Site Valuation: Highest & Best Use and Techniques

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Chapter 6: Site Valuation: Highest & Best Use and Techniques

I. Introduction: The Significance of Site Valuation

Site valuation, the process of determining the economic worth of a parcel of land, forms a critical foundation for accurate real estate appraisal. It’s not simply about the land itself, but rather its potential for generating value. This chapter delves into the core concepts and techniques used by appraisers to assess site value, with a primary focus on the principle of Highest and Best Use (HBU). A precise estimation of the site’s value is needed for the cost approach to value and the building residual technique of income capitalization

II. Highest and Best Use (HBU): The Cornerstone of Site Valuation

A. Defining Highest and Best Use

The Highest and Best Use (HBU) is defined as the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value. The Appraisal Institute further refines this definition, stating it as:

“The reasonably probable and legal use of property that is physically possible, appropriately supported, financially feasible, and results in the highest value.”

This definition embodies a rigorous analytical process designed to identify the most profitable and justifiable use of the land. It is an assumption that real estate is viewed in light of all its possible uses and is measured in the current market.

B. The Importance of HBU Analysis

1. Foundation for Value Estimates: HBU dictates the type of improvements, intensity of development, and income potential considered, directly influencing the final value opinion.
2. Guiding Land and Improvement Valuation: The Principle of Consistent Use mandates that both the land and improvements are valued based on the same HBU scenario. This ensures a cohesive and realistic assessment.
3. Comparable Selection Criteria: HBU acts as a benchmark for selecting comparable properties, ensuring relevance and comparability within the market.

C. The Four Tests of Highest and Best Use

A potential use must satisfy all four of these tests to qualify as HBU:

1. Legally Permissible:

   • This test assesses whether the proposed use conforms to all applicable laws, regulations, and private restrictions.
   • Examples: zoning❓ ordinances (density, setbacks, use restrictions), environmental regulations, historic preservation guidelines, deed restrictions, easements.

   • Mathematically this can be represented as a boolean function:

     • L(use) = 1 if use is legal, 0 if use is illegal
       • A use is discarded if L(use) = 0.

2. Physically Possible:

   • This test considers the inherent physical characteristics of the site that may enable or constrain development.
   • Examples: Size, shape, topography, soil conditions, access, availability of utilities.

   • Mathematically this can be represented as a boolean function:

     • P(use) = 1 if use is physically possible, 0 if use is physically impossible
       • A use is discarded if P(use) = 0.

3. Financially Feasible:

   • This test determines if a proposed use can generate sufficient income or return on investment to warrant development.
   • Requires a discounted cash flow analysis, with calculations involving costs and income to identify economic viability.
   • This requires a detailed understanding of supply/demand within the target marketplace.

   • Mathematical representation:

     • NPV = ∑ (CFt / (1+r)^t) – Initial Investment
     • Where: NPV = Net Present Value, CFt = Cash Flow in period t, r = discount rate, t = period number. If NPV < 0, the use is not financially feasible.

4. Maximally Productive:

   • This test selects the use that generates the highest net return or value among all feasible alternatives.
   • Comparing NPV of multiple feasible options
   • Maximize Value: Select the use that returns the highest net value.

D. The Principle of Anticipation

The Principle of Anticipation asserts that value is based on the future benefits expected from property ownership. Therefore, HBU analysis must consider potential future changes in legal, economic, and physical conditions that could influence land use.

E. Interim Use

An interim use is a temporary use for a site that awaits its ultimate HBU. This may be an economically sound choice pending changes in market conditions, regulations, or infrastructure.

III. HBU of Land as Though Vacant vs. HBU of Property as Improved

Appraisers need to analyze two HBU scenarios:

• Land as though Vacant: This analysis disregards existing improvements, focusing on the most profitable use if the land were currently unimproved.

• Property as Improved: This analysis considers the existing improvements and evaluates whether to continue, modify, or demolish them for a different use. The value contribution of existing improvements and the costs of demolition should be considered.

Mathematical Representation:

• Value (Improved) = Value (Land) + Value (Improvements) – Demolition Costs
• If Value(New Use) > Value (Current Use) + Demolition Cost, then consider a change of use.

A. Legal Nonconforming Use

These uses, allowed to continue despite not meeting current zoning regulations, are often considered when determining the HBU of the property as improved.
They can be difficult to replicate and hence they can increase market value, for the property as improved.

B. Principle of Consistent Use

When applying techniques such as the cost approach, the land and improvements MUST be valued under the same HBU scenario.

C. Excess vs. Surplus Land

• Excess Land: Can be separated from the primary site and has its own highest and best use.
• Surplus Land: Land that cannot be sold off, and is not needed for the highest and best use.

D. Plottage

The concept of plottage applies when combining two or more adjacent parcels increases value due to economies of scale or a new HBU opportunity.

IV. Site Valuation Techniques

A. Sales Comparison Method

• The most reliable and preferred approach.
• Involves analyzing recent sales of comparable vacant land parcels and adjusting their prices for differences with the subject site.

1. Data Sources:

   • Real estate brokers, land developers, owners, and public records.
   • Online databases (MLS, CoStar, etc.).
     2. Elements of Comparison:

   These are characteristics that could affect property value

   a. Real Property Rights Conveyed: Adjust for any differences in the property rights conveyed in the sale, and also for any differences in property restrictions.

   b. Financing Terms: If a comparable sale includes financing concessions or other terms that are not typical of the market, their effect must be accounted for by adjusting the comparable’s sale price.

   c. Conditions of Sale: Did any outside factor cause either the buyer or the seller to act outside the bounds of the reasonable market.

   d. Expenditures Immediately After Sale: the cost to repair or replace structures or parts of structures, the cost to
   remediate environmental contamination, or the costs associated with zoning changes to permit development

   e. Market Conditions Adjustment: Adjustments must be made based on market fluctuation based on when the sales were completed.

   f. Location Adjustments: Location and neighborhood characteristics are critical for comparison.

   g. Physical Characteristics: Size, shape, topography, soil composition, access to utilities.

   h. Economic Characteristics: Zoning, land use regulations, development incentives.

B. Allocation Method

• Estimates land value based on a ratio or percentage of the total property value.
• Useful when comparable vacant land sales are scarce.

C. Extraction Method

• Derives land value by subtracting the depreciated cost of improvements from the total property value.
• Relies on accurate estimation of the replacement cost and depreciation of improvements.

D. Subdivision Development Method

• Used for valuing large parcels of land suitable for subdivision.
• Involves projecting future revenues from lot sales, subtracting development costs, and discounting the net cash flow back to a present value.
  • *NPV = ∑ (CFt / (1+r)^t) – Development Costs
    Where: NPV = Net Present Value, CFt = Cash Flow in period t, r = discount rate, t = period number

E. Land Residual Method

• Capitalizes the income attributable to the land after accounting for the income required to support the improvements.

• Key variables include: Net Operating Income (NOI), building capitalization rate, land capitalization rate, and building value.

  1. Calculate Building Income: Building Income = Building Value * Building Cap Rate

  2. Calculate Land Income: Land Income = Total NOI – Building Income

  3. Calculate Land Value: Land Value = Land Income / Land Cap Rate

F. Ground Rent Capitalization Method

• Applies to properties subject to ground leases.
• Value = Ground Rent / Capitalization Rate

G. Depth Tables (“4-3-2-1 Method”)

• These tables show percentage reduction for less depth of land.

V. Conclusion

Site valuation is a crucial component of real estate appraisal. By carefully considering HBU and employing appropriate valuation techniques, appraisers can arrive at a reliable estimate of site value, leading to a more accurate overall property assessment.