characteristics.

    E. Example of Sales Comparison Adjustments:

    *   **Scenario:** A comparable lot sold for $45,000.
*   **Adjustment:** The comparable has a superior location, making it $5,000 more valuable than the subject lot.
*   **Calculation:** $45,000 (Comparable Price) - $5,000 (Location Adjustment) = $40,000 (Indicated Value of Subject Lot)

    F. Percentage vs. Dollar Adjustments:
    Adjustments can be made as a dollar amount or as a percentage of the comparable sale price. The choice depends on the nature of the difference and market data.
    * The dollar amount of the percentage is calculated and then added to or subtracted from the comparable sale price.

    *   **Scenario:** The sales price of a comparable lot is $45,000. Market data suggest that the subject lot is worth 10% less than the comparable lot, due to changes in the market since the date of the comparable sale.
*   **Calculation:** 0.10 x 45,000 = 4,500,
    $45,000 (Comparable Price) - $4,500 (10% of comparable price) = $40,500 (Indicated Value of Subject Lot)

    G. Experiment: Conduct a market survey to identify recent vacant land sales. Create a spreadsheet to systematically adjust each comparable sale based on market-derived data. Analyze the adjusted prices to arrive at an indicated value range for the subject property.

    III. Allocation Method

    The Allocation Method is used to estimate land value for an improved property. It assumes a certain percentage of the property’s value is attributable to the improvements, with the remaining percentage attributed to the land.

    A. Scientific Basis: This method relies on observed ratios of land value to building value in similar properties. It’s most reliable when applied to homogenous areas with consistent development patterns.

    B. Calculation:

    1. Determine the total property value❓❓ (Vtotal). This can be estimated using other appraisal methods.
    2. Establish the land-to-building value ratio (RL/B). This ratio is derived from market data. Example ratios include (3:1) or (3:2), depending on value of building and the land.
    3. Calculate the land value percentage (Pland). Formula: Pland = Land Value / (Land Value + Building Value) (Example (3:2) -> 2/5)
    4. Calculate land value (Vland). Formula: Vland = Vtotal * Pland

    C. Example of Allocation Method:

    *   **Scenario:** A property is worth $200,000. The building-to-land value ratio is 3:2.
*   **Calculation:**
    1.  Total Property Value: V<sub>total</sub> = $200,000
    2.  Calculate the Land Value Percentage P<sub>land</sub> = 2/5 = 40%
    3.  V<sub>land</sub> = 200,000 \* 40% = $80,000 (Allocated Land Value)

    D. Advantages:
    Simple to calculate.

    E. Drawbacks and Limitations:

    1. Requires Market Data: To determine an accurate ratio.
    2. Inherently Inaccurate: Assumes an average ratio, neglecting variations in improvements on equally valued lots.
    3. Less Reliable: The Sales Comparison Method is preferable when available, it should only be used when other methods are impossible, or impractical.
    4. Variation in improvements: Lots of the same size with equal value can be improved with buildings of different sizes, styles, and functionality.

    IV. Extraction Method

    The Extraction Method values land (vacant or improved property) when vacant land comparables are unavailable. It reverses the cost approach.

    A. Scientific Basis: The idea is to subtract the depreciated cost of the improvements from the total property value, leaving the land value.

    B. Calculation:

    1. Determine the total property value (Vtotal).
    2. Estimate the depreciated cost of the improvements (Cdepreciated).
    3. Calculate land value (Vland). Formula: Vland = Vtotal - Cdepreciated

    C. Example of Extraction Method:

    *   **Scenario:** A comparable property sold for $650,000. The depreciated value of the improvements is estimated to be between $80,000 and $100,000.
*   **Calculation:** V<sub>land</sub> = 650,000 - (80,000 to 100,000) = $550,000 to $570,000.

    D. Advantages:
    Estimates the value of the land.

    E. Drawbacks and Limitations:

    1. Reliability: Dependent on accurate estimation of depreciated cost of improvements.
    2. Improvements are Small: Not useful if the value of improvements is not small in relation to the total value.
    3. Most Useful for Urban Properties: It works well with properties in urban environments, where land tends to represent a higher percentage of total property value.

    V. Development Method (Subdivision Analysis)

    The Development Method is used to value large, undeveloped parcels suitable for subdivision. It uses discounted cash flow techniques to estimate the present value of future net cash flow❓❓s.

    A. Scientific Basis: Based on the principle of anticipation, which states that the value of an asset is the present worth of its expected future benefits (in this case, sales revenue from subdivided lots).

    B. Steps involved in Development Method:

    1.  **Determine Highest and Best Use:** Confirm subdivision as the optimal use.
2.  **Create Development Plan:** Layout lots, roads, and infrastructure.
3.  **Calculate Pricing Schedule:** Estimate the sales price of each lot.
4.  **Estimate Absorption Rate:** Project the number of lots that will be sold each year.
5.  **Calculate Development Expenses:** Include construction costs, marketing, taxes, and overhead.
6.  **Determine Discount Rate:** Reflects the risk and time value of money for this type of investment.

    C. Discounted Cash Flow (DCF) Analysis:

    For each period (year) t, calculate the net cash flow:

    *   NCF<sub>t</sub> = (Number of Lots Sold<sub>t</sub> \* Sales Price per Lot) - Development Expenses<sub>t</sub>
* The land will be sold over a period of several years, so each year's income and expenses over the development period must be properly allocated and discounted.

    Then, discount each year’s net cash flow to its present value:

    *   PV<sub>t</sub> = NCF<sub>t</sub> / (1 + r)<sup>t</sup>
*   Where *r* is the discount rate, and *t* is the number of years from the present.

    Sum the present values of all future net cash flows to arrive at the indicated land value:

    *   V<sub>land</sub> = ∑ PV<sub>t</sub> (summation over all years *t*)

    D. Example

    *   The appraiser may use a financial calculator or a table of reversion factors to apply the proper reversion factor to the problem. (See picture provided in the PDF).

    E. Advantages:
    Useful for valuing land with subdivision potential.

    F. Drawbacks and Limitations:

    1. Complexity: Requires detailed market research and accurate projections.
    2. Sensitivity: The accuracy of this method is highly sensitive to the assumptions made regarding sales prices, absorption rates, development costs, and the discount rate. If the analysis is incorrect, income is overstated or improperly applied.

    VI. Land Residual Method

    The Land Residual Method is an income capitalization approach used to estimate land value based on the income attributable to the land.

    A. Scientific Basis: Income capitalization values an asset based on its expected income stream. The method isolates the land’s contribution to the property’s overall income.

    B. Formula:

    *   V = I / R  (Value = Income / Capitalization Rate)

    C. Steps:

    1. Estimate Total Net Operating Income (NOItotal): Project the property’s annual net income.
    2. Determine Improvement Value (Vimprovements): Estimate the replacement cost new of the improvements, less depreciation.
    3. Determine Building Capitalization Rate (Rbuilding): Obtain a capitalization rate from the market for similar types of improvements.
    4. Calculate Income Attributable to Improvements (Iimprovements):
      *Iimprovements = Vimprovements * Rbuilding
    5. Calculate Income Attributable to Land (Iland):
      *Iland = NOItotal - Iimprovements
    6. Determine Land Capitalization Rate (Rland): Obtain a capitalization rate from the market for land only.
    7. Calculate Land Value (Vland):
      *Vland = Iland / Rland

    D. Example of Land Residual Method:

    *   **Scenario:** The highest and best use of land is determined to be a retail shopping center. The cost to construct the improvements is estimated at $1.2 million dollars, and the property is projected to generate net annual income of $208,000. Market data indicate capitalization rates for this type of property to be 8% for land and 12% for improvements.
*  **Calculations:**
    *   Income attributable to improvements: 1,200,000 \* 0.12 = 144,000
    *   Income attributable to land: 208,000 - 144,000 = 64,000
    *   Land Value: 64,000 / 0.08 = $800,000

    E. Advantages:
    Useful for income-producing properties where land contributes significantly to income.

    F. Drawbacks and Limitations:
    * Reliability hinges on accurate income and capitalization rate estimates.
    * Can be complex and require significant market research.

    VII. Ground Rent Capitalization Method

    The Ground Rent Capitalization Method is another income capitalization approach used to value land based on the rental income generated from a ground lease.

    A. Scientific Basis: This method directly capitalizes the ground rent, which represents the income attributable to the land.

    B. The Process:
    The tenant leases the land from the landlord, and constructs a building on the site.

    C. Formula:

    • V = I/R (Value = Income / Capitalization Rate)

    D. Example of Ground Rent Capitalization:

    • Scenario: A property’s ground rent is $50,000 a year for 50 years. Market data indicates a capitalization rate of 10%.

    • Calculations:

    • V = $50,000 / 0.10
    • V = $500,000 indicated land value

    E. Advantages:
    Useful for properties subject to ground leases.

    F. Drawbacks and Limitations:

    • Complexity arises when dealing with lease terms such as rent escalation clauses or options to renew.
    • The amount of time remaining on the lease must be taken into account.

    VIII. Depth Tables (“4-3-2-1 Method”)

    Depth tables, also known as percentage tables, illustrate how the highest value is located in the front part of the lot.

    A. The Process:
    A depth table is a percentage table that illustrates how the highest value is located in the front part of the lot.
    The appraiser assumes that the value of the parcel is as follows:
    1st ¼ = 40% of Value
    2nd ¼ = 30% of Value
    3rd ¼ = 20% of Value
    4th ¼ = 10% of Value

    B. Example of Depth Tables:
    If a property lost the rear 25 percent of its depth, the value would decline, but the loss in value would be less than 25 percent.

    • Based on this rough formula, you will see that the loss of the rear 25 percent (¼th) would only reduce the value by 10 percent.

    C. Advantages:
    Useful for understanding the value in relationship to depth.

    D. Drawbacks and Limitations:

    • They are NOT accurate because they do NOT consider the need for depth of particular users.

    IX. Conclusion

    Selecting the appropriate site valuation method depends on the availability of data, the nature of the property, and the specific appraisal assignment. Appraisers must understand the theoretical underpinnings and limitations of each method to ensure accurate and reliable valuation results.

    Chapter Summary

    Here’s a detailed scientific summary of the “Adjustments and Methods for Site Valuation” chapter, based on the provided content.

    Chapter Summary: Adjustments and Methods for Site Valuation

    This chapter, within the “Mastering Real Estate Appraisal Principles” training course, focuses on various methodologies employed in determining the market value of land or sites, primarily for appraisal purposes. The core principle underpinning site valuation is the concept of “highest and best use,” dictating that the site’s value is derived from the most profitable and reasonably probable use, considering legal, physical, economic, and maximally productive criteria.

    I. Sales Comparison Method & Adjustments:

    • Core Principle: The sales comparison method stands as the preferred valuation approach, relying on analyzing sales data of comparable vacant lots. This method aligns with principles of market analysis, inferring value from recent, similar transactions.
    • Adjustment Process: A rigorous adjustment process is crucial to account for differences between the comparable properties❓ and the subject property. Adjustments are always applied to the comparable’s sales price, not the subject. Superior characteristics in the comparable require a downward adjustment to its price; inferior characteristics necessitate an upward adjustment.
    • Types of Adjustments: Adjustments can be expressed as either dollar amounts or percentages of the comparable’s sales price. Percentage adjustments require careful sequencing, typically prioritizing adjustments for property rights, financing terms, sale conditions, and market conditions before location and physical characteristics. The order impacts the final adjusted❓ value. This addresses the potential for compounding errors if the sequence is not carefully considered.
    • Scientific Basis: This method is rooted in the principle of substitution – a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. The adjustments are attempts to quantify the differences in desirability.

    II. Alternative Site Valuation Methods (When Sales Comparison is Limited):

    • Allocation Method: This method assumes❓ a typical ratio between land value and the value of improvements for similar properties. By determining the overall property value and applying the assumed land/improvement ratio, the land value is derived. While simple, its accuracy is limited because it relies on broad averages. It is scientifically weak, being inherently inaccurate. The main issue is that it fails to account for variations in improvement values.
    • Extraction Method: This is essentially a reverse-engineered cost approach. It subtracts the depreciated cost of improvements from the total property value❓ to isolate the land value. This method is most reliable when the improvement value is either reliably estimable or constitutes a small portion of the total value. Its scientific validity depends on the accuracy of the cost estimation and depreciation assessment of the improvements.
    • Development Method (Subdivision Analysis): Employed for large undeveloped parcels suitable for subdivision. It utilizes discounted cash flow (DCF) analysis, projecting future sales revenues from subdivided lots and subtracting development costs. The resulting net cash flows are then discounted back to present value. This method requires careful consideration of the highest and best use, development plans, pricing schedules, absorption rates, development expenses, marketing costs, taxes, overhead, and profit allowances. The scientific rigor relies heavily on accurate market data and financial forecasting; errors in these areas can lead to significant valuation inaccuracies.
    • Land Residual Method: An income capitalization approach. It calculates the income attributable to the land by subtracting the income attributable to the improvements (calculated using the building capitalization rate and improvement value) from the total net operating income (NOI). This remaining land income is then capitalized to determine land value. This relies on the core principle of income capitalization (Value = Income / Capitalization Rate).
    • Ground Rent Capitalization: This is another income capitalization approach, specifically applied when the land is subject to a ground lease (a long-term lease where the tenant constructs improvements on the land). The value is derived by capitalizing the ground rent paid by the tenant, considering factors like lease term and rent escalation clauses.
    • Depth Tables (4-3-2-1 Method): Depth tables give a ballpark idea of value in relationship to depth. They are NOT accurate because they do NOT consider the need for depth of particular users.

    III. Key Conclusions and Implications:

    • Data Quality is Paramount: The accuracy of any site valuation method is fundamentally dependent on the quality and reliability of the underlying market data (comparable sales, cost estimates, income projections, capitalization rates, etc.).
    • No Single “Best” Method: The choice of valuation method depends on the availability of data and the specific characteristics of the property being appraised. The sales comparison method is generally preferred when feasible, but alternative methods provide valuable tools when direct sales data is limited.
    • Highest and Best Use Dictates Value: The valuation process must always be guided by the concept of highest and best use, ensuring that the property is valued based on its most profitable and legally permissible use.
    • Professional Judgment is Essential: Site valuation is not a purely mathematical exercise; it requires sound professional judgment and a thorough understanding of local market conditions. Appraisers must critically evaluate the data, select appropriate methods, and carefully interpret the results.
    • Compatibility of design impacts value: This includes compatibility of design with neighboring properties, physical site characteristics, construction materials, and market preferences.

    In essence, this chapter provides a comprehensive framework for site valuation, emphasizing the scientific principles of market analysis, income capitalization, and discounted cash flow analysis, while acknowledging the importance of professional judgment and data quality in producing credible appraisals.

    Explanation:

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