The Cost Approach: Site Valuation

Chapter 6: The Cost Approach: Site Valuation

Course: Mastering Appraisal Reports: A Comprehensive Guide

(Description: Unlock the secrets of effective appraisal reporting! This course dives deep into the structure and components of appraisal reports, focusing on the Uniform Residential Appraisal Report (URAR). Learn how to accurately analyze property data, apply sales comparison, cost, and income approaches, and create comprehensive, compliant reports that meet industry standards. Gain the skills to excel in real estate appraisal and enhance your professional credibility.)

This chapter builds upon the foundational knowledge of appraisal principles introduced earlier in this course, specifically focusing on the critical role of site valuation within the cost approach. It aligns directly with the course description by providing in-depth guidance on accurately analyzing property data, a key component of creating comprehensive and compliant appraisal reports. We will explore the scientific underpinnings of site valuation, relevant valuation techniques, and their practical application in appraisal reporting. Mastery of these concepts is essential for excelling in real estate appraisal and enhancing professional credibility.

6.1 The Importance of Site Valuation in the Cost Approach

The cost approach, one of the three primary approaches to value, relies heavily on a precise estimate of site value. As outlined in the course description, understanding this approach is vital for preparing complete and compliant appraisal reports. The cost approach is predicated on the principle of substitution: a buyer will pay no more for a property than the cost to acquire a comparable site and construct a substitute improvement. This can be expressed as:

Property Value (Cost Approach) = Site Value + Cost of New Improvements - Depreciation

The accuracy of the final value indication is therefore directly dependent on the accuracy of the site valuation. As we progress in this chapter, we will see that the methods of site valuation are tied to certain valuation techniques, including the cost approach.

6.2 Scientific Principles Underlying Site Valuation

Site valuation is not merely an exercise in finding comparable land sales; it is grounded in sound economic and geographic principles. The key is recognizing the highest and best use of the land.

6.2.1 Highest and Best Use (HBU):

The HBU is defined as the most probable and legal use of a property, which is physically possible, appropriately supported, financially feasible, and results in the highest value. Identifying the HBU is crucial in determining the value of a site. It’s the cornerstone upon which valuation is based.

• Legally Permissible: The proposed use must conform to current zoning regulations, building codes, environmental laws, and any private restrictions (e.g., deed restrictions, easements). Appraisers should consult local planning departments and review property records to ascertain legal constraints.
• Physically Possible: The site’s physical characteristics (size, shape, topography, soil conditions, access, and availability of utilities) must be suitable for the proposed use. Geotechnical reports, topographic surveys, and environmental assessments may be required.
• Financially Feasible: The proposed use must generate sufficient revenue to cover operating expenses, debt service, and provide a reasonable return on investment. Market demand and economic conditions must support the financial viability of the use.
• Maximally Productive: Among all feasible uses, the HBU is the one that generates the greatest net return or benefit to the property owner. This is not always the use that generates the highest gross income, but the one that yields the highest profit after all costs and expenses are considered.

6.2.2 Principle of Anticipation:

The principle of anticipation dictates that the value of a site is determined by the expected future benefits (e.g., income, utility, amenity) that the site is expected to provide. The market anticipates these future benefits, and this expectation influences the value.

6.2.3 Supply and Demand:

The forces of supply and demand have a significant impact on site values. High demand and limited supply will increase the value, while oversupply and low demand will decrease it. Economic data, demographic trends, and construction activity must be examined to ascertain the balance of supply and demand in the market.

6.2.4 Externalities:

Site values are affected by external factors such as proximity to amenities, disamenities (e.g., noise, pollution), access to transportation, quality of schools, and the overall desirability of the neighborhood. These factors influence the perceived desirability and utility of the site.

6.3 Site Valuation Methods: A Scientific Approach

Several methods are available for estimating site value, each with its strengths and limitations. In this course, emphasis is placed on understanding the methodologies available, and their role within the context of creating complete and compliant appraisal reports.

6.3.1 Sales Comparison Approach (SCA):

This method is considered the most reliable, and is, as the book content notes, the most often used method of valuing land. It is based on the principle of substitution: a buyer will pay no more for a site than the price of a comparable site. The SCA involves:

1. Identifying Comparable Sales: Selecting recently sold sites that are similar to the subject in terms of location, size, zoning, topography, and other relevant characteristics. The Uniform Residential Appraisal Report (URAR) is dependent on comparable sales.
2. Data Verification: Verifying the details of each sale with reliable sources (e.g., public records, real estate agents, buyers, sellers).

3. Elements of Comparison: Analyzing and comparing the comparable sales to the subject site, considering factors such as:

   • Property Rights Conveyed: (Fee simple, leasehold, etc.)
   • Financing Terms: (Cash equivalent, seller financing, etc.)
   • Conditions of Sale: (Arm’s-length transaction, forced sale, etc.)
   • Market Conditions: (Changes in value over time)
   • Location: (Neighborhood amenities, access, views)
   • Physical Characteristics: (Size, shape, topography, soil)
   • Zoning and Legal Restrictions
   • Economic characteristics

4. Making Adjustments: Adjusting the sales prices of the comparables to account for differences between them and the subject site. Adjustments can be made in dollar amounts or percentages. The formula is

   Adjusted Sale Price = Sale Price +/- Adjustments

5. Reconciliation: Reconciling the adjusted sales prices to arrive at an estimate of the subject site’s value.

Practical Application and Experiment:

• Data Collection: Gather data on at least three vacant land sales in the subject’s market area. Ensure the sales occurred within the last 6 months.
• Quantitative Analysis: Develop an adjustment grid, quantifying adjustments for significant differences in size, location, and other elements of comparison.
• Sensitivity Analysis: Vary the adjustment amounts and observe the impact on the final value indication. This helps to assess the sensitivity of the value estimate to changes in assumptions.

6.3.2 Allocation Method:

This method estimates site value by allocating a percentage of the total property value to the land. It is based on the premise that in a stable market, a typical ratio exists between land and building values.

1. Determine Total Property Value: Estimate the market value of a similar improved property. This requires data collection and analysis using the Sales Comparison Approach or Cost Approach.

2. Determine Allocation Ratio: Research typical land-to-building value ratios for similar properties in the market. This data can be obtained from:

   • Market Studies: Reports that analyze land and building values in specific market areas.
   • Appraisal Data: Ratios observed in comparable appraisal assignments.
   • Tax Assessor Records: Ratios used by local tax assessors.

3. Calculate Site Value: Multiply the total property value by the allocation ratio to estimate the site value.

   Site Value = Total Property Value x Allocation Ratio

Experiment:

• Research typical land to building value ratios for properties similar to the subject (e.g., residential, commercial) by analyzing market studies, tax assessor records or from reputable appraisal data sources. Then repeat site valuation from other methods, to allow you to develop the best possible determination.

Limitations:

This method can be less precise in unstable markets or when applied to properties with unique characteristics or for certain appraisal techniques.

6.3.3 Extraction Method:

The extraction method (or abstraction method) estimates site value by subtracting the depreciated cost of the improvements from the total property value. It is typically applied to improved properties where comparable vacant land sales are scarce.

1. Estimate Total Property Value: Determine the market value of the improved property.
2. Estimate Depreciated Cost of Improvements: Estimate the current cost to replace the improvements, and deduct accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence). This is essentially performing the cost approach for the improvements only.

3. Calculate Site Value: Subtract the depreciated cost of the improvements from the total property value to arrive at the site value.

   Site Value = Total Property Value - Depreciated Cost of Improvements

Experiment:

• Compare several recently sold improved properties that are similar to the subject with a known site value in that area (determined via the sales comparison approach, if possible). Calculate site values using this extraction method, and compare the results to the known site values.

6.3.4 Development Method:

This method (also referred to as the Subdivision Development Analysis or Discounted Cash Flow (DCF) Analysis) is used to estimate the value of land suitable for subdivision or development. It involves projecting the future income and expenses associated with developing and selling the land, and discounting these cash flows back to present value.

1. Develop Feasibility Study: Conduct a comprehensive feasibility study to determine the highest and best use of the land, the optimal subdivision layout, the number of lots, the projected sales prices of the lots, and the development timeline.
2. Estimate Total Revenue: Project the total revenue to be generated from the sale of all lots.
3. Estimate Development Costs: Estimate all costs associated with developing the land, including:
   • Direct Costs: (Site preparation, infrastructure, construction)
   • Indirect Costs: (Engineering, legal, marketing, financing)
4. Project Cash Flows: Project the annual cash flows (revenue less expenses) over the development period.
5. Select Discount Rate: Choose an appropriate discount rate that reflects the risk and uncertainty associated with the development project.

6. Discount Cash Flows: Discount the projected cash flows back to present value using the selected discount rate.

   Present Value = CF1/(1+r)1 + CF2/(1+r)2 + ... + CFn/(1+r)n

   Where:
   * CF = Cash Flow in each period
   * r = Discount Rate
   * n = Number of periods

Practical Application:

• Financial Modeling: Utilize spreadsheet software to create a detailed financial model that projects revenue, expenses, and cash flows over the development period.
• Sensitivity Analysis: Perform sensitivity analysis to assess the impact of changes in key assumptions (e.g., sales prices, discount rate, development costs) on the final value indication.

6.3.5 Land Residual Technique:

This is an income capitalization method used to estimate the value of land, especially when improvements are already present. The method isolates the portion of net operating income attributable to the land and then capitalizes it.

1. Determine Total Net Operating Income (NOI): Estimate the total net operating income (NOI) generated by the improved property. This involves estimating gross income and deducting operating expenses.
2. Estimate Value of Improvements: Use the cost approach to determine the cost of replacing or reproducing the existing improvements.

3. Estimate Income Attributable to Improvements: Multiply the value of the improvements by an appropriate capitalization rate to determine the income required to justify the investment in the improvements.

   Income to Improvements = Value of Improvements x Improvement Capitalization Rate

4. Calculate Income Attributable to Land: Subtract the income attributable to the improvements from the total NOI to arrive at the income attributable to the land.

   Income to Land = Total NOI - Income to Improvements

5. Capitalize Land Income: Divide the income attributable to the land by an appropriate land capitalization rate to estimate the land value.

   Site Value = Income to Land / Land Capitalization Rate

6.3.6 Ground Rent Capitalization:

This method is used when the site is subject to a ground lease (a lease where the tenant owns the improvements, but leases the land from the landowner). The site value is estimated by capitalizing the annual ground rent.

1. Determine Annual Ground Rent: Obtain the annual rent paid by the tenant to the landowner under the ground lease.
2. Select Capitalization Rate: Select an appropriate capitalization rate that reflects the risk and return expectations of investors in similar ground leases.

3. Capitalize Ground Rent: Divide the annual ground rent by the capitalization rate to estimate the site value.

   Site Value = Annual Ground Rent / Capitalization Rate

6.4 Applying Site Valuation Methods in Appraisal Reporting

When reporting the site value in an appraisal report, such as the URAR, it is essential to:

• Clearly identify the method(s) used: Specify the method(s) used to estimate site value (e.g., Sales Comparison Approach, Allocation Method).
• Provide supporting data: Include detailed information on comparable sales, market studies, cost estimates, and any other data used to support the value estimate.
• Explain the analysis: Clearly explain the reasoning and analysis that led to the final site value estimate. Justify the adjustments made to comparable sales, the allocation ratios used, or the discount rates applied.
• Address any limitations: Acknowledge any limitations of the methods used and the potential impact on the accuracy of the value estimate.
• Reconcile if multiple methods are used: If more than one method is used, reconcile the different value indications to arrive at a final, supported site value.

6.5 Conclusion

Site valuation is a critical component of the cost approach to value, and a strong understanding of the underlying principles and methods is essential for producing accurate and reliable appraisal reports. By applying a systematic and scientific approach to site valuation, appraisers can ensure that their value estimates are well-supported and credible, thus increasing their professional credibility. The cost approach to value is dependant on identifying the specific zoning classification.