Approaches to Value: Site Value Estimation

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Chapter 6: Approaches to Value: Site Value Estimation

I. Introduction

The accurate❓❓ estimation of site value is a critical component of real estate valuation. Site value (the value of the land as if vacant and available for its highest and best use) is not merely the residual after accounting for improvements. It is an independent valuation problem requiring its own methodologies and data analysis. This chapter will delve into the scientific principles and practical techniques appraisers employ to determine site value. Estimating site value is required when using: the cost approach to value and the building residual technique of income capitalization. The importance of a separate valuation of site and improvements may also be required by law, particularly in appraisal❓s for property tax assessment and condemnation purposes.

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

A. Definition and Importance:

The estimate of HBU is the most important part of the valuation. The value of the site depends on how it is used. This forms the framework for all subsequent valuation procedures. The Uniform Standards of Professional Appraisal Practice (USPAP) requires that appraisers analyze and report the HBU of the site.
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.

B. The Four Tests of Highest and Best Use:

The HBU analysis follows a four-step testing process. These tests are hierarchical, meaning that each test must be satisfied before proceeding to the next. They can be stated as follows:

1.  **Legally Permissible:**
    *   The proposed use must comply with all applicable zoning regulations, building codes, environmental regulations, and private restrictions (e.g., deed restrictions, easements).
    *   *Scientific Basis:* This step incorporates principles of land economics and law, ensuring the use aligns with the existing legal and regulatory framework.
    *   *Example:* A site zoned for single-family residential cannot legally be used for a high-rise apartment building, regardless of potential profitability.

2.  **Physically Possible:**
    *   The site must be suitable for the proposed use, considering factors such as size, shape, topography, soil bearing capacity, drainage, and access to utilities.
    *   *Scientific Basis:* This incorporates principles of civil engineering, soil mechanics, and hydrology.
    *   *Example:* A steeply sloped site might be unsuitable for constructing a large commercial building due to the high cost of grading and foundation work.

3.  **Financially Feasible:**
    *   The proposed use must generate sufficient income or benefits to justify the costs of development. Consider <a data-bs-toggle="modal" data-bs-target="#questionModal-349711" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">construction</span><span class="flag-trigger">❓</span></a> costs, operating expenses, and the present value of future income streams.
    *   *Scientific Basis:* This relies on principles of financial economics, including cost-benefit analysis and discounted cash flow analysis.
    *   *Mathematical representation:* *Net Operating Income* (NOI) > *Total Costs*.
    *   *Example:* Developing a luxury hotel on a site might be physically possible and legally permissible, but financially infeasible if the market cannot support high room rates and occupancy levels.

4.  **Maximally Productive:**
    *   Among all the feasible uses, the HBU is the one that generates the highest net return or value to the owner.
    *   *Scientific Basis:* This is rooted in the concept of economic efficiency, maximizing the utility or value derived from a limited resource.
    *   *Mathematical Representation:* Maximize:  `Present Value (PV) = ∑ (NOI_t / (1 + r)^t) - Development Costs` where NOI_t is the Net Operating Income in year t and r is the discount rate.
    *   *Example:* A site could be used for either a retail store or an office building. If the retail store is projected to generate a higher net operating income than the office building, it is considered the maximally productive use.

III. Site Valuation Techniques

A. Sales Comparison Approach: (Most Reliable When Data is Available)

1.  **Principle:** Based on the principle of substitution – a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.

2.  **Process:** Involves identifying comparable vacant land sales, verifying the data, and making adjustments to the sale prices of the comparables to reflect differences between them and the subject site.

3.  **Formula:**
    `Subject Value = Comparable Sales Price +/- Adjustments`

4.  **Adjustments:**
    *   **Quantitative Adjustments:** Based on market data (e.g., paired sales analysis) or cost data.

    *   **Qualitative Adjustments:** Used when quantitative data is lacking. Often described as "superior" or "inferior."

5. **Elements of Comparison and Relevant formulas for adjustments**
     *   **Property Rights Conveyed:** Consider differences in fee simple versus leasehold interests.
        *      **Relevant Formula**:   if difference in property right, then  `Value Difference= Sale Price Comparable * ((1+ InterestRate)^LeaseTerm-1)/((InterestRate) * (1+ InterestRate)^LeaseTerm))`
     *   **Financing Terms:** Adjust for non-market financing (e.g., seller financing at below-market rates).
        *     **Relevant Formula**: `Adjustment = (Mortgage Amount * (Market Rate - Contract Rate) * Loan Term)`
     *   **Conditions of Sale:** Account for "arm's length" transactions versus sales involving related parties.  The presence of foreclosure, divorce, or an estate sale might impact the sales price.
        *       **Mathematical Formula**: A judgement based adjustment dependent on the circumstances of the sale.

     *   **Expenditures immediately after Sale:**  Adjust when the purchaser was required to undertake work to ready the site for the intended use.
        *      **Relevant Formula**:   Adjustment = Costs of Preparing the Site for Use

    *   **Market Conditions:** Adjust for changes in market conditions between the date of the comparable sale and the date of valuation.
        *    **Relevant Formula**: If prices have increased by X% since the comparable sale, then  `Adjustment = Sale Price Comparable * X%`

     *   **Location:** Adjust for differences in location (e.g., corner lot versus interior lot, proximity to amenities, exposure to traffic)
        *     **Relevant Formula**:  Requires paired sales analysis, difficult to quantify reliably. Usually, a qualitative assessment or the value derived from the market.

    *   **Physical Characteristics:** Adjust for differences in size, shape, topography, soil conditions, and availability of utilities.
        *       **Mathematical Representation**: Adjustment = Paired Sales.

     *   **Economic Characteristics:** Zoning & Restrictions
        *      **Relevant Formula**: Adjusted as needed according to an assessment derived from the market
            i.    Land Use restriction(s)
            ii.    Development requirement(s)
            iii.    Density

6.  **Example:**
    *   Subject Site: 1 acre, flat, zoned commercial, good utilities.
    *   Comparable Sale 1: 0.9 acres, slightly sloping, zoned commercial, good utilities, sold for $100,000 six months ago.

    *   Adjustments:
        *   Size:  + $5,000 (adjusting the comparable upward for being smaller)
        *   Topography: + $2,000 (adjusting the comparable upward for the slight slope)
        *   Time: + $3,000 (adjusting the comparable upward reflecting an increase in value)

    *   Indicated Value: $100,000 + $5,000 + $2,000 +$3,000 = $110,000

B. Allocation Method:

1.  **Principle:** Divides the total value of an improved property into its land and improvement components based on typical ratios observed in the market.

2.  **Formula:**
    `Site Value = Property Value * Allocation Ratio`
    Where:
     *      Allocation Ratio = Site value / Improved Property Value

3.  **Application:** Useful when comparable land sales are scarce. Often used for property tax assessment.
4.  **Example:** Improved property recently sold for 500,000.  Market Analysis suggest sites of this type generally account for 20% of the improved property values.
   * Site Value = 500,000 * 0.2 = 100,000.

C. Extraction Method:

1.  **Principle:** Estimates land value by subtracting the depreciated cost of the improvements from the total sale price of an improved property.

2.  **Formula:**
    `Site Value = Sale Price - Depreciated Cost of Improvements`

3.  **Application:** Useful when improvements are relatively new or have limited depreciation.
4.  **Example:** An improved property recently sold for 800,000. The estimated depreciated cost of the improvements is 300,000.  Thus, the site value is estimated at 500,000.

D. Development Method (Subdivision Analysis):

1.  **Principle:** Estimates land value based on the expected proceeds from developing and selling finished sites, less development costs and a reasonable profit.
   * Also known as subdivision development method. This is a more complex technique and used in valuation of large parcels of land for subdivision or multi-phase development.

2.  **Formula:**

   Site Value = *Discounted Revenues* from sale of lots *Discounted Development Costs*

PV = ∑ (Lot Sale Price / (1 + r)^t) - ∑ (Development Costs / (1 + r)^t)
Where
* PV is the present Value of the proposed development
* r is the discount rate (reflecting risks involved)

3.  **Application:** Used for large undeveloped sites with potential for subdivision or multi-phased development.
    *It is extremely important to check that each and all expenses and taxes have been factored in.

4. **Experiment - Numerical Example**
Consider a 10 acre parcel of land that an appraiser estimates can be sub-divided into 10 lots priced to sell at $150,000 per lot. The anticipated time frame to prepare and sell the land is 3 years at a rate of 3.33 per year. Costs are estimated as follows:

| Year | Revenue                | Subdivision Preperation  | Marketing Expenses   | Taxes             | Profit Margin          |
| ---- | ---------------------- | ----------------------- | -------------------- | ----------------- | ---------------------- |
| 1    | 500,000                | -75,000                 | -15,000              | -3,000            | -8,000                 |
| 2    | 500,000                | -50,000                 | -15,000              | -3,000            | -8,000                 |
| 3    | 500,000                | -25,000                 | -15,000              | -3,000            | -8,000                 |
|      |                        |                         |                      |                   |                        |

    * Revenue: A total of $1,500,000 derived from the sale of 10 lots over three years
    * Cost of Subdividing the land is $150,000.
    * Other costs associated with marketing the project, such as agent fees, etc. is
    *  $45,000
    * Taxes = $9,000.
    * Profit is anticipated to be $24,000.
    With this knowledge, and in accordance with discounted cash flow principles and the development method, we can derive the approximate land value using the same formula outlined above.

   * Site Value = Present Value
                * PV = Revenue year 1/ (1+ rate)^ 1
                * PV = Revenue year 2/ (1+ rate)^ 2
                * PV = Revenue year 3/ (1+ rate)^ 3

   * Present Value of each period can be calculated as follows. A discount rate of 8% was used.

   * Present value at 8 %
                * PV year 1= ($500,000-75,000-15,000-3000-8000)/(1.08)
                * $398,148
                * PV year 2= ($500,000-50,000-15,000-3000-8000)/(1.08)^2
                * $358,465
                * PV year 3= ($500,000-25,000-15,000-3000-8000)/(1.08)^3
                * $323,407

   * Site Value= 1,079,980 as per Development Method

E. Land Residual Technique:

1.  **Principle:** Determines land value by isolating the net operating income (NOI) attributable to the land, after accounting for the income attributable to the improvements.

2.  **Formulas:**
    *   `NOI_Improvements = Improvement Value * Improvement Capitalization Rate`

    *   `NOI_Land = Total NOI - NOI_Improvements`

    *   `Site Value = NOI_Land / Land Capitalization Rate`

3.  **Application:** Best suited for income-producing properties where the NOI can be reliably allocated between land and improvements.
4.  **Example:**

    *   Total NOI = $50,000
    *   Improvement Value = $400,000
    *   Improvement Cap Rate = 10%
    *   Land Cap Rate = 8%
    *   NOI_Improvements = $400,000 * 0.10 = $40,000
    *   NOI_Land = $50,000 - $40,000 = $10,000
    *   Site Value = $10,000 / 0.08 = $125,000

F. Ground Rent Capitalization:

1.  **Principle:** Capitalizes the ground rent (the rental income generated from the land alone) to estimate site value.  Suitable for properties with long-term ground leases.

2.  **Formula:**
    `Site Value = Ground Rent / Land Capitalization Rate`

3.  **Application:** Used when the site is subject to a ground lease with a clearly defined ground rent.
4.   **Example:** Ground Lease is $10,000 a year. Market rate of return (capitalization rate) for similar sites is 8%. Site Value = 10,000/.08 = $125,000

G. Depth Tables (Less precise, used for rough estimations):

1.  **Principle:** Applied when estimating the value of a portion of a lot. These are often old references that were not based in real-world statistical evidence.

2.  **Formula:**
    Site Value * Percentage
    1/4 lot Value at 40 %
    1/2 lot value at 70%
    3/4 lot value at 90%.
    Full lots (100%)

IV. Reconciliation and Conclusion

After applying multiple site valuation techniques, the appraiser must reconcile the various value indications into a single, supportable conclusion. This requires:

• Evaluating the reliability of each approach: Giving greater weight to the most reliable technique based on data availability and market conditions.
• Considering the limitations of each approach: Recognizing the inherent biases or assumptions within each method.
• Documenting the reasoning for selecting the final site value estimate: Providing a clear and concise explanation of the decision-making process.

V. Conclusion

Site value estimation is a complex process that requires a thorough understanding of real estate principles, market analysis, and appraisal techniques. By applying scientific methodologies and carefully considering all relevant factors, appraisers can develop credible and reliable site value estimates that are essential for accurate real estate valuation.