Site Valuation Methods

Chapter 6: Site Valuation Methods

Part of the Training Course: “Value Reconciliation: Mastering appraisal❓ Judgment”
(Description: Unlock the art of appraisal reconciliation! This course delves into the essential skill of synthesizing value indicators from different approaches. Learn how to weigh evidence, avoid mathematical fallacies, and apply sound judgment to arrive at a well-supported and credible final value opinion. Perfect for appraisers seeking to refine their expertise and deliver defensible valuations.)

Introduction:

This chapter addresses the critical task of site valuation, a cornerstone of appraisal practice. As highlighted in the course description, a thorough understanding of site valuation methods is essential for synthesizing value indicators and arriving at a well-supported and credible final value opinion. The ability to accurately estimate site value is crucial when applying approaches such as the cost approach and income capitalization techniques like the building residual method. The proper application of these methods requires that the appraiser exercise sound judgment and weigh evidence carefully to derive a defensible and credible valuation. This chapter will equip you with the knowledge and skills necessary to master this important aspect of appraisal judgment.

I. Importance of Site Valuation

• Necessity for Certain Valuation Techniques: As referenced in the book content, separate site valuation is crucial for the cost approach and the building residual technique within the income capitalization approach. Without a valid site valuation, the accuracy and reliability of these approaches are compromised.

  • Cost Approach (from Book Content): The value of the improved property is the site value plus the cost to construct improvements, less depreciation:

    • Property Value = Site Value + Replacement Cost - Depreciation
      • Building Residual Technique (Income Approach): This technique isolates the income attributable to the building improvements to derive site value. (Detailed coverage in Chapter 10).
    • Legal and Regulatory Requirements: Property tax assessments and condemnation proceedings frequently mandate separate site valuations. The scope of the appraisal assignment itself dictates the necessity for a separate valuation. This highlights the importance of defensible valuations.
    • Highest and Best Use Analysis: Determining the highest and best use of the land is a foundational step in the appraisal process, influencing the choice of valuation methods and the overall credibility of the final value opinion.

II. Defining Highest and Best Use (HBU)

• Scientific Definition: 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.
• Four Criteria:
  1. Legally Permissible: The use must adhere to current zoning regulations, building codes, environmental regulations, and private restrictions.
  2. Physically Possible: The site must possess the size, shape, topography, and other characteristics to accommodate the proposed use. Geotechnical analysis (soil bearing capacity) may be necessary.
  3. Financially Feasible: The use must generate sufficient income or return to justify the costs of development or renovation. This requires a thorough analysis of market demand, construction costs, and operating expenses. Applying sound judgment is crucial in this determination.
  4. Maximally Productive: Among the feasible uses, the one that yields the highest present value for the property is considered the highest and best use. This requires evaluating potential income streams and discounting them to their present worth.

III. Site Valuation Methods: Detailed Analysis

A. Sales Comparison Method❓❓ (The Primary Approach)

• Principle: This method relies on comparing the subject site to similar vacant sites that have recently sold in the market.
• Scientific Basis: The sales comparison approach is grounded in the economic principle of Substitution❓❓ – a buyer will pay no more for a property than the cost of acquiring a substitute.

• Process:

  1. Identifying Comparable Sales: The appraiser must identify recently sold vacant sites with similar characteristics to the subject property. Identifying truly “comparable” properties is paramount, aligning with the book content’s emphasis on effective sales comparison. This is often a starting point but must not be the whole process.
  2. Data Collection: Thoroughly gather data on the comparable sales, including sale price❓, date of sale, location, physical characteristics, zoning, and any unusual conditions of sale.

  3. Elements of Comparison: Adjust the sale prices of the comparables to account for differences between them and the subject property. This often requires weighing evidence to determine appropriate adjustment amounts.

     • Real Property Rights Conveyed: Consider fee simple, leased fee, life estate.
     • Financing Terms: Address any non-market financing concessions using financial calculations. (e.g., discounting below-market interest rates.)
     • Conditions of Sale: Adjust for any duress, related-party transactions, or atypical motivations.
     • Expenditures Immediately After Sale: Account for the cost to cure any deferred maintenance issues.
     • Market Conditions: Adjust for changes in market conditions using paired sales analysis. This includes identifying market trends to refine your opinion.
     • Location: Account for differences in location using market extraction or paired sales.
     • Physical Characteristics: Adjust for differences in size, shape, topography, soil conditions, and environmental factors.
     • Zoning and Legal Restrictions: Quantify the impact of any zoning limitations or deed restrictions through market analysis.
       4. Quantitative Adjustments: The adjusted values are indicators of value. The appraiser reconciles these values and forms an opinion.

• Mathematical Representation:

  • Adjusted Sale Price = Sale Price +/- Adjustments for differences in elements of comparison.
  • Value Indication (Subject) = Σ (Adjusted Sale Prices) / n (where n is the number of comparables)

• Practical Application and Experiment:

  • Scenario: Imagine valuing a 1-acre residential lot in a suburban area.

  • Experiment: Search for recent sales (within the last 6 months) of similar-sized lots in the same area. Assume you find three comparables with the following sales prices: $150,000, $160,000, and $155,000. After analyzing the sales, you determine the following adjustments:

    • Comparable 1: Requires a -$5,000 adjustment for a superior location and a +$2,000 adjustment for market conditions (sale occurred 3 months ago and prices have increased slightly).
    • Comparable 2: Requires a -$3,000 adjustment for financing and a +$1,000 for a better view.
    • Comparable 3: Requires a +$4,000 adjustment for smaller size and +$1,000 for market conditions.

  • Calculations:

    • Adjusted Price (Comp 1) = $150,000 - $5,000 + $2,000 = $147,000
    • Adjusted Price (Comp 2) = $160,000 - $3,000 + $1,000 = $158,000
    • Adjusted Price (Comp 3) = $155,000 + $4,000 + $1,000 = $160,000

  • Reconciliation: After carefully considering the strengths and weaknesses of each comparable, reconcile the value indicators by weighing the evidence. Giving Comp 2 a little less weight (due to the slightly less reliable financing adjustment) you arrive at a final estimated land value of: ($147,000 + $158,000 + $160,000)/3 = 155,000

  • Relating to Course Description: The sales comparison method exemplifies how appraisers must synthesize value indicators from different approaches and weigh evidence in forming a final opinion of value.
    B. Allocation Method

• Principle: This method derives site value by allocating a percentage of the overall improved property value to the land component.

• Process:

  1. Research Market Ratios: Identify typical land-to-value ratios for similar improved properties in the market area. These ratios are derived from sales of improved properties where land and improvement values are reliably known.
  2. Estimate overall property value❓❓: Determine the market value of the subject property as a whole, using techniques like the sales comparison or income capitalization approaches.
  3. Calculate Site Value: Multiply the overall property value by the appropriate land-to-value ratio to estimate the site value.

• Mathematical Representation:

  • Site Value = Overall Property Value x Land-to-Value Ratio

• Example: If similar homes in a neighborhood typically have a land-to-value ratio of 20% and the market value of the subject property (with improvements) is $300,000, the estimated site value would be $300,000 x 0.20 = $60,000.

• Limitations: This method is less reliable as market conditions rarely exhibit consistency, especially between dissimilar locations.
  C. Extraction Method

• Principle: This method estimates site value by subtracting the depreciated cost of the improvements from the overall property value.

• Process:

  1. Estimate Overall Property Value: As with the allocation method, determine the market value of the subject property (with improvements).
  2. Estimate Depreciated Cost of Improvements: Calculate the cost to replace the existing improvements, and then deduct accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
  3. Calculate Site Value: Subtract the depreciated cost of the improvements from the overall property value to arrive at the estimated site value.

• Mathematical Representation:

  • Site Value = Overall Property Value - Depreciated Cost of Improvements
• Relating to Course Description: Depreciation estimation is a key element of the cost approach and involves avoiding mathematical fallacies by properly addressing all three forms of depreciation.

D. Development Method (Subdivision Analysis)

• Principle: This method, also known as subdivision analysis, is used to value land suitable for residential or commercial development. It involves estimating the expected proceeds from selling developed lots, deducting development costs, and discounting the result to its present value.

• Process:

  1. Feasibility Study: Conduct a comprehensive feasibility study that includes a market analysis, site investigation, and cost estimates.
  2. Development Plan: Create a detailed development plan that specifies the number of lots, lot sizes, infrastructure requirements, and sales prices.
  3. Estimate Development Costs: Compile accurate cost estimates for construction, infrastructure, marketing, legal fees, and financing.
  4. Project Cash Flow: Forecast the expected cash flows from lot sales, factoring in sales rates, development costs, and financing terms.
  5. Discount to Present Value: Discount the projected cash flows to their present value using an appropriate discount rate that reflects the risk and time value of money.

• Mathematical Representation:

  • PV = Σ [CFt / (1 + r)^t] - DC (where: PV = Present Value of Land, CFt = Cash Flow in year t, r = Discount Rate, t = Time period, DC = Initial Development Costs)
• Relating to Course Description: This method heavily relies on sound judgment to select an appropriate discount rate and to estimate future cash flows. Furthermore, potential sources of mathematical fallacies must be avoided in the cash flow projections.
• Example: Estimate all the expenses of a subdivision as a value against the lots’ retail prices. Discount all those expenses that are required now against what the land is worth today.

E. Land Residual Method

• Principle: This method is used to value land that is leased and generates income. It involves isolating the portion of the property’s net operating income (NOI) attributable to the land and capitalizing that income stream to arrive at an estimated land value.

• Process:

  1. Estimate Overall Property NOI: Determine the total net operating income (NOI) generated by the property.
  2. Capitalize Building Income: Estimate the value of the building (improvements) using a separate appraisal or cost approach. Capitalize this value, i.e., multiply that value with the capitalization rate, to estimate the income the building is expected to generate.
  3. Calculate Residual Land Income: Deduct the income from improvements from total NOI to find the amount attributable to land.
  4. Capitalize Land Income: Capitalize the Residual Income❓❓ to estimate the value of the land by using a capitalization rate for land.
     • V = I / R (where: V = Value of Land, I = Residual Income, R = Land Capitalization Rate)

• Mathematical Representation:

• Site Value: NOILAND / LAND CAPITALIZATION RATE
  • NOIProperty - (Building Value x Building Capitalization Rate) / LAND CAPITALIZATION RATE

• F. Ground Rent Capitalization Method

• Principle: This method estimates the value of land by capitalizing the ground rent income generated from a land lease (the income generated from the lease).

• Process:

  1. Find all the market details of the ground lease. This includes amount, length, income stream.
  2. Estimate the property’s value based on capitalization rate.
  3. Find the ground rent value: NOILAND / LAND CAPITALIZATION RATE

• Mathematical Representation:

  *   *V* = *I* / *R* (where: *V* = Value of Land, *I* = Residual Income, *R* = Land Capitalization Rate)
  

• Example: Capitalize the yearly rent payments of land of $10,000 by .075 to determine value.

• Relevance: This is often more complicated because several factors must be taken into consideration.
  G. Depth Tables (Qualitative)

• Principle: Not very reliable. Determines depth based on percentage tables, giving the appraiser a ballpark idea of the value.

• Relating to Course Description: Not accurate as the need for depth of individual users is not considered.
  IV. Value Reconciliation & Appraisal Judgment

• Purpose of Site Valuation:
  As indicated in the book content, site valuation is the basis from which value conclusions are made. The appraiser must be prepared to reconcile site data if there are vast differences, depending on the method employed.

• Sound Judgement:
  The accurate use of the above techniques dictates the sound judgement and analytical prowess of the appraiser. This judgement allows for an accurate opinion of value.

Conclusion:

Mastering site valuation methods is a crucial skill for real estate appraisers. By understanding the principles behind each method and applying sound judgment in the selection of comparables and the reconciliation of value indicators, appraisers can arrive at well-supported and credible final value opinions. A thorough understanding of market forces, building construction, and financial calculations, combined with an adherence to ethical standards, will enable appraisers to deliver defensible valuations that stand up to scrutiny.