Comparable Adjustments & Site Valuation Methods

Chapter 6: comparable❓ Adjustments & Site Valuation Methods

This chapter delves into the crucial aspects of real estate appraisal, focusing on how to accurately adjust comparable sales prices and various methods for determining the value of land or a site. Understanding these techniques is essential for financial institutions and real estate appraisers alike to ensure accurate valuations and informed decision-making.

I. Comparable Adjustments: Refining the Sales Comparison Approach

The sales comparison approach is a cornerstone of real estate valuation. It relies on analyzing recent sales of properties similar to the subject property (the property being appraised). However, perfect similarity is rare, necessitating adjustments to comparable sales prices to reflect differences between the comparables and the subject property. The adjustment is always applied to the price of the comparable, rather than the subject property.

A. The Principle of Contribution: The Foundation of Adjustments

The amount of an adjustment is based on the Principle of Contribution. This principle states that the value of a component or feature of a property is measured by its contribution to the total value, rather than its separate cost.

Example: Adding a swimming pool to a house might cost $50,000, but if it only increases the market value by $30,000, then the swimming pool’s contribution to value is $30,000, even if the cost was higher. This $30,000 becomes the basis for adjustments in comparable sales involving properties with or without pools.

B. Types of Adjustments: Addressing Key Differences

Adjustments are typically categorized as either dollar amounts or percentages of the comparable sales price.

• Dollar Adjustments: Reflect a specific, measurable difference in value due to a particular feature or condition.

  • Example: A comparable lot sold recently for $45,000. The comparable has a superior location, which makes it $5,000 more valuable than the subject lot. Because the comparable is superior in location, its price is adjusted downward:

    • Adjusted Price = Comparable Sales Price - Adjustment
    • Adjusted Price = $45,000 - $5,000 = $40,000
    • The indicated value of the subject lot is $40,000.

• Percentage Adjustments: Used when the difference in value is best expressed as a proportion of the sales price. The dollar amount of the percentage adjustment is calculated and then added to or subtracted from the comparable sale price.

  • Example: 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. The amount of the adjustment is 10% of $45,000 (0.10 * 45,000), or $4,500. Since the comparable is more valuable, the adjustment is made by subtracting the difference in value from the comparable sales price.

    • Adjustment Amount = Comparable Sales Price * Adjustment Percentage
    • Adjustment Amount = $45,000 * 0.10 = $4,500
    • Adjusted Price = Comparable Sales Price - Adjustment Amount
    • Adjusted Price = $45,000 - $4,500 = $40,500
    • The indicated value of the subject lot is $40,500.

C. Order of Adjustments: Minimizing calculation errors❓

The order in which percentage adjustments are applied can significantly influence the final adjusted price. To mitigate this, a standardized sequence is often followed. While the specific order can depend on the appraiser’s market analysis, a general guideline is:

1. Property Rights: Address differences in the legal rights conveyed (e.g., fee simple vs. leasehold).
2. Financing Terms: Adjust for any favorable or unfavorable financing concessions in the comparable sale. These concessions can artificially inflate or deflate the price.
3. Conditions of Sale: Account for any unusual circumstances surrounding the sale (e.g., a forced sale, a sale between related parties).
4. Market Conditions: Reflect changes in the market between the date of the comparable sale and the date of the appraisal.
5. Location: Address differences in location attributes (e.g., proximity to amenities, schools, noise levels).
6. Physical Characteristics: Account for differences in physical attributes (e.g., size, age, condition, features).

7. Economic Characteristics: Adjust for differences in economic factors (e.g. rental income, operating expenses)

   Example:
   An appraiser determines that a comparable sales price must be adjusted downward by 10% to account for the value of financing concessions in the comparable sale. In addition, the subject property is worth $5,000 more than the comparable due to superior utility service. The sales price of the comparable is $100,000.
   If the adjustment for financing terms is made first, the result is as follows.
   $100,000 x 10% (0.10) = $10,000 financing adjustment
$100,000 - $10,000 = $90,000 value adjusted for financing
$90,000 + $5,000 = $95,000 value adjusted for financing and utilities
   If the adjustment for utilities is made first, the result is a different indicated value for the subject lot.
   $100,000 + $5,000 = $105,000 value adjusted for utilities
$105,000 x 10% (0.10) = $10,500 financing adjustment
$105,000 - $10,500 = $94,500 value adjusted for financing and utilities

II. Site Valuation Methods: Determining Land Value

Determining the value of the land, separate from any improvements, is a critical component of many appraisal assignments. Several methods exist, each with its strengths and weaknesses.

A. sales comparison method❓❓❓❓ (Preferred)

This is the most reliable method when sufficient data is available. It involves analyzing sales of vacant land comparable to the subject site. The same adjustment principles discussed above are applied.

• Key Considerations: Location, size, zoning, shape, topography, soil conditions, availability of utilities, and access.

B. Allocation Method

The Allocation method estimates land value based on the ratio between land value and total property value for similar properties. It assumes a relatively consistent relationship between these values.

• Formula:

  • Land Value = Total Property Value * (Land Value Percentage)
  • Where Land Value Percentage = Land Value / Total Property Value (derived from comparable sales).
  • Example: An appraiser has estimated that a property is worth a total of $200,000, and that the ratio of building value to land value for similar properties is 3:2 (3 to 2). In this case, 60% (3/5) of the property’s value is allocated to the improvements, and 40% (2/5) is allocated to the land.
    $200,000 x 40% (0.40) = $80,000 allocated land value
  • Drawbacks: Assumes a constant ratio, which may not be accurate. Best used as a check on other methods, not as a primary valuation tool. Data on Land Value Percentage must be extracted from comparable properties, using one of the other methods described below.

C. Extraction Method

This method subtracts the depreciated cost of the improvements from the total property value to arrive at the land value. It is essentially the cost approach in reverse.

• Formula:

  • Land Value = Total Property Value - Depreciated Cost of Improvements
  • Example: A comparable urban property sold recently for $650,000. The appraiser estimates that the depreciated value of the comparable’s improvements is between $80,000 to $100,000. By extraction, the value of the comparable’s land is in the range of $550,000 to $570,000.
    Land value range: $650,000 - $100,000 = $550,000 to $650,000 - $80,000 = $570,000
  • Applicability: Most reliable when the improvements are relatively new and depreciation is minimal, or when the improvement value is very small in relation to the total property value.
  • Limitations: Accuracy depends on the accuracy of the depreciation estimate and the cost of the improvements.

D. Development Method (Subdivision Analysis)

The land development method is often applied to large “raw” or undeveloped vacant parcels of land for the purposes of subdivision.
This method utilizes discounted cash flow❓❓ TECHNIQUES. Subdivision is often carried out over a period of several years. This method requires that future net cash flows projected from sales after deduction of expenses be discounted to arrive at the present value of the land. Discounting is a means of calculating the present value of a future amount.

• Process:

  1. Determine the highest and best use (typically subdivision).
  2. Develop a detailed subdivision plan.
  3. Project expected sales prices for individual lots.
  4. Estimate all development costs (infrastructure, marketing, etc.).
  5. Project a sales absorption rate (how quickly the lots will sell).

  6. Discount future net cash flows back to present value using an appropriate discount rate.
     * Formula:
     The basic formula for present value (PV) is:
     PV = CF / (1 + r)^n

     Where:

     PV = Present Value

     CF = Cash Flow in a Future Period

     r = Discount Rate (required rate of return)

     n = Number of Periods (years) in the future the cash flow will be received
     * Example: An appraisal is required of a 10 acre site with a highest and best use of subdivision of 1 acre lots. After considering absorption rates, costs and selling prices, a discounted cash flow is used to obtain the land value.
     * Requires: Detailed market research, accurate cost estimates, and a realistic discount rate reflecting the risk and holding period.

E. Land Residual Method

This method utilizes income capitalization to estimate land value. It is based on the premise that the land’s value is the present value of the income remaining after accounting for the return on the improvements.

• Basic Income Capitalization Formula:

  • Value (V) = Net Operating Income (NOI) / Capitalization Rate (R)
  • Land Residual Process:
  1. Estimate the property’s total net operating income (NOI).
  2. Estimate the value (or depreciated cost) of the improvements.
  3. Determine the appropriate capitalization rate for the improvements (R_improvements).
  4. Calculate the income attributable to the improvements: I_improvements = Value of Improvements * R_improvements.
  5. Subtract the income attributable to the improvements from the total NOI to find the income attributable to the land: I_land = NOI - I_improvements.
  6. Determine the appropriate capitalization rate for the land (R_land).
  7. Capitalize the land income to determine the land value: Land Value = I_land / R_land.
     * Example: The highest and best use of a parcel 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. The first step is to calculate the income attributable to the improvements, by multiplying the improvement capitalization rate by the value of the improvements.
     I = V x R
I = $1,200,000 x 0.12
I = $144,000 income attributable to improvements
     Next, the improvement income is subtracted from the total net income to find the income attributable to the land.
     $208,000 - $144,000 = $64,000 income attributable to land
     Finally, the land income is capitalized by dividing it by the land capitalization rate. V = I ÷ R
V = $64,000 / 0.08
V = $800,000 indicated land value
     * Requires: Accurate income and expense projections, reliable capitalization rates for both land and improvements, and an accurate estimate of improvement value.

F. Ground Rent Capitalization Method

This method is another application of the income capitalization approach, specifically suited for properties subject to ground leases. In a ground lease, the tenant leases the land and constructs improvements on it. The rent paid for the land is the ground rent.

• Formula:

  • Land Value = Ground Rent / Capitalization Rate

  • V = I/R

  • Example: A property’s ground rent is $50,000 a year for 50 years. If market data indicates a capitalization rate of 10%, then the value of the property can be estimated by income capitalization as follows:
    V = I/R
V = $50,000 / 0.10
V = $500,000 indicated land value
  • Complications: The capitalization rate must reflect the risk associated with the ground lease, and any provisions for rent escalation or other lease terms must be considered.

G. Depth Tables (“4-3-2-1 Method”)

Depth tables are tools that estimate the value of a lot based on its depth, assuming that the front portion of the lot has a higher value than the rear portion.

• Example: The “4-3-2-1” depth table 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
    *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.
  • Limitations: These tables are NOT accurate because they do NOT consider the need for depth of particular users.

III. Conclusion

Accurate comparable adjustments and sound site valuation are critical skills for real estate appraisers. Mastering these techniques requires a thorough understanding of market principles, data analysis, and the application of appropriate valuation methods. Combining theoretical knowledge with practical experience ensures reliable and defensible appraisals.