English
Site Valuation: Methods and Highest & Best Use
Chapter: Site Valuation: Methods and Highest & Best Use
Part of: Mastering Appraisal Reconciliation and Reporting
Course Description: Unlock the secrets to confident appraisal reconciliation and reporting! This course delves into the art of analyzing value indicators, ensuring accuracy, and crafting clear, understandable appraisal reports. Learn how to reconcile conflicting data, assess reliability, and communicate your findings effectively, meeting uspap standards❓ and exceeding client expectations. Elevate your appraisal expertise and deliver credible, defensible valuations.
Introduction
This chapter focuses on the crucial elements of site valuation and highest and best use analysis. Understanding these concepts is fundamental to accurate appraisal reconciliation and reporting, aligning directly with the goals of this course to elevate appraisal expertise and deliver credible, defensible valuations that meet USPAP standards. We will explore various scientific theories and practical methods, including mathematical formulas, and provide examples relevant to the broader appraisal process.
I. Highest & Best Use: Foundational Principles
Understanding Highest and Best Use (HBU) is the starting point for any credible appraisal. This concept, rooted in microeconomic theory, helps to identify the most profitable and appropriate use for a property.
A. Definition & Significance
Highest and Best Use is formally 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. This analysis is crucial in the appraisal process because it:
- Determines the appropriate valuation approach: As outlined in the course description, choosing the correct approach to value (sales comparison, cost, or income) depends largely on the HBU. For example, income-producing properties rely heavily on the income approach derived from the most profitable use.
- Guides the selection of comparables: Selecting truly comparable properties (crucial in appraisal reporting as per the course description) hinges on them having a similar HBU to the subject.
B. Scientific Principles & Economic Underpinnings
The concept of HBU is based on several fundamental economic principles:
- Principle of Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. HBU dictates the “most desirable” attributes.
- Principle of Anticipation: Value is created by the expectation of future benefits. HBU defines the highest potential benefits.
- Principle of Contribution: The value of any component of a property (including the site) is determined by its contribution to the value of the whole.
C. The Four Tests of Highest & Best Use
The four tests, which must all be satisfied, are applied sequentially to determine HBU:
- legally permissible❓❓:
- This test considers zoning regulations, building codes, environmental regulations, deed restrictions, and historic preservation laws.
- Example: A site may be physically suitable and economically viable for a high-rise apartment building, but if zoning restricts height to 4 stories, the high-rise is not legally permissible and therefore, not the HBU.
- Relevance to Course: Failing this test leads to an inaccurate scope of work and a non-defensible valuation.
- Physically Possible:
- This test evaluates the site’s size, shape, topography, soil conditions, access, and availability of utilities.
- Example: A steeply sloped site may be unsuitable for a large commercial building due to high construction costs and engineering challenges.
- Relevance to Course: Physical limitations impact cost estimations, crucial in the cost approach.
- Financially Feasible:
- This test examines whether a proposed use will generate sufficient income or return to justify the costs of development. Consider market demand, construction costs, operating expenses, and potential income.
- Formula:
Profitability Index (PI) = Present Value of Future Cash Flows / Initial Investment- If PI > 1, the project is considered financially feasible.
- Example: Developing a luxury condominium complex in a market with an oversupply of high-end units may not be financially feasible, even if legally permissible and physically possible.
- Relevance to Course: Evaluating financial feasibility is vital for the income approach and reconciling value indicators from various approaches.
- Maximally Productive:
- This test determines which of the remaining feasible uses will generate the highest net return or value to the owner.
- Example: If a site could be used for either a small retail store or a fast-food restaurant, the use that generates the higher net operating income (NOI) would be considered the maximally productive use.
NOI = Potential Gross Income - Vacancy & Collection Losses - Operating Expenses
- Relevance to Course: The final estimate of value hinges on identifying the use that maximizes profitability.
II. Highest & Best Use of Land as Vacant vs. Improved
It’s critical to distinguish between HBU of land “as if vacant” and HBU of the property “as improved.”
A. Land as Vacant
- This considers the site devoid of any existing structures. The aim is to determine the most profitable use that the site could support if it were undeveloped.
- Importance: This helps identify the theoretical potential of the land and can reveal if the existing improvements are an underutilization of the site.
B. Property as Improved
- This considers the existing structures and their contribution to value. The analysis considers the cost to demolish existing improvements vs. the value they contribute.
- Example: A property with a functionally obsolete building might have a higher HBU as vacant land, even after factoring in demolition costs.
C. Interim Use
- A temporary use that generates income while awaiting the most profitable, but not yet feasible, permanent use.
- Example: A parking lot on land slated for future development.
- Relevance to Course: Recognising interim use is useful in the Direct Capitalization method in determining accurate income.
D. Consistent Use
- Appraisal principle stating that land and improvements must be valued based on the same use.
- Relevance to Course: This ensures a coherent and logical reconciliation of value indicators.
E. Legal Nonconforming Use
- A use that was legally established but no longer conforms to current zoning regulations.
- Example: A convenience store in a now-residential zone.
- Relevance to Course: Appraisers need to be able to determine whether this has an effect on highest and best use.
F. excess land❓ vs. Surplus Land
- Excess Land: Land that can be legally and physically separated from the subject parcel and has its own HBU and value.
- Surplus Land: Land that cannot be legally or physically separated, or which has no independent HBU.
G. Plottage
- An increase in value that results from combining two or more sites to create a single site with a higher and better use.
- Example: Combining several small residential lots to build a larger apartment complex.
III. Site Valuation Methods
Accurately valuing the site is crucial for applications of the cost approach and the income approach (building residual technique), techniques detailed in later chapters (8 and 10). Each valuation method leverages specific types of data and requires a distinct understanding of market dynamics.
A. Sales Comparison Approach❓❓
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This is the most reliable method and should be used whenever possible. It involves analyzing sales of comparable vacant sites and adjusting for differences.
- Data Sources: MLS data, public records, real estate brokers, developers.
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Elements of Comparison:
- a. Real Property Rights Conveyed: Adjust for fee simple vs. leased fee interests.
- b. Financing Terms: Adjust for below-market interest rates or seller financing.
- c. Conditions of Sale: Adjust for distress sales or related-party transactions.
- d. Expenditures Immediately After Sale: Adjust for required demolition or site remediation.
- e. market conditions❓: Adjust for changes in market conditions between the comparable sale date and the valuation date.
Adjustment = Sales Price * (1 + Market Appreciation Rate)^Time Difference
- f. Location: Adjust for differences in neighborhood characteristics or proximity to amenities.
- g. Physical Characteristics: Adjust for differences in size, shape, topography, soil conditions, and environmental hazards.
- h. Economic Characteristics: Adjust for differences in development potential, zoning restrictions, and utility availability.
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Mathematical Adjustments: These adjustments are applied to the comparable sales prices. The goal is to make the comparables as similar as possible to the subject property.
- Example:
- Comparable Site Sale Price: $100,000
- Adjustment for Smaller Size: +$5,000
- Adjustment for Inferior Location: +$2,000
- Adjusted Sale Price: $107,000
- Relevance to Course: The sales comparison approach directly addresses the need for accurate comparable analysis as stressed in the course description.
- Example:
B. Allocation Method
- This method estimates site value as a percentage of the total property value. The allocation percentage is derived from market data on typical ratios of land to building value for similar properties.
- Example: In a neighborhood where land typically accounts for 20% of total property value, a $500,000 property would have an estimated land value of $100,000.
- Formula:
Land Value = Total Property Value * Land Allocation Percentage - Limitations: Assumes a consistent relationship between land and building values. Less reliable in heterogeneous markets.
C. Extraction Method
- This method estimates site value by subtracting the depreciated cost of the improvements from the total property value.
- Formula:
Land Value = Total Property Value - Depreciated Cost of Improvements - Limitations: Reliant on accurate cost estimates and depreciation calculations.
- Relevance to Course: The cost approach requires a reliable site valuation. This method ensures that you will extract an estimate of site value.
D. Development Method (Subdivision Analysis)
- Used for valuing land suitable for subdivision and development. It involves estimating the projected sales revenue from the developed lots and subtracting the costs of development, including construction, marketing, and financing. The resulting figure is then discounted back to present value.
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Steps:
- Estimate total revenue from lot sales.
- Estimate development costs (construction, infrastructure, marketing).
- Estimate financing costs.
- Calculate net cash flow.
- Discount net cash flow to present value using an appropriate discount rate.
Present Value = ∑ (Net Cash Flow / (1 + Discount Rate)^Year)
* Relevance to Course: This technique, while complex, highlights how market assumptions and accurate cost analysis impact the final value estimate, essential components of appraisal reconciliation.
E. Land Residual Method
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This method is used for income-producing properties and separates the income stream attributable to the land from the income stream attributable to the improvements.
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Steps:
- Estimate the net operating income (NOI) of the property.
- Estimate the value of the improvements.
- Determine an appropriate capitalization rate for the improvements.
- Calculate the income attributable to the improvements:
Income (Improvements) = Value (Improvements) * Capitalization Rate (Improvements) - Subtract the income attributable to the improvements from the total NOI to find the income attributable to the land:
Income (Land) = Total NOI - Income (Improvements) - Capitalize the land income to estimate land value:
Land Value = Income (Land) / Capitalization Rate (Land) - Limitations: Highly sensitive to the accuracy of income and expense projections and capitalization rates.
- Relevance to Course: This method reinforces the critical analysis of income streams and capitalization rates.
- Example
- Step 1: Estimate Net Operating Income (NOI)
- Step 2: Estimate the Value of Improvements $2,500,000
- Step 3: Determine appropriate Capitalization Rate for Improvements 8%
- Step 4: Income (Improvements) = Value (Improvements) Capitalization Rate (Improvements)
Income (Improvements) = $2,500,000 * 0.08 = $200,000
- Step 5: Income (Land) = Total NOI - Income (Improvements)
- Step 6: Capitalize the land income to estimate land value
- Step 7: Select Capitalization Rate
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F. Ground Rent Capitalization
- Used when land is leased under a ground lease. Site value is estimated by capitalizing the ground rent.
Land Value = Ground Rent / Capitalization Rate
G. Depth Tables
- Percentage table used to illustrate how the highest value is located in the front part of a lot.
- Example: 4-3-2-1 Method
IV. Conclusion
This chapter provided a comprehensive overview of site valuation methods and the principle of highest and best use. Mastering these concepts, coupled with the techniques for analyzing value indicators discussed throughout this course, will significantly enhance your appraisal skills, enabling you to produce credible, defensible valuations that meet USPAP standards and exceed client expectations. Remember to always document your reasoning, supported by reliable data, to justify your valuation conclusions and adhere to professional appraisal standards. The ability to effectively communicate these findings is the ultimate goal of appraisal reporting.
Chapter Summary
- list the technical terminology used to describe residential construction,
I. Classification of Houses
Houses are generally classified on the basis of four characteristics: the number of units, whether the building is attached or detached, the number of stories and the architectural style.
The NUMBER OF UNITS refers to the number of separate households that the building is designed to accommodate. Although usage may vary in different areas, the term “house” is most often used to refer to a SINGLE-FAMILY RESIDENCE. If a building has multiple units that share a common access and other common areas, it is usually referred to as an APARTMENT BUILDING.
A DETACHED HOUSE is one that is not connected to any other property. ATTACHED HOUSES share one or more walls, called “party walls,” that are jointly owned by the two adjoining properties. ROW HOUSES, common in many urban areas, are an example of attached dwellings. Ownership of an attached dwelling often involves a PARTY WALL AGREEMENT, which assigns responsibility for maintenance and repair of the party wall(s) (see Figure 7-1).
A. TYPES OF HOUSES
The “type of house” refers to the number of stories or levels in the house, and their relationship to each other.
Although modern construction methods allow for all sorts of variations, the vast majority of houses fall into five basic “type” categories (see Figure 7-2):
1. one-story,
2. one and one-half story,
3. two-story,
4. split-level, and
5. bi-level (also known as split-entry or raised ranch).
A well-designed house should provide space for three basic activities: living, working, and sleeping.
Ideally, the spaces provided for each of these activities should be separated, so that one activity does not interfere with another. For example, bedrooms should be located where they will not be disturbed by activities in the living and working areas of the house.
Figure 7-5 shows how the spaces for the three different activities can be separated into zones. The LIVING ZONE includes the public areas of the house: the living room, dining room, family room and guest bath. The WORKING ZONE is comprised of the kitchen and laundry/ utility room. Bedrooms and private baths are located in the SLEEPING ZONE.
- understand the technical terminology used to describe residential construction.
I. Classification of Houses
Houses are generally classified on the basis of four characteristics: the number of units, whether the building is attached or detached, the number of stories and the architectural style.
The NUMBER OF UNITS refers to the number of separate households that the building is designed to accommodate. Although usage may vary in different areas, the term “house” is most often used to refer to a SINGLE-FAMILY RESIDENCE. If a building has multiple units that share a common access and other common areas, it is usually referred to as an APARTMENT BUILDING.
A DETACHED HOUSE is one that is not connected to any other property. ATTACHED HOUSES share one or more walls, called “party walls,” that are jointly owned by the two adjoining properties. ROW HOUSES, common in many urban areas, are an example of attached dwellings. Ownership of an attached dwelling often involves a PARTY WALL AGREEMENT, which assigns responsibility for maintenance and repair of the party wall(s) (see Figure 7-1).
A. TYPES OF HOUSES
The “type of house” refers to the number of stories or levels in the house, and their relationship to each other.
Although modern construction methods allow for all sorts of variations, the vast majority of houses fall into five basic “type” categories (see Figure 7-2): - one-story,
- one and one-half story,
- two-story,
- split-level, and
- bi-level (also known as split-entry or raised ranch).
This summary distills the key scientific and practical aspects of residential construction for appraisal professionals. It directly supports the course description by providing the foundational knowledge needed to confidently analyze property characteristics, reconcile value indicators, and produce credible appraisal reports, aligning with USPAP standards.
Scientific Summary of “Site Valuation: Methods and Highest & Best Use” Chapter
This chapter, essential for mastering appraisal reconciliation and reporting, focuses on the crucial skill of site valuation and its link to the highest and best use (HBU) determination. The chapter addresses the scientific basis of valuation by providing a systematic framework for analyzing land, separate from improvements, which is often required for the cost approach and income❓ capitalization techniques. It emphasizes the understanding of Market Trend Data as related to Competitive Supply and Demand Data that influences property values on a regional, community, and neighborhood level. The course directly supports the overall course goal of delivering credible, defensible valuations.
Main Scientific Points and Conclusions:
- Highest and Best Use (HBU): The chapter introduces HBU as the legally permissible, physically possible, economically feasible, and maximally productive use of a property. It differentiates between HBU “as if vacant” and “as improved,” recognizing the importance of the Principle of Anticipation (potential future benefits). Determining the appropriate type is emphasized to correctly evaluate comparables and ensure appraisal❓ accuracy.
- Land Valuation Methods: Six scientifically validated methods are detailed, including the sales comparison❓ (most reliable), allocation, extraction, development, land residual, and ground rent capitalization. Each technique is presented with clear explanations of its underlying assumptions, required data, and specific application scenarios. This knowledge supports the course’s aim of equipping appraisers with the ability to reconcile conflicting data.
- Elements of Comparison: Detailed discussion of the adjustments including: Real Property Rights Conveyed, Financing Terms, Conditions of Sale, Expenditures Immediately After Sale, market conditions❓ Adjustment, Location Adjustments, Physical Characteristics, and Economic Characteristics.
- Mobile Applications: Specific applications for on-site data gathering including those by Al La Mode, are described in detail.
- Functional Utility: The appraisal draws significant weight to features of a functional design.
Implications for Appraisal Reconciliation and Reporting:
- Accurate Valuation: The chapter highlights that a flawed HBU analysis invalidates the entire appraisal process. The methods presented provide appraisers with the tools to independently derive site values, reducing reliance on potentially biased sources and improving accuracy.
- Data Reconciliation: The chapter stresses the importance of understanding the strengths and weaknesses of each valuation method, allowing appraisers to assess the reliability of different value indicators and reconcile discrepancies.
- Defensible Reports: By mastering these methods and understanding their underlying scientific principles, appraisers can produce well-supported, transparent appraisal reports that meet USPAP standards and withstand scrutiny.
- In Summary: An appraisal requires the highest level of market knowledge of not only sales transactions, but also, real estate regulations, demographic data, population trends and patterns, and the skill to extract the essence of property values using the three traditional approaches to value.
