Site Valuation Techniques for Real Estate Income Analysis

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Chapter 6: Site Valuation Techniques for Real Estate Income Analysis

Introduction

Within the context of mastering real estate income analysis, accurate site valuation stands as a cornerstone. This chapter delves into the methodologies appraisers use to isolate and quantify the value attributable to the land component of a real estate asset, independent of its improvements. A thorough understanding of these techniques is crucial for accurately reconstructing operating statements, understanding income multipliers and capitalization rates, and ultimately, making informed investment decisions as highlighted in the course description, and for maximizing the real estate potential. This chapter emphasizes the scientific rigor underpinning these valuation methods, integrating relevant economic theories and practical applications for robust income analysis.

1. The Imperative of Separate Site Valuation

A separate site valuation becomes necessary for several compelling reasons, each directly impacting the accuracy and applicability of real estate income analysis:

• Specific Valuation Approaches: The Cost Approach and the Building Residual Technique of Income Capitalization (detailed in later chapters) inherently require a distinct estimate of site value. The cost approach, in its fundamental formula, explicitly adds site value to the depreciated replacement cost of improvements. The building residual technique isolates the income attributable to the building, implicitly requiring a prior determination of site value and its income contribution.

  • Formula for the Cost Approach:
    • Property Value = Site Value + Cost (New) - Depreciation

• Legal and Regulatory Mandates: Appraisals for property tax assessment and condemnation proceedings often mandate a separate site evaluation by law. This is critical because these valuations directly impact taxation and just compensation, underscoring the importance of precision and defensibility.

• Highest and Best Use Analysis: Site valuation is intrinsic to determining the highest and best use of a property, which dictates its optimal development potential and, consequently, its potential income generation. As the book content suggests, the value is determined not just by the physical structure but by the most productive (profitable) use of the entire property.

2. Highest and Best Use: A Foundation for Site Valuation

The principle of Highest and Best Use is the linchpin of any site valuation methodology. It is not simply about identifying a potential use; it’s about rigorous analysis rooted in economic and legal principles.

• 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 Tests of Highest and Best Use:

  1. Legally Permissible: This analysis considers zoning regulations, building codes, environmental regulations, and any private restrictions (e.g., deed restrictions). The analysis MUST be supportable by written evidence.

     • Practical Application: An experiment to determine legal restrictions could involve researching local ordinances and consulting with planning officials to verify permitted uses, setback requirements, and density restrictions.

  2. Physically Possible: The site’s size, shape, topography, soil bearing capacity, access to utilities, and environmental conditions must be assessed. Geotechnical reports can be invaluable.

     • Practical Application: A “perc test” (percolation test) is an example of an experiment that can demonstrate whether the ground is physically possible to build on.

  3. Financially Feasible: A use is only considered if it is financially viable.

     • Financial Feasibility Equation

NPV = ∑ [CFt / (1 + r)^t] - Initial Investment

Where:

• NPV = Net Present Value
• CFt = Cash flow during period t
• r = Discount rate (required rate of return)
• t = Time period

• ∑= The sum of the cashflows in each period

  *   ***Practical Application:*** Develop pro forma financial statements for various potential uses. Calculate the Net Present Value (NPV) or Internal Rate of Return (IRR) for each use.
  

  4. Maximally Productive: Among all feasible uses, the one that generates the highest net return or value is the highest and best use.

     • Maximally Productive Equation
       • PV = CF1 / (1 + r) + CF2 / (1 + r)² + … + CFn / (1 + r)ⁿ

Where:

• PV = Present Value
• CF = Cash Flow
• r = Discount Rate
• n = Number of Periods

3. Site Valuation Methodologies: A Scientific Approach

Several established methodologies exist for estimating site value, each relying on different economic principles and market data. It is essential to note that different site valuation approaches are more applicable in certain situations. The appraiser must choose the best tool for the scenario.

1. Sales Comparison Approach

   • This is the most direct and reliable method when sufficient comparable vacant land sales are available. It relies on the Principle of Substitution: a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.

   • The challenge lies in identifying truly comparable sales and making appropriate adjustments.

     • Practical Application: Collect sales data on similar vacant lots, focusing on key elements of comparison:

       • *Real Property Rights Conveyed: Adjustments for fee simple, leasehold, etc.
       • *Financing Terms: Account for atypical financing arrangements.
       • *Conditions of Sale: Eliminate sales influenced by duress or unusual circumstances.
       • *Expenditures Immediately After Sale: Deduct expenses from sales
       • *Market Conditions: Adjust for changes in market conditions since the sale date: Adjustment = Sale Price * (Market Change Rate * Time)
       • *Location: Account for neighborhood desirability, access, amenities.
       • *Physical Characteristics: Size, shape, topography, soil conditions.

2. Allocation Method:

   • This method is most used if there is a lack of data. The allocation method is used to value the land as a percentage of the total price of the improved property.

     • Land Value = Total Property Value * Allocation Percentage

   • Practical Application:

     1. Determine an appropriate land value percentage.
     2. This method is best utilized when combined with extraction.

3. Extraction Method:

   • This is used to remove all improvement values and identify only land values.

     • Land Value = Total Property Value - Depreciated Value of Improvements

   • Practical Application:

     1. Research total property value of the subject property.
     2. Assess depreciation through reviewing a list of all capital improvements.
     3. Calculate value through subtracting depreciated value of improvement from the total property value.
     4. Combine with allocation approach to determine reliability.

4. Subdivision Development Analysis (Development Method):

   • This method is also known as the discounted cash flow (DCF) method.
   • It is used for the valuation of larger properties.

   • The market value is determined through calculating all expected revenue less development costs.

     • Property Value = Present Value of Project Sales - Cost of Development

   • Practical Application:

     1. Determine a development plan.
     2. Calculate all development costs.
     3. Research market data to determine market cash flow and expense.
     4. Complete DCF to determine site value.

5. Land Residual Technique:

   • This method is used for improved properties generating income.

     • Land Income = Total Property Value - Income Attributable to Improvements
     • Land Value = Land Income/ Land Capitalization Rate

   • Practical Application:

     1. Determine the stabilized net operating income (NOI) for the total property.
     2. Estimate the value of the building (improvements) using an appropriate capitalization rate reflecting its risk.
     3. Calculate the income attributable to the building by multiplying its value by the building capitalization rate.
     4. Subtract the income attributable to the building from the total NOI to find the income attributable to the land.
     5. Capitalize the land income using a market-derived land capitalization rate to estimate land value.

6. Ground Rent Capitalization:

   • This is an income capitalization approach.

     • Land Value = Ground Rent Income/ Ground Rent Capitalization Rate

   • Practical Application:

     1. Calculate how much income to expect and how much will stay constant in the next several years.
     2. Capitalize for land value

4. Special Considerations

• Interim Use: If the current use is temporary pending future development, the site valuation must consider the present value of that future development potential, adjusted for the costs and risks associated with the interim period.

• Excess Land: This refers to land that is not necessary to support the property’s highest and best use. Its value must be separately estimated, considering its potential for independent development or sale. The value must be based on data supportable and related to highest and best use.

• Plottage Value: The incremental value created by assembling two or more parcels into a larger, more useful site must be considered. This requires an analysis of the market for larger parcels and their potential for superior development.

5. Depth Tables and Their Limitations

The “4-3-2-1” method or depth tables, as mentioned in the book content, provide a simplistic way to allocate value to different portions of a lot based on depth. However, they are crude tools and should be used with caution.

• These tables do not account for:

  • Specific market demands for certain depths.
  • Irregular lot shapes.
  • The varying importance of frontage for different uses (e.g., retail vs. residential).

Conclusion

Accurate site valuation is crucial for informed decision-making in real estate income analysis. This chapter provided a framework for understanding the principle of Highest and Best Use, the application of different site valuation methodologies, and the limitations that may affect each approach. By understanding these approaches, the course participant will have the foundational knowledge required to accurately reconstruct operating statements, to understand income multipliers and capitalization rates, and to maximize the real estate potential.