Site Valuation Methods: An Overview

Chapter 6: Site Valuation Methods: An Overview

(Part of Training Course: Mastering Real Estate Appraisal: Regulations & Standards)

Description: This chapter provides an overview of the scientific principles and practical applications of site valuation methods, essential for accurate and compliant real estate appraisal within the context of FIRREA, Fannie Mae/Freddie Mac guidelines, and comparable sales analysis. We will delve into the theoretical underpinnings of each method and illustrate its applicability in the appraisal process, ensuring ethical and legally sound valuations for financial institutions.

6.1. Introduction: The Importance of Site Valuation

A separate site valuation is a critical component of several appraisal techniques, particularly when adhering to FIRREA and Fannie Mae/Freddie Mac guidelines for appraisals intended for financial institutions. Specifically:

• The Cost Approach, mandated by many lending institutions, relies on a separate estimate of site value.
• The Building Residual Technique, used in income capitalization, also demands a precise site valuation to isolate the value attributable to the improvements.

Beyond these specific applications, a separate site valuation is often required by law, especially in appraisals for property tax assessment and eminent domain proceedings. The scope of the appraisal assignment itself may dictate the need for a distinct site valuation, reinforcing the importance of this process in ensuring regulatory compliance and sound valuation practices.

6.2. Scientific Principles Underlying Site Valuation

The bedrock of site valuation lies in the economic principle of Highest and Best Use. This principle, rooted in microeconomics and Land❓❓ economics, dictates that the value of a site is determined by its most profitable and legally permissible use. This translates to the use that yields the highest net return to the land, considering all relevant factors.

6.2.1. Highest and Best Use Analysis:

The determination of Highest and Best Use is a systematic process involving four sequential tests:

1. Legally Permissible: The proposed use must comply with zoning regulations, environmental restrictions (e.g., wetland regulations, endangered species act), building codes, and private covenants (e.g., deed restrictions). Appraisers should consult with local zoning officials and legal professionals when navigating complex regulatory environments.
2. Physically Possible: The site must be physically suitable for the proposed use, considering its size, shape, topography (slope, drainage), soil conditions (bearing capacity, contamination), and access to utilities. Geotechnical reports and site surveys are essential data sources for this analysis.
3. Financially Feasible: The proposed use must generate sufficient revenue to cover all operating expenses, debt service, and provide a reasonable return on investment. Market analysis, including supply and demand studies, is crucial for determining financial feasibility.
4. Maximally Productive: Among all feasible uses, the highest and best use is the one that generates the highest residual land value. This involves comparing the net operating income (NOI) of each feasible use and subtracting all costs of production.

6.2.2. Anticipation Principle:

Underlying the Highest and Best Use principle is the Principle of Anticipation, which states that property value is determined by the anticipated future benefits derived from its ownership. This is reflected in the mathematical models used for discounted cash flow analysis (DCF), particularly in the development approach to site valuation.

6.3. Site Valuation Methods: An Overview

Several methods are employed to estimate site value, each relying on different scientific and economic principles. We’ll explore the most commonly used techniques.

6.3.1. Sales Comparison Approach

• Principle: The Sales Comparison Approach, based on the principle of substitution (a buyer won’t pay more than the cost of acquiring a comparable substitute), directly relies on market data. The value of the subject site is inferred from the sale prices of comparable vacant parcels.

• Process:

  1. Identify Comparable Sales: Find recent sales of vacant sites with similar characteristics and zoning.
  2. Identify Elements of Comparison: Key elements include:
     • Real Property Rights Conveyed: Fee simple vs. leasehold, mineral rights, water rights.
     • Financing Terms: Cash equivalent adjustments for below-market financing.
     • Conditions of Sale: Arm’s length transactions only. Distressed sales must be excluded or heavily adjusted.
     • Expenditures Immediately After Sale: Costs for demolition, remediation, etc.
     • Market Conditions: Adjustments for changes in the real estate market from the date of sale to the appraisal date. (See formula below)
     • Location: Proximity to amenities, schools, transportation, and disamenities (noise, pollution).
     • Physical Characteristics: Size, shape, topography, soil conditions, frontage, access.
     • Zoning and Legal Restrictions: Density limitations, permitted uses, setback requirements.
  3. Apply Adjustments: Adjust the sale prices of the comparables to reflect any differences between them and the subject property. Adjustments can be expressed as dollar amounts or percentages. The sequence of adjustments is important, and market conditions are usually accounted for first.

• Formula for Market Condition Adjustment

  Adjustment Amount = Sales Price of Comp × (Market Change Rate × Months Since Comp Sale)/12

• Example: A comparable lot sold for $100,000 six months ago. The market has appreciated at an annual rate of 6%. The adjustment for market conditions is calculated as: $100,000 × (0.06 × 6/12) = $3,000. The adjusted sales price is then $100,000 + $3,000 = $103,000

  If the adjustment is a percentage, the dollar amount of the percentage is calculated and then added to or subtracted from the comparable sale price.

• Challenges: Finding truly comparable vacant sites can be difficult, especially in developed areas. Subjectivity in applying adjustments is a potential source of error. Compliance with Fannie Mae/Freddie Mac guidelines requires clear documentation of the rationale for each adjustment.

6.3.2. Allocation Method

• Principle: This method assumes a typical or standard ratio between the value of land and the value of improvements for a particular property type within a specific market. The land value is estimated by multiplying the total property value by the percentage allocated to land.

• Process:

  1. Determine Total Property Value: Estimate the overall market value of a similar, improved property. This is usually done using the sales comparison approach to value or the income capitalization approach to value.
  2. Determine Land-to-Value Ratio: Derive the typical land-to-value ratio for similar properties in the area from market data (e.g., sales of new construction where land and construction costs are readily available).
  3. Calculate Land Value: Land Value = Total Property Value x Land-to-Value Ratio

• Formula:

  Land Value = Total Property Value * Land Percentage.

• Example: A similar property sold for $500,000. Market data suggests a typical land-to-value ratio of 20%. Therefore, the land value estimate is $500,000 * 0.20 = $100,000.

• Challenges: This method is less reliable than the sales comparison approach because it relies on broad generalizations about market ratios. Furthermore, the data quality of the land and improvement assessment needs to be assessed, and is often challenged by the market.
• This is usually a secondary valuation method for this reason. This also is a good test to use when employing the extraction method.

6.3.3. Extraction Method

• Principle: The value of the land is extracted by subtracting the depreciated cost of the improvements from the total sale price of an improved property.

• Process:

  1. Identify Comparable Sales: Find recent sales of similar, improved properties.
  2. Estimate Depreciated Cost of Improvements: Estimate the replacement cost new of the improvements and deduct all forms of depreciation (physical deterioration, functional obsolescence, and external obsolescence).
  3. Calculate Land Value: Land Value = Sale Price of Improved Property - Depreciated Cost of Improvements

• Formula:

  Land Value = Sale Price – Depreciated Cost of Improvements

• Example: An improved property sold for $600,000. The estimated replacement cost of the improvements is $400,000, and total depreciation is estimated at $50,000. The land value is, therefore, $600,000 - ($400,000 - $50,000) = $250,000.

• Challenges: The accuracy depends heavily on the ability to accurately estimate depreciation, which is often subjective. It is most reliable when the improvements are relatively new and depreciation is minimal, or in markets where land is in short supply and highly valuable.

6.3.4. Subdivision Development Analysis (Development Method)

• Principle: This method is primarily used for valuing large, undeveloped tracts of land suitable for subdivision. It estimates the present worth of a future income stream generated from the sale of finished lots after deducting all development costs.

• Process:

  1. Develop a Feasibility Study: This includes a detailed site plan, cost estimates for all development activities (infrastructure, utilities, marketing), projected sales prices for finished lots, and an absorption rate (the rate at which lots are expected to be sold).
  2. Project Future Cash Flows: Calculate the anticipated revenue from lot sales and deduct all development costs to arrive at net cash flows for each year of the project.
  3. Discount Cash Flows to Present Value: Apply a discount rate (reflecting the risk and time value of money) to the projected cash flows to determine their present value. The sum of the present values represents the estimated land value.

• Formula:

  Land Value = Σ [Net Cash Flow / (1 + Discount Rate)^Year]

  Where Σ represents the sum across all years of the project.

• Example:
  Net cash flow from the subdivided sales are as follows
  Year 1 = $100,000
  Year 2 = $150,000
  Year 3 = $200,000
  Year 4 = $150,000
  Year 5 = $50,000
  The appraiser determines the discount rate for the project should be 12%. The appraiser would discount each year of net cash flow separately using the rate and the years, which results in a value of $510,973.

• Challenges: This method is complex and requires significant expertise in development feasibility analysis. Accurate projections of sales prices, costs, and absorption rates are essential.

6.3.5. Land Residual Technique

• Principle: This method separates the income from an improved property into the income stream that is properly attributed to the building and the land. This allows the appraiser to subtract all costs of producing the income less the income generated by the building. What is left is the residual.

• Process:

  1. Estimates Total Value of the site Using other methods such as sales or income methods.
  2. Estimate Building Value By applying depreciation principles and construction costs
  3. Apply proper rent calculations Proper rental calculations must be determined
  4. Apply the rate of return for real estate as a whole
  5. Apply the Building interest rate This rate needs to be a fair amount and should include all things pertaining to the actual structure itself.
  6. From a proforma perspective, value can then be accurately derived by subtracting the building expenses from the income. This residual should be attributed to land.
     * Formula

Land Value = Property’s Value as a whole – The Building’s Value

• Example
  A comparable sale goes for $1,000,000. The appraiser has calculated that the structure is worth around $750,000, The land value, then is $250,000.
• Challenges
  Determining all factors into the assessment can prove difficult and is dependent upon accurate data for depreciation and construction, making the process difficult.

6.3.6. Ground Rent Capitalization

• Principle: This method is applicable when land is leased under a ground lease, where the tenant leases the land and constructs improvements. It capitalizes the ground rent (lease payments) to estimate the land value.

• Process:

  1. Identify Ground Lease Information: Determine the annual ground rent❓ and the remaining term of the lease.
  2. Select an Appropriate Capitalization Rate: Derive a capitalization rate for land from comparable ground leases in the area.
  3. Calculate Land Value: Land Value = Annual Ground Rent / Capitalization Rate

• Formula:

  Land Value = Annual Ground Rent / Capitalization Rate

• Example: The annual ground rent❓ is $10,000, and the appropriate capitalization rate for land is 8%. The land value is $10,000 / 0.08 = $125,000.

• Challenges: Reliable data on ground leases and appropriate capitalization rates may be limited. The value estimate may need to be adjusted if the ground lease contains unusual terms (e.g., rent escalation clauses).

6.3.7. Depth Tables

• Principle: This method recognizes that different portions of a lot offer different value to the whole lot. The 4-3-2-1 method is used to show the differences in value.

• Process:

  1. Divide the value of a lot The appraiser will then decide the depth is the entire value. The 4-3-2-1 method states that the total is the depth (4/10ths, 3/10ths, 2/10ths, 1/10ths), while the number indicates the overall importance.
  2. Add the total value of the lot* To make sure the value matches, add all factors to the value to the whole lot
     * Formula:**

Lot = 40% + 30% + 20% + 10% = 100% of Total Value

• Challenges
  It is difficult to properly assess the entire lot using this method because the method relies on generalization and simplification. Each lot is different.

6.4. Application in the Appraisal Process & Experimentation

6.4.1. Application of the Site Valuation Methods

These methods are tested and cross-referenced in the appraisal process, particularly within the Cost Approach. Fannie Mae and Freddie Mac guidelines emphasize the use of market-based data to support all value conclusions.

6.4.2. Experiment - Comparative Analysis

To gain a better understanding, the students can research and create a table in each of the valuation methods, analyzing multiple factors for each factor to see the impact and results of each appraisal type.

The Sales Comparison Method is the most accurate and accepted method for residential properties and most lending companies, this is generally the required method. While others can be useful for gaining understanding, the use should be limited unless the method is required in the appraisal report.

6.5. Conclusion

Site valuation is a critical component of accurate real estate appraisal, required by regulations such as FIRREA and influenced by guidelines from Fannie Mae and Freddie Mac. A thorough understanding of the scientific principles and practical applications of site valuation methods is essential for ethical and legally sound valuations. This chapter has provided an overview of these methods, but continued professional development and practical experience are necessary to master this essential appraisal skill.