Site Valuation Methods and Highest & Best Use

Chapter 6: site valuation methods❓❓ and Highest & Best Use

Description: Unlock the secrets of appraising unique property interests! This chapter delves into the valuation of sites, a crucial aspect of real estate appraisal, particularly for unique property interests such as condominiums, cooperatives, timeshares, manufactured homes, and leased lands. Gain expertise in applying various site valuation techniques, understanding their application within the cost approach, and reconciling them with the principles of Highest & Best Use.

I. The Indispensable Role of Site Valuation in Real Estate Appraisal

Site valuation is a fundamental component of the real estate appraisal process. It provides essential data for various valuation techniques, especially the cost approach, and is crucial for determining the Highest and Best Use (HBU) of the property. For unique property interests, understanding the site’s contribution to the overall value is even more paramount.

A. Reasons for Separate Site Valuation:

1. Cost Approach to Value: The cost approach estimates the value of a property by summing the land value and the depreciated cost of improvements. Thus, a separate site valuation is inherently required. The cost approach equation is represented mathematically as:

   • Property Value = Land Value + Cost (New) of Improvements - Depreciation

2. Building Residual Technique: In income capitalization, the building residual technique isolates the income attributable to the improvements, requiring a prior estimate of land value.

3. Legal and Regulatory Requirements: Appraisals for property tax assessment, condemnation, and other legal purposes often mandate separate site valuations. This relates directly to professional standards and can be affected by the type of property being assessed, such as manufactured homes or leased lands.

B. The Interplay with USPAP and Ethical Considerations:

• Scope of Work Rule: USPAP requires the appraiser to identify the problem, determine the scope of work necessary to solve the problem, and correctly complete the appraisal assignment. The need for a separate site valuation directly impacts the scope of work.
• Competency Rule: Appraisers must have the knowledge and experience to perform the valuation service competently. This includes the ability to properly apply different site valuation techniques to various types of property.
• Ethics Rule: Ethical obligations under USPAP demand unbiased and impartial valuations. Selecting and applying site valuation methods must be free from bias and aimed at achieving a credible result. This becomes especially critical when dealing with unique property interests where value may be highly subjective.

II. Unlocking the Concept of Highest & Best Use (HBU)

HBU analysis is not merely an exercise; it serves as the cornerstone upon which the entire appraisal process rests. For condominiums, cooperatives, timeshares, and leased lands, the nuances of ownership and restrictions significantly influence the HBU and subsequent valuation.

A. Definition of Highest & Best Use:

The HBU is defined as the reasonably probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and that results in the highest value. HBU must meet all four of these criteria, and can be expressed as:

1. Legally Permissible: The use must comply with zoning regulations, environmental laws, deed restrictions, and other applicable legal constraints.
2. Physically Possible: The site’s size, shape, topography, soil conditions, and other physical characteristics must be suitable for the proposed use.
3. Financially Feasible: The use must generate sufficient income or return to justify the investment. This considers construction costs, operating expenses, market demand, and capitalization rates.
4. Maximally Productive (Most Profitable): Among all the feasible uses, this is the one that yields the highest present value.

B. HBU As Vacant vs. HBU As Improved:

• HBU As Vacant: This considers the optimal use of the site if it were vacant and available for development. It disregards any existing improvements and analyzes the potential returns from developing the site with a new use. For instance, leased lands with a limited lease term may have a different HBU as vacant than as improved with an existing structure.
• HBU As Improved: This considers the optimal use of the site with the existing improvements. It analyzes whether the current improvements contribute to the site’s value or detract from it. If the value of the property with existing improvements exceeds the value as vacant less demolition costs, the current use is likely the HBU as improved. Timeshares, for example, might only be HBU under a shared ownership arrangement.

C. Mathematical Representation of HBU:

The difference between HBU can be conceptualized using the following:

• Value (as vacant) = Potential Income / Capitalization Rate
• Value (as improved) = Current Income / Capitalization Rate

The use that results in the higher value would represent the more suitable HBU.

D. HBU and Unique Property Interests (Relating to Course Description):

1. Condominiums and Cooperatives: The HBU analysis must consider the restrictions imposed by the condominium declaration or cooperative bylaws. While a single-family home might be HBU at one location, a restriction to condominiums changes it completely. The shared ownership structure impacts the financially feasible and maximally productive criteria.
2. Timeshares: HBU is almost always tied to the shared ownership model. The key lies in how well that model generates income relative to other potential uses of the underlying land, such as a hotel or residential development.
3. Manufactured Homes: The HBU considers both the land and the manufactured home itself. Depending on local regulations and market preferences, the HBU might be permanent placement on a foundation (treated as real property) or temporary placement (treated as personal property).
4. Leased Lands: The HBU is restricted by the terms of the lease. The analysis needs to consider the remaining lease term, any renewal options, and the allowed uses under the lease agreement. The discount rate applied to income projections must also reflect the risk associated with a leasehold interest.

III. Methods for Separately Valuing Sites: Scientific Principles, Formulas, and Applications

Appraisers employ a range of techniques to estimate land or site value. Each method has its strengths and weaknesses, and the selection depends on data availability, market conditions, and the specific characteristics of the property.

A. sales comparison❓❓ Method (Market Approach):

• Principle: Value is directly related to the sales prices of comparable sites in the market.
• Scientific Basis: This method is based on the principle of substitution, which posits that a rational buyer will pay no more for a property than the cost of acquiring a similar substitute.

• Process:

  1. Identify comparable vacant sites that have recently sold.
  2. Collect detailed data on each comparable, including sales price, location, size, zoning, topography, and any restrictions.

  3. Adjust the sales prices of the comparables to account for any differences between them and the subject site. Adjustments can be made for:

     • Property Rights Conveyed: Did the comparable sale involve fee simple ownership or a leasehold interest?
     • Financing Terms: Were there any unusual financing concessions that affected the sales price?
     • Conditions of Sale: Were there any extenuating circumstances (e.g., forced sale, family transaction) that might have influenced the price?
     • Expenditures Immediately After Sale: Were there any costs of the purchase immediately after the sale?

  • Market Conditions: Has the market changed significantly since the date of the comparable sale?

    • Location: Are there any differences in neighborhood amenities, access, or desirability?

    • Physical Characteristics: Are there any differences in size, shape, topography, or soil conditions?

  • Economic Characteristics: Are there any differing income, operating expenses, lease provisions, management, and tenant mix issues?

  4. Reconcile the adjusted sales prices to arrive at an indicated value for the subject site.
     * Mathematical Representation of Adjustments:
  • Adjusted Sales Price = Comparable Sales Price +/- Adjustments

• Experiments & Practical Applications:

  • Experiment: If there are multiple comparable properties, conduct a sensitivity analysis by systematically varying the adjustments to see how the final value estimate changes.
  • Application: When appraising a leased land parcel for a manufactured home, this would be the primary method to value vacant lots with leased land rights.

B. Allocation Method:

• Principle: A percentage of an improved property’s total value is allocated to the land.
• Scientific Basis: This relies on the assumption that there’s a consistent ratio between land value and improvement value within a given market.

• Process:

  1. Research market data to determine the typical ratio of land value to total value for similar properties.
  2. Estimate the total value of the subject property (using other appraisal approaches).
  3. Multiply the total value by the allocation percentage to arrive at an estimate of land value.

• Formula:

  • Land Value = Total Property Value * Allocation Percentage

• Experiment & Applications:

  • Experiment: Calculate the land value using allocation percentages from several different sources (e.g., local tax assessor, developer surveys). Analyze the results and determine which source provides the most credible data.
  • Application: Useful for quick assessments or when comparable land sales are limited.

C. Extraction Method:

• Principle: Land value is derived by subtracting the depreciated cost of the improvements from the total property value.
• Scientific Basis: Value is the sum of its parts (land & improvements). By isolating one part, the other can be found by subtraction.

• Process:

  1. Estimate the total value of the improved property (using other appraisal approaches).
  2. Estimate the replacement cost new of the improvements.
  3. Estimate the accrued depreciation of the improvements (physical deterioration, functional obsolescence, and external obsolescence).
  4. Subtract the depreciated cost of the improvements from the total property value to arrive at an estimate of land value.

• Formula:

  • Land Value = Total Property Value - Depreciated Cost of Improvements

• Experiments & Applications:

  • Experiment: Compare the land value obtained using extraction with the value obtained using the sales comparison method. Investigate any significant discrepancies.
  • Application: Helpful in situations where land values are rising rapidly and the existing improvements have minimal value. It’s also useful when comparable land sales are scarce.

D. Development Method (Subdivision Analysis):

• Principle: Land value is derived by estimating the future sales revenue from a proposed development and deducting all development costs, including profit, to arrive at a residual land value.
• Scientific Basis: This method incorporates the principle of anticipation, recognizing that land value is influenced by the potential future benefits of developing the site.

• Process:

  1. Determine the highest and best use of the site for development.
  2. Prepare a detailed development plan, including the number and type of units, construction costs, marketing expenses, and sales projections.
  3. Estimate the total sales revenue from the developed property.
  4. Deduct all development costs, including a reasonable profit margin for the developer.
  5. Discount the remaining value back to the present to account for the time value of money.

• Formula:

  • Land Value = (Projected Sales Revenue - Total Development Costs) / (1 + Discount Rate)^n

  where n is the number of years until completion of the project.
  * Experiments & Applications:

  • Experiment: Conduct a sensitivity analysis by varying the key assumptions (e.g., sales price, absorption rate, discount rate) to assess the risk associated with the development.
  • Application: Useful for valuing large tracts of land that are suitable for subdivision or multi-phase development. It’s commonly used for valuing land for condo development.

E. Land Residual Method:

• Principle: Land value is derived by isolating the net operating income (NOI) attributable to the land and capitalizing it into a value indication.
• Scientific Basis: Value is a function of income (the income approach to valuation).

• Process:

  1. Estimate the total NOI of the improved property.
  2. Estimate the value of the building improvements (using the cost approach).
  3. Determine the appropriate capitalization rate for the building improvements.
  4. Calculate the income attributable to the building improvements: Building Value * Building Cap Rate = Improvement Income
  5. Subtract the income attributable to the improvements from the total NOI to determine the income attributable to the land: Total NOI - Improvement Income = Land Income
  6. Capitalize the land income to arrive at an estimate of land value: Land Value = Land Income / Land Cap Rate

• Formulas:

  • Improvement Income = Building Value * Building Cap Rate
  • Land Income = Total NOI - Improvement Income
  • Land Value = Land Income / Land Cap Rate

• Experiments & Applications:

  • Experiment: Compare the land value obtained using the land residual method with the value obtained using the sales comparison method. Investigate any significant discrepancies.

F. Ground Rent Capitalization:

• Principle: Land value is derived by capitalizing the ground rent paid under a long-term lease.

• Scientific Basis: Capitalizing income is a direct application of the income approach to value.

• Process:

  1. Obtain the ground rent amount and the capitalization rate appropriate for the risk involved.
  2. Capitalize the land income to arrive at an estimate of land value: Land Value = Ground Rent / Cap Rate

• Formula:

  • Land Value = Ground Rent / Capitalization Rate

• Experiments & Applications:

  • Experiment: Compare the land value obtained with the comparable sales of leased land.
  • Application: This is specifically used with appraisals of leased lands, such as in the valuation of land underlying a manufactured home park, or with long-term commercial leases.

G. Depth Tables and Rules of Thumb:

• Principle: Value is not uniformly distributed across a site; the front portion typically has a higher value than the rear.
• Scientific Basis: Rules of thumb are a simplified representation of patterns observed in the market.

• Process:

  1. Use a table to allocate percentages of the site value to the front, middle, and rear.

• Formula: Land Value = Base Land Price * Table %

IV. Reconciling Site Values and the Appraisal Report

1. Reconciliation:

   • After applying the different site valuation methods, reconcile the value indications into a single, final estimate of site value.
   • Give the most weight to the method that is most reliable and appropriate for the specific property and market conditions. Typically, the sales comparison approach is given the most weight if sufficient data exists.
   • Clearly explain the reasoning for selecting the final value estimate in the appraisal report.

2. Reporting:

   • The appraisal report must clearly and accurately describe the site, including its size, shape, location, topography, and any other relevant characteristics.
   • Identify the highest and best use of the site, and explain the reasoning behind the determination.
   • Describe the site valuation methods that were used, and provide supporting data and analysis for each method.
   • State the final estimate of site value, and explain the reconciliation process.
   • Comply with all applicable USPAP requirements.

By mastering site valuation methods and their relationship to the concept of highest and best use, appraisers can unlock the complexities of valuing unique property interests and become trusted experts in the real estate market.