Site Valuation: Highest & Best Use and Valuation Methods

Chapter 6: Site Valuation: Highest & Best Use and Valuation Methods

Part of: Mastering Appraisal Reconciliation: From Data to Defensible Value

(Description: Unlock the secrets to accurate and defensible property valuation! This course delves into the art of appraisal reconciliation, guiding you through the process of analyzing value indicators, applying sound judgment, and reaching a credible final value opinion. Learn to weigh the reliability and relevance of different appraisal approaches, address uncertainty, and confidently present your findings in compliance with industry standards. Elevate your appraisal skills and become a trusted valuation expert.)

Introduction

This chapter delves into the critical aspects of site valuation, a cornerstone of accurate and defensible property appraisals. Understanding the highest and best use of a site, whether vacant or improved, is fundamental to selecting the appropriate valuation methods and ensuring a credible final value opinion. This knowledge is directly relevant to mastering appraisal reconciliation as it informs the weighting and reliability assessment of the three approaches to value, thereby contributing to a more defensible final opinion, directly related to the COURSE DESCRIPTION. This chapter will explore these core concepts and will help solidify your standing as a trusted valuation expert.

6.1 Highest and Best Use (HBU): The Foundation of Site Valuation

The concept of Highest and Best Use (HBU) forms the bedrock upon which all credible property valuations are built. Misinterpreting or failing to properly analyze HBU can lead to significant errors in the reconciliation process and ultimately compromise the defensibility of the final value opinion.

6.1.1 Defining Highest and Best Use

Highest and Best Use 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.”

Mathematically, we can represent this as:

Maximize V(u)

Where:

• V(u) = Present Value of the property under use u
• u = A potential use of the property.

The HBU maximizes V(u) while satisfying all four constraints (legal, physical, financial, and maximal productivity).

The definition emphasizes that the appraiser must support their determination with thorough analysis of each individual requirement. This is not a speculative exercise, but a reasoned opinion supported by market data❓ and analysis.

Relevance to Appraisal Reconciliation: A flawed HBU analysis necessitates re-evaluation of ALL data and valuation indicators gathered in the appraisal process, greatly affecting the RECONCILIATION step.

6.1.2 The Four Tests of Highest and Best Use

Each potential use must be rigorously tested against these four criteria:

1. Legally Permissible:
   • The use must comply with all applicable zoning ordinances, building❓ codes, environmental regulations, and private deed restrictions. Consider potential variances or zoning changes.
   • Mathematically, legally permissible uses can be represented as a set: L = {u | u is legally permissible}. HBU must be a member of this set.
   • Example: A site zoned for single-family residential use cannot have a commercial building as its HBU, unless a reasonable probability of rezoning can be demonstrated.
2. Physically Possible:
   • The site’s size, shape, topography, soil conditions, accessibility, and environmental factors must be suitable for the proposed use.
   • Consider: Can the land support the structure (soil bearing capacity)? Is there adequate access (road frontage, utilities)? Are there environmental constraints (floodplain, wetlands)?
   • This requirement limits the solution set by intersection with the physically possible use set: L ∩ P = {u | u is legally permissible AND physically possible}
   • Example: A steep hillside might preclude the construction of a large, multi-story building.

3. Financially Feasible:

   • The use must generate sufficient income or utility to justify the costs of development, construction, and operation, reflecting current market conditions.
   • A feasibility analysis is critical to determine if the proposed use is economically viable.
   • Net Present Value (NPV) is a key indicator:
   • NPV = Σ [CFt / (1+r)^t] - Initial Investment
   • Where:
     • CFt = Cash flow in period t
     • r = Discount rate
     • t = Time period
   • The NPV must be greater than zero for the use to be considered financially feasible.

   • Intersecting with the financially feasible set gives: L ∩ P ∩ F = {u | u is legally permissible AND physically possible AND financially feasible}

   • Example: Building a high-end luxury condo in an area where demand is low and construction costs are high would likely not be financially feasible.

4. Maximally Productive:

   • Of all the remaining legally permissible, physically possible, and financially feasible uses, the HBU is the one that generates the highest present value for the property, maximizing its utility.
   • This step involves comparing the NPVs of all feasible uses and selecting the highest one.

   • The set HBU = {u | u ∈ (L ∩ P ∩ F) AND V(u) is maximized} contains the highest and best use.

   • Example: If a site can be used for either a retail store or a small office building, the use that generates the higher net operating income and thus highest value would be the HBU.

6.1.3 Vacant vs. Improved Property Analysis

A key distinction must be made between analyzing the HBU of land as if vacant and the HBU of the property as improved.

• Land as if Vacant: This analysis disregards any existing improvements and considers the site as if it were raw land, ready for development.
• Property as Improved: This analysis considers the existing improvements and evaluates whether the current use contributes to the overall property value. It involves assessing if modifications to the existing improvements would add value.

Crucially, an existing improvement may not represent the land’s HBU. The cost of demolition/renovation versus the potential increase in value by changing to the ideal use must be considered.

6.1.4 Interim Use

An interim use is a temporary use of a property that is not its ultimate highest and best use. It is often employed while waiting for market conditions or legal changes to make the ultimate HBU feasible.

Example: A site slated for future high-rise development might be used as a parking lot in the interim.

6.1.5 Legal Nonconforming Use

This occurs when a property’s current use no longer conforms to existing zoning regulations, but is permitted to continue because it was established before the zoning change.

It’s important to note the restrictions on expansion or alteration that typically accompany legal nonconforming uses, as these can limit their long-term value.

6.1.6 Consistent Use

The principle of consistent use requires that when land and improvements are valued separately, they must be valued based on the same use. This ensures that the value of the land is consistent with the use that supports the improvements.

6.1.7 Excess Land vs. Surplus Land

• Excess Land: Land that has the potential to be sold off separately and has its own highest and best use. The income potential of the excess land must be considered.
• Surplus Land: Land that cannot be sold off separately and does not have its own highest and best use. Its value is primarily derived from contributing to the existing improvements.

6.1.8 Plottage Value

Plottage refers to the increase in value that may occur when two or more contiguous parcels of land are assembled to create a larger parcel. The value of the assembled parcel must exceed the sum of the individual parcels to recognize a plottage increment.

Mathematically:
P = VA - (V1 + V2 + … + Vn)

Where:
P = Plottage value
VA = Value of assembled parcel
V1, V2, … Vn = Values of individual parcels

6.1.9 Experiments

Here are a couple of practical applications and related experiments.

1. Comparative Legal Analysis: To develop comparative reasoning and critical thinking skills regarding legality.
* Find properties with current “legal” zoning, or legal non-conforming zoning, to discuss and to compare.
* Discuss whether and how properties may have been considered legal, to then be deemed as having changed to non-conforming uses.
* Discuss the benefits of different legally permissive uses.

2. Economically Feasible Use Assessment: This exercise involves assessing whether a potential development project is economically viable given current market conditions.
* Outline potential uses to determine economic feasibility, such as retail, office, residential, and a mix of these.
* Estimate potential development costs, taking into account land acquisition, construction, operating expenses, and market value.
* Create financial pro forma statements to determine if a project will be economically viable for investment.

6.2 Methods of Site Valuation

Once the HBU has been established, the appraiser must select and apply appropriate valuation methods to estimate the site’s market value. Several methods are available, each with its own strengths and weaknesses.

6.2.1 sales comparison❓ Approach

The sales comparison approach is the preferred method for site valuation, where sufficient data is available. It involves analyzing sales of comparable vacant land parcels and adjusting their prices to reflect differences in characteristics compared to the subject site.

Key Steps:

1. Identify Comparable Sales: Locating similar sites that have recently sold in the same market area.
2. Verify Information: Confirm the details of each sale with reliable sources (e.g., brokers, buyers, public records).
3. Analyze Elements of Comparison: Identifying key differences between the comparables and the subject property that might affect value.
4. Adjust Comparable Sales Prices: Making appropriate adjustments to the sales prices of the comparables to account for differences from the subject property.
5. Reconcile Adjusted Values: Weighing the adjusted values of the comparables to arrive at an indicated value for the subject site.

Elements of Comparison (Adjustments):
The value of each must be considered.

1. Real Property Rights Conveyed: Fee simple, leasehold, etc.
2. Financing Terms: Cash, seller financing, favorable mortgage rates.
3. Conditions of Sale: Arm’s length transaction, motivated seller/buyer.
4. Expenditures Immediately After Sale: Site remediation, demolition, legal fees.
5. Market Conditions: Changes in market demand, interest rates, economic conditions.
6. Location: Neighborhood desirability, proximity to amenities, zoning.
7. Physical Characteristics: Size, shape, topography, soil conditions, access.
8. Economic Characteristics: Income, operating expenses, lease provisions.

Formula:

Adjusted Sales Price = Comparable Sales Price +/- Adjustments

6.2.1.1 Experiments

Here are a couple of practical applications and related experiments.

1. Identify Comparables Data: Finding comparable data requires thorough searching, which involves finding and assessing credible sources of sales.
* Research online for data, focusing on sources available through online sources for data, multiple listing services, realtors, title companies, and other similar entities.
* Review the strengths and weaknesses for each specific source.

2. Elements of Comparision Role Play: This exercise is designed to help gain hands-on and reasoning skills.
* Review a case study with various comparable parcels and then discuss differences that exist and that affect value, such as property rights, market dynamics, financing, and physical characteristics.

6.2.2 Allocation Method

This method estimates land value by comparing land to total value, relying on typical ratios of land value to total property value in the market area. This is most useful for new construction.

Formula:

Land Value = Total Property Value x Allocation Percentage

This method is less reliable than Sales Comparison due to the generalized nature of the allocation percentage.

6.2.3 Extraction Method

This method estimates land value by subtracting the depreciated cost of the improvements from the total property value.

Formula:

Land Value = Total Property Value - Depreciated Cost of Improvements

Accurate cost and depreciation estimates are critical for this method to be reliable.

6.2.4 Development Method (Subdivision Analysis)

This method, also known as subdivision analysis, is used to value land suitable for residential, commercial, or industrial development. It involves estimating the gross sales revenue and deducting all costs associated with development to arrive at a residual land value. The resulting figure is then discounted back to a present value.

Steps:

1. Estimate the number and type of lots/units that can be created on the site.
2. Project the gross sales revenue from the sale of the lots/units.
3. Estimate all development costs (e.g., construction, infrastructure, marketing, financing, permits).
4. Calculate the developer’s profit.
5. Deduct the development costs and the developer’s profit to arrive at a total land value estimate.
6. Discount the income to its present value.

Formula:
Present Value of Land = [Projected Gross Income – (Development Costs + Developer’s Profit)] / (1 + Discount Rate)^n

Where n = the project completion time❓

6.2.5 Land Residual Method

This income capitalization technique is used to value land by determining the residual income attributable to the land after deducting income to the improvements.

Steps:

1. Estimate the net operating income (NOI) of the property.
2. Estimate the value of the improvements.
3. Determine an appropriate capitalization rate for the improvements.
4. Calculate the income attributable to the improvements by multiplying the value of the improvements by the improvement capitalization rate.
5. Subtract the income attributable to the improvements from the total NOI to arrive at the income attributable to the land.
6. Capitalize the land income using a land capitalization rate to derive the land value.

Formulas:

Income (Land) = Total NOI - (Value (Improvements) * Cap Rate (Improvements))

Land Value = Income (Land) / Cap Rate (Land)

6.2.6 Ground Rent Capitalization

This income capitalization technique is used to value land that is subject to a ground lease, relying on the present worth of future ground rents. The land value is estimated by capitalizing the ground rent income stream.

Formula:

Land Value = Annual Ground Rent / Capitalization Rate

6.2.7 Depth Tables

These tables use percentages to reflect the depth of the lot. This tool uses the front section of a lot for the highest value.
The 4-3-2-1 method is commonly used for this, where value is broken down as follows:
* 40% of value for 25% of depth
* 30% of value for 25% of depth
* 20% of value for 25% of depth
* 10% of value for 25% of depth

6.3 Considerations for Appraisal Reconciliation

In the reconciliation process, carefully weigh the strengths and weaknesses of each valuation method used for site valuation.

• Sales Comparison: Considered most reliable when sufficient comparable sales data is available and adjustments can be reasonably supported.
• Allocation & Extraction: Useful as supporting techniques, but inherently less precise than Sales Comparison.
• Development Method: Highly sensitive to assumptions regarding development costs, sales prices, and discount rates.
• Land Residual & Ground Rent Capitalization: Require accurate income and expense data and appropriate capitalization rates.

6.4 Defensibility and USPAP Compliance

• Document All Data and Analysis: Maintain a complete and well-organized workfile to support all conclusions.
• Justify Adjustments: Provide clear and convincing evidence to support all adjustments made to comparable sales prices.
• Clearly Explain the HBU: Thoroughly document the HBU analysis, addressing each of the four tests (legal, physical, financial, maximally productive).
• Identify and Address Uncertainty: Acknowledge any limitations in the data or analysis, and discuss their potential impact on the value opinion.

6.5 Conclusion

Mastering site valuation requires a strong understanding of highest and best use principles and the application of appropriate valuation methods. By carefully analyzing each of these components and thoroughly documenting the process, appraisers can arrive at credible and defensible value opinions, critical in addressing uncertainty and presenting findings defensibly, as emphasized in the COURSE DESCRIPTION. This solidifies their role as trusted valuation experts.