Site Valuation: Highest & Best Use Analysis

Site Valuation: Highest & Best Use Analysis: A Scientific Introduction

This chapter of “Mastering Cost Estimation in Real Estate Appraisal” delves into the critical process of site valuation, focusing specifically on the application of Highest and Best Use (HBU) analysis. Accurate site valuation forms the bedrock for employing techniques detailed later in this training course, particularly the cost approach to value and certain income capitalization methods, as explicitly mentioned in the course description and as will be elaborated upon in subsequent chapters. These valuation methods inherently require a separate estimate of site value, making the understanding and application of HBU analysis indispensable. Furthermore, as the course aims to equip appraisers with skills to analyze market data and make adjustments, mastering HBU analysis provides a structured framework for identifying relevant market factors that influence land values.

Scientifically, HBU analysis operates on the principle of economic rationality, asserting that market participants will allocate resources to their most productive use. This chapter will dissect this principle, establishing a rigorous framework for determining HBU based on four distinct criteria: legal permissibility, physical possibility, economic feasibility, and maximal productivity. Each criterion will be examined through the lens of market forces, demonstrating how appraisers can objectively assess potential land uses based on empirical data. Furthermore, the chapter will explore the crucial distinction between HBU as if vacant and HBU as improved, acknowledging the interplay between existing improvements and underlying land potential. This detailed examination will equip trainees with the nuanced understanding necessary for navigating complex appraisal scenarios, directly aligning with the course’s goal of elevating appraisal expertise and providing a competitive edge in the industry. This detailed examination is imperative for the cost approach covered in Chapter 8.

This chapter aims to provide participants with:

1. A scientifically sound understanding of the theoretical underpinnings of HBU analysis within the context of real estate valuation.
2. The ability to systematically evaluate the legal, physical, and economic constraints that influence land use potential.
3. The competence to apply various techniques for site valuation, including the sales comparison, allocation, and extraction methods, ensuring accurate cost estimation crucial for appraisal assignments.
4. The knowledge to interpret and utilize market data for informed decision-making in HBU determination, essential for accurate valuation and providing a competitive edge in the real estate industry.
5. The understanding of how HBU analysis directly supports the cost approach and income capitalization valuation techniques.

By mastering the principles and methods presented in this chapter, participants will gain a robust foundation for conducting thorough and defensible site valuations, a core competency for successful real estate appraisal. The tools and techniques learned will enable accurate cost estimation, ultimately contributing to more reliable and credible property appraisals.

Chapter 6: Site Valuation: Highest & Best Use Analysis

Part of Training Course: Mastering Cost Estimation in Real Estate Appraisal

(Description: Unlock the secrets of cost estimation in real estate appraisal! This course provides a comprehensive understanding of the cost approach to value, equipping you with the skills to accurately estimate building costs using the square foot and unit-in-place methods. Learn how to analyze market data, utilize cost estimating manuals, and make essential adjustments for size, location, and other factors. Gain a competitive edge in the real estate industry and elevate your appraisal expertise.)

I. Introduction: The Cornerstone of Site Valuation

Site valuation is a critical component of real estate appraisal, especially when employing the cost approach to value, and, depending on the approach, potentially other approaches as well, as highlighted in the book content. This chapter will delve into the intricate process of analyzing a site’s highest and best use (HBU), a concept that forms the very foundation of any sound site valuation. A thorough understanding of HBU is crucial for accurately estimating land value, which, in turn, is vital for the cost approach and techniques like the building residual technique of income capitalization. Further, for appraisals performed for property tax assessment and condemnation, as also described in the book content, HBU directly impacts the valuation and allocation of value between land and improvements. Mastering HBU analysis, therefore, provides a competitive edge in the real estate appraisal industry, a primary aim of this course.

II. Defining Highest and Best Use: A Scientific Framework

A. Conceptual Definition:

Highest and Best Use (HBU) 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. This value determination is directly related to the principle of anticipation, covered later in this chapter. The HBU analysis is performed as of the date of appraisal and is based on market evidence, reflecting market participants’ actions and expectations.

B. The Four Tests of Highest and Best Use: A Systematic Approach

The HBU analysis involves a rigorous, sequential application of four interrelated tests:

1. Legally Permissible❓❓: This test assesses the legal constraints that govern the use of the property.

   • Zoning Regulations: Examine current zoning ordinances, including permitted uses, setback requirements, height restrictions, and minimum lot sizes. For example, can commercial structures be built at this site?
   • Environmental Regulations: Consider environmental protection laws, wetland restrictions, and endangered species habitats, which might limit development options and increase costs.
   • Private Restrictions: Review easements, covenants, conditions, and restrictions (CC&Rs) that might restrict use of a property.
   • Example Application: A 1-acre parcel is zoned for residential use only. While a commercial venture might generate higher returns, it’s legally impermissible and thus not part of the HBU analysis.

2. Physically Possible: This test assesses the physical characteristics of the site and their impact on its development potential.

   • Site Size and Shape: Does the lot’s size and configuration accommodate the proposed use? Irregularly shaped lots might preclude certain types of construction.
   • Topography: Consider the slope, drainage, and soil stability of the land. Steep slopes might increase construction costs, while poor soil stability might require costly remediation.
   • Environmental Conditions: Examine factors like flood zones, earthquake fault lines, and hazardous materials, which might restrict development or require specialized construction techniques.
   • Example Application: A steeply sloped site may be legally permissible for a high-rise building, but the increased construction costs associated with the slope make it impractical.

3. Financially Feasible: This test assesses the economic viability of a proposed use. The project, after construction, must produce sufficient revenue to justify its construction costs.

   • Market Analysis: Evaluate the demand for the proposed use in the subject’s market area. Excess supply may mean lower rents or sale prices, making the project financially unfeasible.
   • Cost Estimates: Develop detailed cost estimates for construction, including hard costs (materials and labor), soft costs (permits, fees, and architectural design), and carrying costs (interest, insurance, and property taxes).
   • Revenue Projections: Estimate the potential revenue the project will generate, considering factors like rent levels, occupancy rates, and expense ratios.

   • Financial Modeling: Use discounted cash flow (DCF) analysis to determine the net present value (NPV) of the proposed project.

     • Formula: NPV = ∑ (CFt / (1+r)^t) - IC

       Where:

       • CFt = Cash flow in period t
       • r = Discount rate
       • t = Time period
       • IC = Initial cost
         • Example Application: A mixed-use project might be legally permissible and physically possible, but if market analysis shows insufficient demand for the retail component, resulting in negative cash flow, it might be financially unfeasible.

4. Maximally Productive: This final test seeks to identify the use that maximizes the property’s value, given that the other tests have been satisfied.

   • Comparative Analysis: Compare the NPV or IRR (Internal Rate of Return) of all financially feasible uses to determine which generates the highest return.
   • Refinement: This may involve refining the scale, design, or operation of a proposed use to optimize its profitability.
   • Example Application: Two uses, a small office building, or a retail strip mall both are legally permissible, physically possible and financial feasible. Of the two, the strip mall provides a substantially larger return on investment than does the small office building. The retail strip mall therefore, would be the HBU.

C. The Principle of Anticipation and its Role in HBU:

The principle of anticipation, as mentioned in the book content, recognizes that value is based on future benefits an investor expects to receive from the property. In HBU, anticipate future revenues and expenditures including taxes and other government regulation that will impact the property value. This highlights the significance of accurate revenue projections as in the above example.

III. HBU as if Vacant vs. HBU as Improved: A Dichotomy

The book also mentions considering both HBU as if vacant and HBU as improved.

A. HBU as if Vacant:

This analysis assumes that the site is cleared of all existing improvements. It considers the hypothetical, yet possible, range of uses that could be constructed on the land, consistent with the four tests described above. This analysis is vital for several valuation methods, most notably the Cost Approach, which requires a separate site valuation.

B. HBU as Improved:

This analysis takes into account the present improvements on the site. It requires examining whether the existing structures are aligned with the highest and best use of the land. Several possibilities exist:

1. Conforming Use: The existing improvements align with HBU as if vacant.

   • No action is needed beyond documenting its conformity.

2. Non-Conforming Use: The existing improvements do not align with the HBU as if vacant.

   • Several actions are possible:

     a. Demolition/Renovation: If the cost of demolition/renovation is less than the incremental value created by a new use, it’s economically prudent to change the use to the HBU.

     b. Continuation of Existing Use: The current use of the property may not be the most valuable use, but the costs associated with changing to the HBU may be so expensive as to preclude conversion to the HBU. Consider such variables such as legal restrictions and costs of construction, and economic feasibility based on market values. The HBU as improved is continued utilization.

C. Legal Nonconforming Uses:

As mentioned in the book, legal nonconforming use applies to existing properties that no longer conform to existing zoning, but continue to be legally permitted. The property must have been compliant with zoning at the time of its construction, and the change in zoning must have occurred after the property was originally developed.

The HBU of a non-conforming site must recognize the existing structure and its use. In many cases, the change in zoning regulations also have negative affects on value such as preventing modifications to the property.

D. Interim Use:

As also discussed in the book, interim use describes a short-term HBU, pending the conversion to a more profitable long-term use.
These short-term uses often have minimal improvements since the property will soon be altered. For example, a vacant parcel approved for residential development may temporarily function as a parking lot while construction permits are being processed.

E. The Principle of Consistent Use

For purposes of techniques such as residual techniques and the cost approach the appraiser must adhere to the principle of consistent use, valuing both land and improvements with the same HBU.

IV. Special Site Characteristics: Excess Land and Plottage

A. Excess Land:

Excess land is not required to support the primary use of a site and could be sold separately. Excess land may have a different HBU than the rest of the parcel.

To value excess land, treat it as an independent parcel and conduct its own HBU.

B. Plottage:

As mentioned in the book content, plottage describes the incremental increase in value created by combining adjacent parcels. Plottage value emerges when combining parcels permits a more profitable use that would have been infeasible as independent parcels.

Value the combined parcels first, then subtract the sum of their individual values. The difference represents the plottage value.

V. Site Valuation Techniques: Applying Scientific Principles

The book content highlights six methods of site valuation. The Cost Approach, for example, is dependent upon a reliable land valuation. As mentioned in the book, the most reliable approach is the Sales comparison approach❓❓. However, depending on the scope of work and the amount of reliable data, other approaches may be used.

A. Sales Comparison Approach: (Most Preferred)

The Sales Comparison Approach relies on market data to value a specific site. This can be more difficult in certain markets than it is in others. For example, a residential property may be much more difficult to value because there is an insufficient supply of vacant land for valuation purposes. As stated in the book, this approach requires careful selection of comparable sales.

1. Data Sources: Public Records, Multiple Listing Services, Real Estate Professionals, Cost Data Sources.

2. Elements of Comparison:

   a. Real Property Rights Conveyed:

   b. Financing Terms: Calculate effective interest rates and impacts from seller concessions for each property.

   *   **Formula:**  Effective Interest Rate = (Total Interest Paid / Loan Amount) / Loan Term (Years)
   

   c. Conditions of Sale: Were market values affected due to any special conditions, such as forced sales?

   d. Expenditures Immediately After Sale: Account for any demolition or remediation costs to properly value the land.

   e. Market Conditions: Adjust properties depending on market conditions.

   *   **Formula:**  Value Adjustment = (Comparable Sale Price x Market Conditions Change (%))
   

   f. Location Adjustments: Value differs based on local factors such as neighborhood income level, desirability, and school district.

   g. Physical Characteristics: Examples of considerations may be size, soil, and slope.

   h. Economic Characteristics: Account for qualities such as rental rates and leases.

3. Statistical Adjustment Techniques:

   a. Paired Data Analysis: Identify matched pairs of properties to analyze incremental changes between properties.

   b. Regression Analysis: Employ statistical techniques to calculate value based on similar characteristics.
   * Formula: Y = a + b1X1 + b2X2 + … + bnXn
   Where:
   Y = Dependent variable (e.g., property value)
   a = Intercept
   b1, b2, …, bn = Coefficients
   X1, X2, …, Xn = Independent variables (e.g., square footage, number of bedrooms)

B. Allocation Method:

The allocation method assumes a typical ratio exists between the value of the land and the value of the total property.

1. Market Extraction: Examine similar properties to derive the ratio based on current values.

   *   **Formula:**  Land Value = Total Value / (% Ratio)
   

2. Limitations: Lacks accuracy because the values are based on market averages rather than factors specific to the property being appraised.

C. Extraction Method:

For properties where there is no supply of vacant land for valuation, the appraiser subtracts the value of the improvements from the property value.
* Calculation:

    *Land Value = Property Value - Improvement Value

D. Subdivision Development Method:

1. Feasibility Study: Examine the financial viability of a proposed project based on market information.

2. Cost Breakdown: Determine costs (materials and labor), sales price of completed units, marketing costs, etc.

3. Discount Cash Flow Analysis: Discount the expected future cash flows to present value.

E. Land Residual Method:

As stated in the book, this approach values the income from a property based on capitalization rates. This approach uses the concept of discounted cash flow for the entire property, and then takes that data to extract the value of the land as a component.

1. Net Operating Income (NOI) Breakdown
   *Net Operating Income = Net Income / Capitalization Rate

2. Land Value Breakdown
   *Land Value = Income / Capitalization Rate

F. Ground Rent Capitalization:

As the book content mentions, value may be estimated through the capitalization of the ground rent for a property.

1. Calculate Net Operating Income to find ground rent based on market data.
2. Capitalize the income.
3. Use this approach with care. Market participants may require an analysis beyond income such as expenses and other market considerations, to properly value this land.

G. Depth Tables:

Although depth tables may be helpful, the book also describes the limitations of their reliability. These tables can give a general idea of the affect of value and depth, but fail to consider specific considerations for users.

VI. Conclusion: The Appraiser as a Scientific Analyst

Mastering HBU analysis and site valuation techniques requires a scientific approach. The methods discussed in this chapter rely on economic principles, statistical analysis, and a deep understanding of market dynamics. In particular, skills relating to cost estimation are beneficial when utilizing methods such as the cost approach, subdivision development, and land residual.

By diligently applying these techniques, appraisers can accurately estimate land value and provide sound guidance to their clients. This chapter, along with the others in this course, provides a foundation for understanding and using the cost approach, equipping students with the skills and confidence to excel in their appraisal careers.