Site Valuation: Highest & Best Use and Appraisal Methods

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Chapter Title: Site Valuation: Highest & Best Use and Appraisal Methods

Introduction

As emphasized in “Mastering Appraisal Reconciliation and Reporting,” a credible and defensible valuation hinges upon rigorous analysis and a clear understanding of all contributing factors. Site valuation, intertwined with the concept of highest and best use, is a crucial step in this process, directly impacting the reliability of value indicators derived from the cost approach and income capitalization techniques. This chapter delves into these core concepts, equipping you with the scientific knowledge and practical skills needed to perform accurate site valuations that meet USPAP standards and exceed client expectations. This process involves understanding the interplay of legal constraints, market forces, and physical attributes, to determine the highest and best use. This, in turn, informs the selection of appropriate appraisal methods to reconcile value indicators, and ultimately, produce credible and defensible valuations.

I. Highest and Best Use: A Foundational Principle

• A. Definition and Scientific Basis:

  • Highest and Best Use (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.

  • The concept is rooted in economic principles of utility and scarcity. Utility dictates that a use must provide a benefit to potential users, while scarcity implies that the land resource is finite, thus driving competition for its optimal use.

  • Mathematical Model:
    Let $V_i$ be the present value of income stream from use i. Then, the Highest and Best Use is the use i such that:
    $$V_{HBU} = \max(V_1, V_2, ..., V_n)$$
    Where n is the set of all potential uses. This process of selection must be defendable.
    Present value formula:
    $$PV = \frac{CF}{(1+r)^n}$$
    Where PV is the present value, CF is the future cash flow, r is the discount rate, and n is the number of years.

  • B. The Four Tests of Highest and Best Use:

  • 1. Legally Permissible:

    • This criterion assesses the legal constraints on potential uses, considering zoning regulations, environmental laws, building codes, and private restrictions❓ (e.g., deed restrictions, easements).
    • Theories: Relates to legal and regulatory economics, specifically how property rights and regulations affect land utilization and value.
    • Example: Experiment: A developer plans to build a high-rise apartment complex. A thorough title search reveals a height restriction imposed by a historic preservation covenant. This renders the proposed use legally impermissible, even if it is economically the most profitable.
    • Note that legal changes may have an impact on valuation, such as new zoning ordinances or changes in environmental law.

  • 2. Physically Possible:

    • This criterion evaluates the site’s physical characteristics, such as size, shape, topography, soil conditions, drainage, and access.
    • Scientific Principles: Geotechnical engineering principles are vital in assessing soil stability and load-bearing capacity. Topography affects development costs and usability. Hydrology is critical for drainage considerations.
    • Example: Experiment: A site with a steep slope may be physically unsuitable for a large commercial building due to excessive grading and foundation costs. Soil percolation tests can determine if a septic system is viable, affecting residential development options.

  • 3. Financially Feasible:

    • This criterion assesses whether a potential use can generate sufficient income to cover development costs, operating expenses, and provide a reasonable return on investment.

    • Scientific Basis: This relates to financial economics and investment analysis. Net Present Value (NPV) and Internal Rate of Return (IRR) calculations are crucial.

    • Example: Experiment: A market feasibility study analyzes the demand and potential rental income for a proposed office building. If the NPV is negative, the use is considered financially infeasible.

    • Mathematical Formulas:

      • Net Present Value (NPV):
        $$NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t} - I$$

        Where:
        * $CF_t$ = Cash flow in period t
        * $r$ = Discount rate (required rate of return)
        * $n$ = Number of periods
        * $I$ = Initial investment
        * Capitalization Rate (Cap Rate):
        $$Cap Rate = \frac{Net Operating Income}{Property Value}$$
        * Net Operating Income (NOI) = Revenue - Expenses.

  • 4. Maximally Productive:

    • Among all the legally permissible, physically possible, and financially feasible uses, this criterion selects the use that generates the highest net return or value. It directly relates to income potential.
    • Theory: Principles of microeconomics relating to profit maximization and resource allocation.
    • Example: Experiment: A site could be developed as either a retail strip mall or a residential apartment building. Financial modeling indicates that the retail mall would generate a higher NPV, making it the maximally productive use. This selection MUST be defensible.

  • C. Relation to Course Description:

  • The application of these HBU principles is not merely academic. The appraiser must analyze the reliability of the data and the logic applied to the data to come up with an HBU conclusion. The chosen HBU serves as a cornerstone for accurate appraisal reconciliation. As stated in the book content, Step 7 of the appraisal process involves reconciling value indicators, which is only achievable with reliable data and sound judgement and analysis. This includes selecting the most appropriate method, and the HBU directly impacts the selection of such method. The resulting estimate should be a reliable one that can be communicated effectively, in accordance with USPAP.

II. Highest and Best Use: Vacant vs. Improved Land

• A. Separate Analyses: It’s essential to analyze HBU both:

  • 1. As if Vacant: This assumes the site is devoid of any improvements, enabling an assessment of the potential value that could be realized with completely new development.
  • 2. As Improved: This recognizes the value contribution (or detraction) of existing improvements, considering the cost of demolition or renovation.

• B. Interim Use:

  • Defines an interim use as the short-term or temporary use to which a site is put, pending its ultimate development for its highest and best use, as if vacant. The appraiser’s goal is to determine the current HBU, as if vacant, AND determine the value-maximizing interim use of the improved property, so that a final value may be developed.
  • Example: Parking lots are often an interim use of a commercially-zoned lot, that can be developed later for a high-rise complex.

• C. Legal Nonconforming Use:

  • A use that was legally established but no longer conforms to current zoning regulations. Appraisers must determine if that nonconforming use aligns with HBU.
  • Example: A retail store in an area that has been rezoned as residential.
  • Legal research and due diligence are critical here, as these uses may have restrictions (e.g., cannot be expanded). An error here may result in a misleading appraisal.

• D. Excess Land and Plottage:

  • Excess Land: Land not needed to support the primary HBU and capable of independent use.
  • Plottage: The incremental value created by combining two or more parcels of land into a single, more valuable parcel.
  • Both concepts impact site valuation and HBU analysis. They can be tested utilizing the same method as in I. B. 3.

III. Methods of Site Valuation

• A. sales comparison method❓❓❓ (Most Reliable)

  • This method involves analyzing recent sales of comparable vacant land parcels and adjusting their prices to reflect differences between the comparables and the subject property.

  • This is the most reliable due to the “Principle of Substitution” which states that a prudent investor will pay no more for a property than the cost of acquiring an equally desirable substitute on the open market.

  • Sources of Data: Real estate brokers, title companies, county records, MLS data, specialized data services (e.g., CoreLogic, FNC).
    It is vital to verify data accuracy and source reliability, addressing any limitations in the data.

  • Elements of Comparison:

    • Real Property Rights Conveyed (e.g., fee simple, leasehold)

    • Financing Terms❓❓ (adjust for non-market financing)

    • Conditions of Sale (adjust for atypical motivations, e.g., forced sale)

    • Expenditures Immediately After Sale (e.g., demolition costs, environmental remediation)

    • Market Conditions (adjust for changes in value over time)

      • Mathematical Formula:
        $$Adjustment = Sales Price \times Percentage Change$$
      • Regression analysis may be useful in identifying and quantifying market trends.

    • Location (adjust for neighborhood amenities, access, views)

    • Physical Characteristics (adjust for size, shape, topography, soil conditions)

    • Economic Characteristics (adjust for zoning, development potential)

      Adjustments must be supported by market data and clearly explained in the appraisal report, addressing their impact on value indicators.

• B. Allocation Method

  • Involves estimating the land value by applying a ratio or percentage derived from market data. For instance, in a residential area, land might typically account for 20% of the total property value.
  • Formula:
    $$Land Value = Total Property Value \times Allocation Percentage$$
  • This method is less precise and relies heavily on market-derived averages. Its application should be carefully justified and supplemented with other methods where possible.
• C. Extraction Method
  • Estimates land value by subtracting the depreciated cost of improvements from the total property value.
  • Formula:
    $$Land Value = Total Property Value - Depreciated Cost of Improvements$$
  • Depreciation estimation is critical for this method. It’s most reliable when improvements are new or easily valued. Note that depreciation is physical deterioration, functional obsolescence, and external obsolescence.

• D. Development Method (Subdivision Analysis)

  • Used for valuing land suitable for subdivision or development. It involves projecting future revenues from lot sales and subtracting development costs and a profit margin to arrive at a present value for the land.
  • Key Steps:
    • Develop a detailed development plan.
    • Estimate project costs (infrastructure, marketing, etc.).
    • Project sales revenues (number of lots * price per lot).
    • Discount future cash flows to present value using an appropriate discount rate.
  • Formulas:
    $$Projected Revenue= ∑n (Units Sold \_t * Sales Price\_t)$$
    $$Projected Costs= Initial Investment+ ∑n (Dev Costs \_t * Marketing \_t)] \[Land Value= \frac{Projected Revenue-Projected Costs}{(1+r)^t}$$
  • Highly dependent on accurate projections and the selection of an appropriate discount rate. Sensitivity analysis should be performed to assess the impact of varying assumptions.

• E. Land Residual Method

  • Determines land value by isolating the income attributable to the land and capitalizing it into value.

  • Steps:

    • Estimate the total net operating income (NOI) of the improved property.

    • Estimate the income attributable to the improvements (based on replacement cost and appropriate return rate).

    • Subtract the improvement income from the total NOI to determine the residual income attributable to the land.

    • Capitalize the land income into value using an appropriate land capitalization rate.

    • Formulas:
      $$Land Value = Land Income \div Land Capitalization Rate$$
      [Land Income= NOI−(Improvement Value×Improvement Capitalization Rate)]

      • Reliance on accurate income projections and capitalization rates is essential. This method is most applicable to income-producing properties.

• F. Ground Rent Capitalization Method

  • Valuation based on capitalizing the ground rent income of a leased site.

  • Formula:
    $$Land Value = \frac{Ground Rent}{Land Capitalization Rate}$$

  • Accurate determination of the capitalization rate is vital. This is best used for sites with existing ground leases and minimal future development potential.

• G. Depth Tables:

  • Used to adjust the value of a site based on its depth relative to a standard depth.

  • Reliance on accurate table and adjustment must be defendable.

IV. Reconciliation and Reporting

• As noted in Step 7 of the appraisal process, and noted in the book content, Reconciling Value Indicators, a thorough reconciliation of value indicators is crucial in determining the HBU conclusion. After value indicators are derived, they must be reconciled to arrive at a defensible single-point value.
• Reconciling the values is not a simple averaging of values, but involves a judgement by the appraiser to arrive at the most reliable estimate.

• Relevance to the Course Description:

  • This discussion directly addresses the course objective of ensuring accuracy and confidence in appraisal reconciliation. By understanding and applying appropriate appraisal methods, analyzing the reliability of the HBU data and analysis, and communicating findings clearly, appraisers can create credible and defensible valuations that meet USPAP standards and client expectations.

Conclusion

The process of site valuation is a core component of any defensible and credible appraisal report. By applying the process of HBU, selecting appropriate methodology, selecting reliable data, and reporting findings, an appraiser may add value to the appraisal process. These activities may, in turn, make the valuation a more defensible one and can minimize the risks for clients and appraisers alike.
This chapter has equipped you with a scientific framework for rigorous site valuation, empowering you to: confidently apply HBU principles, select appropriate appraisal methods, and reconcile value indicators with precision. As you continue through the course, remember that mastering these skills will elevate your appraisal expertise, enabling you to deliver credible and defensible valuations that exceed client expectations and adhere to the highest standards of professional practice.