Site Valuation: Determining Land Value

Chapter 6: Site Valuation: Determining Land Value

Part of Training Course: Mastering Appraisal Scope of Work & Reporting
(Description: Unlock the secrets to crafting credible and compliant appraisal reports! This course delves into the critical concept of Scope of Work, empowering you to determine the necessary research and reporting depth for accurate valuations. Learn how to navigate client expectations, avoid❓ misleading information, and master the Uniform Residential Appraisal Report (URAR). Gain the confidence to produce appraisal reports that meet professional standards and client needs, securing your position as a trusted valuation expert.)

I. Introduction

This chapter addresses the crucial topic of site valuation within the broader context of appraisal scope of work and reporting. As highlighted in the course description, mastering appraisal requires not only technical skills but also the ability to define a credible and compliant Scope of Work. Determining the value of land separately from any improvements is frequently required, particularly when utilizing the cost approach or income capitalization techniques such as the building residual technique. This chapter will explore the scientific foundations of site valuation, connect it to the overall appraisal process, and address the requirements for reporting a separate site valuation compliant with USPAP and relevant lending guidelines.

This chapter expands on earlier chapter’s description of site valuation, offering a deeper dive, and is related to both chapters 8 (Cost Approach) and 10 (Income Approach). This chapter helps appraisers determine land value, an important component of both of these chapters.

II. Highest and Best use❓: The Cornerstone of Site Valuation

A. Definition and Importance

The concept of Highest and Best Use is fundamental to all real estate valuation, especially site valuation. It’s the foundation on which an appraiser’s opinion of value rests and must be rigorously analyzed and documented. The Highest and Best Use (HBU) is defined as:

• Definition: 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.

• Importance: HBU analysis directly influences:

  • Data Selection: Guides the appraiser in selecting relevant data, identifying comparable properties, and determining the appropriate approaches to value. As the course description points out, the right scope of work includes the necessary research.
  • Valuation Approaches: Determines which valuation approaches are most applicable. For example, if the HBU is for a commercial development, the income approach might be prioritized.
  • Scope of Work: Defines the necessary research, verification, and reporting depth required in the appraisal assignment. A complex HBU requires a more detailed scope. As the course description mentions, understanding how to navigate client expectations helps develop an appraisal scope of work that meets professional standards.

B. Four Tests of Highest and Best Use

Each potential use of a site must satisfy four interrelated tests to qualify as its HBU. Failure to meet any of these tests eliminates that use from consideration.

1. Legally Permissible: The proposed use must be allowed under current zoning regulations, building codes, and other legal restrictions.

   • Example: A site might be ideal for a high-rise apartment building based on its location and economics, but if the zoning only permits single-family residences, this use is not legally permissible.
   • Scientific Principle: Legal permissibility is based on principles of constitutional law, property law, and land use regulations. These principles ensure that land use is consistent with the public good and protects the rights of neighboring property owners.

   • Experiment/Application: Appraisers must research zoning ordinances, consult with local planning departments, and review deed restrictions to determine permissible uses. A preliminary title report is also helpful to determine potential easements or encumbrances. In the case of complex zoning restrictions, a formal zoning verification letter from the local municipality might be required.
     2. Physically Possible: The site’s physical characteristics (size, shape, topography, soil conditions, access, environmental conditions) must be suitable for the proposed use.

   • Example: A steep, rocky site might be unsuitable for building a large shopping mall. Similarly, a site with significant environmental contamination might be limited in its potential uses.

   • Scientific Principle: This criterion rests on geotechnical engineering principles, which govern the suitability of soil for supporting structures. Topography and drainage patterns also play key roles.

   • Experiment/Application: A soil test may be necessary to evaluate the soil’s load-bearing capacity and permeability. Topographic surveys and environmental assessments can also be valuable tools.
     3. Financially Feasible: The proposed use must be economically viable, generating sufficient income or utility to justify the cost of development.

   • Example: A proposed apartment complex may be legally permissible and physically possible, but if the rental rates in the area are too low to cover construction costs and operating expenses, it is not financially feasible.

   • Mathematical Formulation: Profitability can be expressed by the following inequalities:

     • Net Operating Income (NOI) > Total Costs (TC) (for income-producing properties)
     • Utility > Cost (for owner-occupied properties)
       • Experiment/Application: Appraisers often conduct feasibility studies, analyzing market demand, construction costs, operating expenses, and potential revenues. Discounted cash flow (DCF) analysis can also be used to project future returns and determine the present value of the proposed development.
         4. Maximally Productive: Among all the legally permissible, physically possible, and financially feasible uses, the HBU is the one that yields the highest value or utility to the owner.

   • Example: A site could be used for either a small office building or a retail store. Both are permissible, possible, and feasible. The HBU is the one that generates the higher net income and therefore the highest value.

   • Scientific Principle: This test aligns with the principle of substitution and the concept of opportunity cost. The market will favor the use that provides the greatest return relative to alternative investments.
   • Experiment/Application: The appraiser must compare the value indications for all feasible uses. This often involves developing multiple scenarios and applying various valuation approaches to each.

C. The Principle of Anticipation

The Principle of Anticipation is critical to HBU analysis. It states that value is based on the expectation of future benefits, not just current conditions. An appraiser must consider future changes in zoning, market conditions, or other factors that might affect the potential uses of a site.

• Example: A site might be currently zoned for single-family residences, but if there’s a strong likelihood of rezoning for commercial use in the near future, this anticipation would significantly affect its current value.

D. Interim Uses

An Interim Use is a temporary use of a property that is not its ultimate HBU. It’s often a lower-intensity use employed while waiting for market conditions or other factors to warrant a higher-density development.

• Example: Farming on land intended for future residential development, or a parking lot on a site slated for an office building.

• Implications: In the Scope of Work, the appraiser must clearly identify if an interim use exists, and its potential impact on value. As the course description highlights, the scope should avoid misleading information in the report.
  This is particularly important in narrative appraisal reports.

III. Vacant Land vs. Improved Property: Highest and Best Use Considerations

A. Land as Vacant vs. Property as Improved

A key distinction in HBU analysis involves the question of whether the property should be valued as if vacant or as improved.

• Land as Vacant: This analysis disregards any existing improvements and focuses solely on the potential uses of the site. As chapter 3 notes, site valuation is essential for this analysis.

• Property as Improved: This analysis considers the existing improvements and evaluates whether they contribute to or detract from the overall value. The appraiser needs to consider the cost to cure functional or external obsolescence and/or the costs for demolition.

B. Determining the True Highest and Best Use

The true HBU is the use that results in the higher value, considering the cost of demolition and any value contributed by existing improvements.

1. Formula: The value of property at its HBU may be calculated as follows:

HBU value = max(Land Value (as if vacant) - Demolition Costs, Value of Property (as improved))

2. Decision Rule:

   • If (Land Value (as if vacant) - Demolition Costs) > Value of Property (as improved): HBU is as if vacant, indicating that the property should be redeveloped.
   • If (Land Value (as if vacant) - Demolition Costs) < Value of Property (as improved): HBU is as improved, indicating that the existing use should continue.

Remember, the appraiser must provide a detailed explanation, which means the appraisal report may require an addendum.

C. Legal Nonconforming Uses

A Legal Nonconforming Use is a use that was legally established but no longer conforms to current zoning regulations. These uses are typically allowed to continue but may be subject to restrictions on expansion or alteration.

D. Principle of Consistent Use

This principle requires that the land and improvements be valued consistently with the same HBU. If the HBU is for a commercial development, the land and potential improvements must be valued based on a commercial standard.

E. Excess Land vs. Surplus Land

• Excess Land: Has the potential to be sold separately and still allows the remaining lot to be developed to it’s legally permissible zoning capacity. Separate highest and best use from remaining land can exist.
• Surplus Land: Cannot be sold separately and still allow the remaining lot to be developed to it’s legally permissible zoning capacity. This land does not have a separate highest and best use from the remaining land.

F. Plottage

Plottage is an increase in value resulting from combining two or more sites under single ownership, where the larger parcel has a higher HBU.

G. Highest and Best Use in Residential Appraisals

In residential appraisals, the current use is typically assumed to be the HBU if it’s legally permissible, physically possible, financially feasible, and maximally productive. As chapter 3 notes, it is the responsibility of the appraiser to provide value indicators to ensure that value is in accordance with highest and best use. This assumption should always be verified with market data.

IV. Site Valuation Methods

This section details the primary methods for estimating land value. Selection of the appropriate method depends on data availability and the complexity of the appraisal assignment.

A. Sales Comparison Method

The Sales Comparison Method is the preferred and most reliable method when sufficient comparable sales data is available. The process is as follows:

1. Identify Comparable Sales: Gather data on recent sales of similar vacant sites in the same market area. As the course description emphasizes, this task requires determining the necessary research for the appraisal.
2. Verify Data: Confirm the details of each sale, including the price, date, terms, and conditions.

3. Elements of Comparison: Analyze each sale and identify relevant differences from the subject property based on the following elements:

   • Real Property Rights Conveyed: Account for any differences in ownership rights (fee simple, leasehold, etc.).
   • Financing Terms: Adjust for non-market financing or seller concessions.
   • Conditions of Sale: Ensure that sales were “arm’s length” transactions without undue pressure or special relationships.
   • Expenditures Immediately After Sale: Account for any necessary repair costs that a prudent purchaser would make.

   • Market Conditions: Adjust for changes in market conditions between the date of sale and the date of the appraisal. Mathematical Formulation:

     Adjusted Sale Price = Sale Price * (1 + Market Appreciation Rate)^(Time Difference)

   • Location Adjustments: Make adjustments for differences in neighborhood desirability, accessibility, or proximity to amenities.

   • Physical Characteristics: Account for differences in size, shape, topography, soil conditions, frontage, view, and other physical attributes.
     Mathematical Formulation: Depth Tables can be used, but there are limits as their use is limited in today’s marketplace.

     Adjusted Value = Depth Table Factor * Original Value
     * Economic Characteristics: For income-producing sites, consider differences in zoning, potential uses, or development costs.
     4. Comparable Sale Price Adjustments

   • Calculate the amount of the adjustments for all considerations. Remember that the comparable sales prices are adjusted to reflect the characteristics of the subject property.

   • Example: Comparable sales price is adjusted as follows:

   • Sale Price: $100,000
   • Financing Adjustment: -10% ($10,000)
   • Location: +$5,000
   • Net adjusted Value: $95,000
     5. Reconciliation: Reconcile the adjusted sales prices to arrive at an estimate of the subject site’s value. This requires careful judgment and weighting based on the reliability of each comparable sale and the magnitude of the adjustments.

• Formula: To determine how the comparable sale is weighed and ultimately reconciled, the appraiser follows these steps:
  Step 1: Determine weight of adjustments by adding all adjustments.

  • $10,000 (financing adjustment) + $5,000 (location adjustment) = $15,000.
    Step 2: Divide the comparable’s original sale price by the total adjustments.

  • $100,000 / $15,000 = 6.67%
    Step 3: Multiply the percentage by the comparable’s original sale price

  • 6.67% * $100,000 = $6,670.
    This is how much weight, in the form of dollars, will be provided to the sale.

B. Allocation Method

• Process: The Allocation Method estimates land value based on a typical ratio between land value and total property value for similar properties.

• Formula:

  Land Value = Total Property Value * Allocation Ratio

• Limitations: Relies on the assumption that a typical ratio exists, which may not be accurate in diverse markets.

• Application: Often used for property tax assessments or as a check on other valuation methods.

C. Extraction Method

• Process: The Extraction Method subtracts the depreciated cost of improvements from the total property value to estimate land value.

• Formula:

  Land Value = Total Property Value - Depreciated Cost of Improvements

• Limitations: Requires accurate estimation of depreciation, which can be subjective.

• Application: Most reliable when improvements are relatively new or of low value.

D. Development Method (Subdivision Analysis)

• Process: The Development Method projects the potential income from subdividing and developing a parcel of land, then discounts those future revenues to their present value.

• Formula:

  Land Value = Present Value of (Projected Revenues - Development Costs)

• Limitations: Complex and requires numerous assumptions about market conditions, absorption rates, and development costs.

• Application: Suitable for large, undeveloped parcels with subdivision potential.

E. Land Residual Method

• Process: The Land Residual Method isolates the income attributable to the land by subtracting the income attributable to the improvements from the total net operating income (NOI). As you can see, this is a component of Chapter 10.

• Formula:

Land Value = (NOI - Improvement Income) / Land Capitalization Rate

• Limitations: Requires reliable estimates of both the improvement value and the land capitalization rate.
• Application: Useful for income-producing properties where land value is a significant component of overall value.

F. Ground Rent Capitalization Method

• Process: The Ground Rent Capitalization Method capitalizes the ground rent income to estimate land value.

• Formula:

Land Value = Ground Rent / Land Capitalization Rate

• Limitations: Only applicable when a ground lease exists.
• Application: Useful for valuing leased land in commercial areas.

G. Depth Tables

Depth tables are typically expressed in chart form which shows the additional value for additional depth of a parcel.

• Process: These charts assume that the greatest value of the parcel resides in the front. The charts have already made their formulas, with each section reflecting additional depth of the parcel. Typically expressed in quarters, with the first section representing approximately 40% of the parcel.

Formula:
As previously listed (100%):
* 1st Section: 40%
* 2nd Section: 30%
* 3rd Section: 20%
* 4th Section: 10%

• Limitations: Limited in today’s marketplace. Not as applicable in the current market and may not be accurate.

• Application: Useful for an overview of the potential values throughout a parcel’s landscape.

V. Scope of Work and Reporting Requirements

• Scope of Work: In determining the Scope of Work, the appraiser must clearly define the extent of the research and analysis necessary to develop a credible opinion of land value. As previously mentioned, and highlighted in the course description, there must be credible and compliant appraisals done in a step-by-step procedure. This includes:
  • Identifying the most appropriate site valuation method(s) based on data availability and the complexity of the assignment.
  • Gathering and verifying relevant data from reliable sources.
  • Performing thorough analysis and making appropriate adjustments.
• Reporting:
  • The appraisal report must clearly and accurately describe the site, its HBU, and the methods used to estimate its value.
  • All data sources, assumptions, and adjustments must be adequately documented and supported.
  • The report must comply with USPAP standards, including the Ethics Rule, Competency Rule, and Scope of Work Rule.
  • As the course description highlights, it is imperative to craft appraisal reports that meet professional standards.

VI. Conclusion

Accurate site valuation is essential for reliable appraisal practice. This chapter has provided an overview of the key concepts, methods, and reporting requirements for determining land value. By mastering these principles, appraisers can develop credible and compliant appraisals that meet the needs of clients, safeguard the public trust, and secure their position as valuation experts.
This understanding of site valuation, combined with a strong grasp of appraisal principles and USPAP requirements, is essential for success in the appraisal profession. By following the orderly process of appraisal, as described in this course, and by adhering to a well-defined scope of work, appraisers can develop credible opinions of value that meet the needs of clients and stakeholders. As such, this lesson expands chapter 3’s description of site valuation and is directly related to chapters 8 and 10.

VII. Chapter Quiz

1. Define Highest and Best Use (HBU) and explain its significance in site valuation.
2. What are the four tests of HBU? Explain the importance of each test.
3. Describe the sales comparison method for site valuation. What are the key elements of comparison?
4. What are the advantages and disadvantages of the allocation and extraction methods?
5. Explain the income capitalization approach to site valuation, including the land residual and ground rent capitalization methods.
6. How does the Principle of Anticipation affect HBU analysis and site valuation?
7. Define interim use and give an example.
8. What is the difference between excess land and surplus land? How does this distinction affect value?
9. Explain the Scope of Work requirements related to site valuation. What are the key reporting elements?
10. How should you determine that a property with legal nonconforming use is still in accordance with its highest and best use?