Site Valuation Techniques: Sales Comparison and Beyond

Real Estate Income Analysis: Mastering Direct Capitalization

Chapter: Site Valuation Techniques: Sales Comparison and Beyond

Course Description Connection: This chapter directly supports the course description by providing detailed site valuation techniques, crucial for accurately assessing property value based on income-generating potential and mastering the direct capitalization method. Understanding site value is fundamental to reconstructing operating statements and making sound financial decisions.

I. Introduction: The Importance of Site Valuation

• Site valuation is a critical component of real estate income analysis, impacting investment decisions and appraisals. This chapter will delve into various techniques to estimate the value of a site, both with and without existing improvements.
• Accurate site valuation is essential for:
  • Cost Approach: Determining the Replacement Cost New❓❓ of the improvements, a key component of value.
  • Building Residual Technique: Part of the income capitalization approach where site value is estimated separately to isolate income attributable to the building.
  • Property Tax Assessment & Condemnation: Legal requirements often necessitate separate site and improvement valuations.

II. Defining Highest and Best Use (HBU): The Foundation of Site Valuation

• Definition: The HBU is the use of a property that is (1) legally permissible, (2) physically possible, (3) financially feasible, and (4) maximally productive, leading to the highest present value.

• Mathematical Context: The goal is to find the land use that maximizes:

  NPV = Σ [CFt / (1 + r)^t]

  Where:
  * NPV = Net Present Value
  * CFt = Cash Flow in period t
  * r = Discount Rate
  * t = Time period

• HBU as if Vacant vs. HBU as Improved: It’s essential to distinguish between the optimal use if the site were vacant and the optimal use given existing improvements.

  • If Value (Vacant Land, HBU) > Value (Property as Improved) + Demolition Costs, a change in use is indicated.
  • If Value (Vacant Land, HBU) \< Value (Property as Improved) + Demolition Costs, the current use❓ should continue.
• Interim Use: A temporary use of the site pending its transition to a higher and better use.
• Legal Nonconforming Use: A use that was legally established but no longer conforms to current zoning regulations.

III. Site Valuation Techniques: Sales Comparison and Beyond

A. sales comparison approach❓❓: The Primary Technique

• The sales comparison approach estimates site value by analyzing recent sales of comparable vacant land parcels. This technique is most reliable when sufficient and credible comparable sales data is available.

• Formula:

  Subject Value = Comparable Sales Price ± Adjustments
  * Elements of Comparison: Key characteristics that require adjustment between comparable sales and the subject property.
  1. Real Property Rights Conveyed: Differences in fee simple vs. leased fee, easement rights.
  2. Financing Terms: Non-market financing (e.g., below-market interest rates) require adjustment.
  3. Conditions of Sale: Forced sales, transactions between related parties, etc., necessitate adjustments.
  4. Market Conditions: Adjustments for changes in market conditions between the comparable sale date and the valuation date (e.g., increasing or decreasing market prices).
  * Example: If the market is increasing by 1% per month, a comparable sale 3 months prior to the valuation date would need a +3% adjustment.
  5. Location: Consider differences in neighborhood desirability, access, and exposure.
  6. Physical Characteristics: Adjust for differences in size, shape, topography, soil conditions, frontage, and utility access.
  7. Zoning & Legal Restrictions: Adjust for variances in allowable uses, density restrictions, setback requirements, and environmental regulations.
  8. Economic Characteristics: Qualities such as income, operating expenses, lease provisions, management, and tenant mix (commercial properties).
  * Example:
  Comparable Sale Price: $100,000 Market Condition Adjustment (Increasing Market Value +5%): +$5,000 Location Adjustment (Better Location -2%): -$2,000 Physical Characteristics (Larger Site Size +3%): +$3,000 Adjusted Value: $100,000 + $5,000 - $2,000 + $3,000 = $106,000
  * Experiment:
  1. Identify 3-5 vacant lot sales in a specific area.
  2. Develop a data grid with relevant elements of comparison (size, zoning, location, date of sale).
  3. Research and quantify adjustments for each element of comparison.
  4. Calculate the adjusted value of each comparable.
  5. Reconcile the adjusted values to arrive at an indicated value range for the subject property.

B. Allocation Method: Isolating Land Value

• The allocation method assumes a consistent ratio between land value and overall property value within a specific market.

• Formula:

  Land Value = Total Property Value × Allocation Percentage
  * Practical Application: Determine the typical land-to-value ratio from market analysis (e.g., builders, developers, sales). Apply the percentage to the subject property’s value.
  * Limitations: Relies on established ratios, which may not accurately reflect the specific characteristics of the subject site.
  * Example:
  Total property value $300,000. Based on location and comparable lots, lots normally account for 20% of a total sale price. $300,000*.2 = $60,000

C. Extraction Method: Inferring Land Value

• The extraction method derives land value by subtracting the depreciated cost of improvements from the total property value.

• Formula:

  Land Value = Total Property Value - Depreciated Cost of Improvements
  * Steps:
  1. Estimate the total property value using the sales comparison or income capitalization approach.
  2. Calculate the replacement cost new of the improvements.
  3. Estimate accrued depreciation (physical deterioration, functional obsolescence, external obsolescence).
  4. Subtract the depreciated cost of improvements from the total property value to arrive at the land value.
  * Practical application:
  Using the Cost Approach, estimate property value as $500,000 Replacement Cost New = $200,000 Accrued Depreciation = $20,000 Value of Land = $500,000-$200,000+$20,000 = $320,000

D. Development Method (Subdivision Analysis): Discounted Cash Flow

• The development method is used for valuing raw land with potential for subdivision. This technique requires projecting future cash flows from the sale of developed lots, discounting them to their present value.

• Formula:

  Land Value = Present Value of Total Revenue - Present Value of Total Costs
  * Steps:
  1. Determine the HBU (number and type of lots, pricing).
  2. Develop a detailed development plan (layout, infrastructure).
  3. Project lot sales revenues (pricing, absorption rate).
  4. Estimate all development costs (infrastructure, marketing, holding costs, construction).
  5. Discount projected cash flows to their present value using an appropriate discount rate.
  6. Consider entrepreneur incentive and profit.
  * Example: Development costs are 100,000
  Total revenue $300,000 Profit 50,000 $300,000-$100,000-$50,000 = $150,000 lot value.

E. Land Residual Technique: Attributing Income to the Land

• The land residual technique estimates land value by isolating the net operating income (NOI) attributable to the land and capitalizing it.

• Formulas:

  1. Calculate NOI attributable to improvements:
     • NOI (Improvements) = Improvement Value * Capitalization Rate (Improvements)
  2. Calculate NOI attributable to the land:
     • NOI (Land) = Total NOI - NOI (Improvements)
  3. Calculate Land Value:
     • Land Value = NOI (Land) / Capitalization Rate (Land)
     • Example:

  Total NOI: $50,000 Improvement Value: $400,000 Capitalization Rate (Improvements): 8% Capitalization Rate (Land): 7% NOI (Improvements): $400,000 * 0.08 = $32,000 NOI (Land): $50,000 - $32,000 = $18,000 Land Value: $18,000 / 0.07 = $257,143

F. Ground Rent Capitalization: Leasing the Land

• This method is used when land is leased separately under a ground lease, where the tenant constructs improvements.

• Formula:

  Land Value = Ground Rent / Capitalization Rate
  * Practical application:

  The amount a person is willing to pay for a ground lease is considered the amount a person is willing to pay for that location.

G. Depth Tables:
* This technique shows additional value for different depth, with most of the value in the front.

IV. The Importance of Reconciliation

• Each site valuation technique has strengths and weaknesses.
• Reconciliation involves analyzing the reliability of each method and weighing their results to arrive at a final opinion of site value. The sales comparison approach is generally given the most weight when credible data is available.

V. Conclusion

• Mastering site valuation techniques is crucial for accurate real estate income analysis and investment decision-making. By understanding the sales comparison approach and various alternative methods, appraisers and investors can better estimate the value of a site, contributing to more informed and successful outcomes.

VI. Practical Application

• This can involve the reconstruction of operating statements.
• Calculations of pre-tax cash flow.
• Accuracy in property evaluation.