Cost Approach to Value: Site Valuation Essentials

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Chapter 6: Cost Approach to Value: Site Valuation Essentials

I. Introduction

The cost approach to value is a fundamental appraisal methodology wherein the value of a property is derived by estimating the current cost of reproducing or replacing the improvements, deducting accrued depreciation, and adding the estimated land (site) value. A precise and defensible site valuation❓❓ is paramount to the accurate application of the cost approach. This chapter will explore the essential principles and techniques involved in site valuation within the context of the FIRREA and USPAP requirements, focusing on scientific underpinnings and practical application for federally related transactions. As FIRREA emphasizes the need for sound appraisal practices to maintain the stability of financial institutions, accurate site valuation plays a critical role.

II. The Theoretical Basis of Site Valuation in the Cost Approach

A. Principle of Substitution:

The cost approach operates based on the principle of substitution. This principle posits that a rational buyer will pay no more for a property than the cost of acquiring an equivalent substitute. In the cost approach, the substitute is the land and new improvements.

B. Irreproducible Asset Consideration:

Land, unlike improvements, is an irreproducible asset. It cannot be manufactured or readily replicated. This intrinsic scarcity contributes significantly to its value. As such, the market forces of supply and demand, and location attributes, have a prominent impact on land values.

C. Contribution & Diminishing Returns:

The site’s value makes a distinct contribution to the total property value. However, the principle of diminishing returns dictates that adding excessive improvements or inappropriate improvements may not result in a commensurate increase in value, and the appraiser must consider this in their analysis of HBU.

III. Site Valuation: Scientific Methods and Practical Application

A. Sales Comparison Approach (Most Reliable):

1. Theoretical Framework: This approach draws upon the principle of substitution. Value is inferred from the sale prices of comparable sites, adjusted for differences in characteristics.
2. USPAP Compliance: USPAP Standard 1-4(a) requires the appraiser to analyze all agreements of sale, options, and listings of the subject property and comparable properties if such are reasonably available to the appraiser. This directly impacts the data gathering and analysis for the sales comparison approach.
3. Methodology:
   • Identify comparable sites: Must share similar zoning, size, location characteristics, and potential uses with the subject site. As FIRREA applies to federally related transactions, data needs to be credible and verifiable.
   • Data Collection: Sales prices, dates of sale, property rights conveyed, financing terms, and conditions of sale. Utilize primary sources whenever possible (deeds, interviews with parties to the transaction).
   • Adjustments: Apply quantitative and qualitative adjustments to the comparable sales prices to account for differences between the subject and comparable sites. The order of adjustments matters (typically, financing and conditions of sale first, followed by physical characteristics and location).

4. Mathematical Representation:

   Subject Value = Comparable Sales Price +/- Adjustments

   Where:

   • Subject Value is the estimated value of the subject site.
   • Comparable Sales Price is the sales price of the comparable site.
   • Adjustments are dollar or percentage adjustments for differences.

5. Example:

   Comparable Site A sold for $100,000. It is 10% smaller than the subject, and market data suggests a $5,000 premium for the subject's location.
   
   *   Adjustment for size: +$10,000 (assuming a linear relationship between size and value for this range)
   *   Adjustment for Location: -$5,000.
   
   `Subject Value = $100,000 + $10,000 - $5,000 = $105,000`
   

   6. Experiment (Simulated Paired Sales Analysis):

   Select two seemingly identical sites in the same area, sold around the same time, but one with and one without a specific feature (e.g., view, street access). Calculate the difference in price and attribute it to the specific feature. Repeat with several paired sales to derive an average adjustment for this characteristic.

B. Allocation Method:

1. Theoretical Framework: Based on the typical ratio of land value to total property value in a given market. Less precise than sales comparison but sometimes useful where vacant land sales are scarce.
2. Methodology:
   • Determine the overall property value of comparable improved properties (sales comparison).
   • Research typical land-to-property value ratios for similar properties. This data is typically derived from market analysis or expert surveys.
   • Multiply the overall property value by the land-to-property ratio to estimate land value.

3. Mathematical Representation:

   Land Value = Total Property Value * Land Ratio
   4. Limitations: The allocation method is more suitable for residential properties within homogenous neighborhoods, where a clear value ratio is available. For commercial or industrial properties, the method is less reliable due to the wide variability in improvement types and values.
   5. Example:

   Comparable Property B sold for $500,000. Market data indicates that land typically accounts for 20% of total property value in this area.

   Land Value = $500,000 * 0.20 = $100,000

C. Extraction Method:

1. Theoretical Framework: This method infers land value by subtracting the depreciated cost of improvements from the total sale price of an improved property.
2. Methodology:
   • Identify comparable improved properties.
   • Estimate the reproduction or replacement cost new of the improvements (using cost data from Marshall & Swift, local contractors, etc.).
   • Estimate accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
   • Subtract accrued depreciation from the cost new to arrive at the depreciated cost of the improvements.
   • Subtract the depreciated cost of the improvements from the total sale price to estimate land value.

3. Mathematical Representation:

   Land Value = Sale Price - Depreciated Cost of Improvements

4. Equation for Depreciation Estimation (Straight-Line Method):

   Annual Depreciation = (Cost New - Salvage Value) / Useful Life

5. Example:

   Comparable Property C sold for $600,000. The cost new of the improvements is estimated at $400,000, and total accrued depreciation is $50,000.

   Land Value = $600,000 - ($400,000 - $50,000) = $250,000
   6. Experiment (Comparative Depreciation Analysis):

   Select several properties in a homogenous area with varying ages and conditions. By analyzing their sale prices and using a depreciation methodology, infer the annual depreciation rate typical in the market and apply it to the subject.

D. Other Techniques (Less Commonly Used for Site Valuation in Federally Related Transactions, But Potentially Relevant):

• Land Residual Technique: This involves isolating the income attributable to the land and capitalizing it to determine the land’s value.
• Subdivision Development Analysis: This method is used to value large tracts of land suitable for subdivision. It involves projecting the revenue from selling individual lots, deducting development costs and profit, and discounting the net cash flow to present value to determine the land value.

IV. Highest and Best Use (HBU) Analysis in Site Valuation

A. Definition and Importance:

Highest and best use (HBU) is the reasonably probable and legal use of a vacant land or improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value. An accurate determination of HBU is crucial to site valuation, as it guides the selection of comparable sales and the application of appropriate valuation techniques.

B. Four Tests of HBU:

1. Legally Permissible: Zoning ordinances, building codes, environmental regulations, and deed restrictions.
2. Physically Possible: Site size, shape, topography, soil conditions, access, and availability of utilities.
3. Financially Feasible: Demand, supply, market conditions, cost of development, and potential revenue.
4. Maximally Productive: The use that generates the highest net return or value.

C. HBU as Vacant vs. HBU as Improved:

An appraiser must consider both the highest and best use of the site as though vacant and available for development and the highest and best use of the property as currently improved. If these uses differ, the appraiser must determine the use that results in the highest value.

D. Mathematical and Statistical considerations in estimating HBU:

• Economic Feasibility Analysis: In this, the appraiser estimates the cost of development of a given HBU, the demand, and revenues. The income is then discounted by a discount rate to arrive at the Net Present Value.
• Sensitivity Analysis: The NPV should be tested against possible changes in the estimated revenue/expenses to determine to what degree a minor change in the input parameters could change the output significantly.
• Data confidence Intervals: Confidence Intervals are based on statistical modeling to determine the range of likelihood that a property will sell at the estimated value. This increases or reduces the confidence in the HBU for the subject property, and this should be adjusted as required in the valuation estimate.

V. FIRREA and USPAP Compliance

A. FIRREA Requirements:

The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) mandates that appraisals used in federally related transactions comply with USPAP. This includes rigorous standards for data collection, analysis, and reporting.

B. USPAP Standard 1 and 2:

• Standard 1 requires appraisers to develop credible opinions and conclusions. This involves thorough market research, accurate data gathering, and appropriate analysis.

• Standard 2 sets forth requirements for reporting appraisals. Appraisal reports must clearly and accurately communicate the scope of work, data used, reasoning, and conclusions.

C. Specific USPAP Rules Related to Site Valuation:

• Competency Rule: Ensure the appraiser has the knowledge and experience to competently perform the assignment.
• Ethics Rule: Maintain objectivity and impartiality.
• Record Keeping Rule: Maintain work files that contain sufficient information to support the appraiser’s opinions and conclusions.

D. Impact of USPAP on Site Valuation:

USPAP emphasizes the need for credible data, appropriate methodology, and a well-supported rationale. This requires appraisers to:

• Thoroughly research the market to identify comparable sales of vacant land.
• Verify data with reliable sources (deeds, interviews).
• Apply appropriate adjustments based on market evidence.
• Clearly explain the reasoning behind the selection of the valuation method and the application of adjustments.

VI. Case Study: Federally Related Transaction

Consider a single-family residential appraisal for a mortgage loan insured by the FHA.

• Property: A vacant lot in a suburban area.
• Zoning: Single-family residential.
• FIRREA Relevance: The FHA insurance makes this a federally related transaction, requiring USPAP compliance.
• Appraisal Problem: Determine the market value of the site using the cost approach.

Step 1: HBU Analysis
* Legally Permissible: Zoning allows single-family housing.
* Physically Possible: Lot is suitable for residential construction.
* Financially Feasible: Market data shows demand for housing in the area.
* Maximally Productive: Single-family housing is the most profitable use given market conditions.

Step 2: Data Gathering
* Sales data on comparable vacant lots in the area.
* Information on zoning regulations, taxes, and utilities.
* Data on construction costs and depreciation rates for residential improvements.

Step 3: Site Valuation
* Sales Comparison Approach: Identify 3-5 comparable sales, adjust for differences in size, location, and market conditions.
* Extraction Method: If vacant land sales are scarce, use the extraction method based on improved property sales. Estimate the depreciated cost of a typical home and subtract it from the sale price.

Step 4: Reconciliation and Reporting
* Reconcile the value indications from each approach to arrive at a final opinion of site value.
* Prepare an appraisal report that meets USPAP requirements, including a clear explanation of the methodology, data, and reasoning.

VII. Challenges and Mitigation Strategies

A. Limited Data Availability: Vacant land sales may be infrequent in some markets.
* Mitigation: Expand the geographic search area, consider sales of improved properties and use the extraction method, or consult with local real estate professionals.

B. Subjectivity in Adjustments: Adjustments for differences between the subject and comparable sites may involve some degree of subjectivity.
* Mitigation: Rely on market evidence to support adjustments, use paired sales analysis, and provide clear explanations in the report.

C. Compliance with USPAP:
*Mitigation: Maintain detailed workfiles and ensure data, reasoning and reports are USPAP compliant. Maintain the highest level of objectivity in valuation estimates.

VIII. Conclusion

Accurate site valuation is essential for a credible cost approach to value, and is directly tied to regulatory compliance, particularly with FIRREA and USPAP. Appraisers must apply sound judgment, utilize credible data, and adhere to ethical principles to develop defensible opinions of value. The use of scientific methods, detailed documentation, and thorough analysis are key to maintaining the integrity of the appraisal process in federally related transactions.