Site Valuation: Foundations of the Cost Approach

Chapter 6: Site Valuation: Foundations of the Cost Approach

Course Context

This chapter lays the groundwork for understanding how to isolate and determine the value of the land component in real estate appraisal, a critical step in the Cost Approach to Value. This is aligned with the course goals of mastering cost estimation techniques, depreciation analysis, and their practical application in real estate appraisal for accurate property valuation and informed investment decisions.

I. Importance of Site Valuation in the Cost Approach

The Cost Approach rests on the principle of substitution: a buyer won’t pay more for a property than the cost of acquiring a comparable site and constructing a similar improvement. This approach fundamentally relies on accurate site valuation.

A. Formula for Cost Approach

The Cost Approach can be represented mathematically:

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

B. Why Separate Site Valuation is Necessary

• Cost Approach & Building Residual Technique: As the book content makes clear, “the cost approach to value and the building residual technique of income capitalization both require a separate estimate of site value.”

• Legal Requirements: “A separate valuation of site and improvements may also be required by law, particularly in appraisals for property tax assessment and condemnation purposes.”

• Highest and Best Use Analysis: The determination of a site’s most profitable and legal use informs the entire appraisal process, guiding decisions related to potential improvements and overall property value.

C. Accuracy and Reliability of Site Valuation

The accuracy of the cost approach is directly tied to the precision of the site value estimation. Over or underestimating site value distorts the entire valuation process.

II. Core Principles: Highest and Best Use & Site Valuation

Central to accurate site valuation is the concept of Highest and Best Use (HBU). It provides a framework for determining❓ the most profitable, legal, and physically possible use of a site.

A. Scientific Definition of Highest and Best Use

HBU is defined as the “use that is legally permitted, physically possible, economically feasible, and maximally productive.”

1. Legally Permitted

• Zoning Ordinances: Local zoning laws dictate permissible land uses (residential, commercial, industrial, agricultural, etc.) and regulate aspects like building height, density, and setbacks.
• Environmental Regulations: Constraints imposed by environmental protection agencies (e.g., wetlands regulations, endangered species habitats) can significantly restrict potential uses.
• Deed Restrictions (Covenants, Conditions, and Restrictions - CC&Rs): Private agreements recorded in a deed can further limit land usage.

2. Physically Possible

• Site Size and Shape: The dimensions and configuration of the site dictate the types of structures that can be accommodated.
• Topography and Soil Conditions: Steep slopes, unstable soils (e.g., expansive clays, liquefiable soils), and the presence of bedrock can impose severe constraints on development.
• Availability of Utilities: The presence and capacity of essential utilities (water, sewer, electricity, gas) can influence the feasibility of different uses.

3. Economically Feasible

• Market Demand: Demand for the proposed use must exist. Overbuilding can render a use economically infeasible, even if it is legally permitted and physically possible.
• Construction Costs: The cost of constructing improvements must be considered in relation to potential revenues or benefits. High construction costs can make certain uses economically unattractive.
• Operating Expenses: Projected operating expenses (property taxes, insurance, maintenance, etc.) must be factored into the economic analysis.

4. Maximally Productive

• Financial Analysis: Involves projecting potential revenues, expenses, and profits for each economically feasible use.
• Net Present Value (NPV) Analysis: Uses discounting to determine the present value of future cash flows for each potential use. The use with the highest NPV is considered the most productive.

B. Highest and Best Use “As Vacant” vs. “As Improved”

• As Vacant: Assumes the site is unimproved and available for development. Considers the full range of potential uses, subject to legal, physical, and economic constraints.
• As Improved: Acknowledges existing improvements and their potential impact on value. Considers the cost of demolition or renovation to achieve the most productive use.

Formula: Determine use of improved property

If (Value of Land Vacant - Cost to demolish and prepare lot) > Value of Improved Property then HBU = Land Vacant
Else HBU = Improved Property

C. Principle of Anticipation

The principle of anticipation is crucial: value reflects the anticipated future benefits. Potential changes in zoning, market conditions, or other factors can influence the determination of HBU.

III. Site Valuation Methods: Detailed Scientific Explanation

The choice of site valuation method hinges on the availability of data and the characteristics of the property.

A. Sales Comparison Approach

This approach, also known as the market data approach, is universally considered the most reliable method for site valuation. It involves analyzing recent sales of comparable vacant land parcels.

1. Elements of Comparison

These are characteristics of properties and transactions that cause dissimilarities that would require adjustments to the sales prices of the comparable properties

• a. Real Property Rights Conveyed: This encompasses the scope of ownership, including fee simple, leased fee, or a partial interest. Any encumbrances, such as easements or restrictive covenants, are also part of this

  • Experiment: A real-world example of this is to look at a 1-acre property that has a 30-year easement versus a similar property with no easement.

• b. Financing Terms❓❓: An adjustment must be made to the comparable sale price if financing arrangements were atypical for the market (e.g., seller financing at below-market interest rates)

  • Formula: Adjustment = (Interest Rate Differential) x (Loan Amount) x (Loan Term)
  • Experiment: Calculate and compare the present values of mortgage payments under market and seller financing terms to quantify the value difference.

• c. Conditions of Sale: Adjustments are needed for “non-arm’s length” transactions (e.g., sales between family members, forced sales due to foreclosure).

  • Experiment: A real-world example of this is a family selling a house for much less than the market price of the area to another family member.

• d. Expenditures Immediately After Sale: These expenditures should be included in the sales contract

  • Formula: Adjustment = (Total Land Value * Cost of remediation)
  • Experiment: Look at multiple properties and note these costs to get a more accurate sense of what an environmental remediation would cost.

• e. Market Conditions Adjustment: Changes in market values over time must be accounted for.

  • Formula: Adjustment = (Market Appreciation/Depreciation Rate) x (Time Difference Between Sale and Valuation Date) x (Comparable Sale Price)
  • Experiment: Analyze historical sales data to determine appreciation/depreciation trends in the subject area.

• f. Location Adjustments: Addresses neighborhood-specific factors like access, amenities, and desirability.

  • Experiment: Survey market participants (buyers, brokers) to quantify the value difference between the subject neighborhood and the comparable neighborhood.

• g. Physical Characteristics: Differences in size, shape, topography, soil conditions, and environmental attributes require adjustments.

  • Experiment: Conduct paired sales analysis to isolate the value contribution of specific physical characteristics (e.g., view, frontage).

• h. Economic Characteristics: Attributes impacting income-producing properties (lease terms, operating expenses, tenant quality) require adjustments.

2. Mathematical Considerations:

• Paired Sales Analysis: Isolate and quantify the value of a single attribute by comparing the sales prices of two nearly identical properties, differing only in that attribute.

• Regression Analysis: Uses statistical techniques to model the relationship between sale prices and multiple independent variables (elements of comparison). This provides a more sophisticated means of estimating adjustments.

B. Allocation Method

This technique relies on the principle of contribution, which states that the value of any component of a property is determined by its contribution to the value of the whole.

• Procedure: Relies on sales of similar properties where a “typical” land-to-building value ratio can be extracted from market data.

1. Formula

Site Value = (Total Property Value) x (Percentage Allocated to Land)

2. Scientific Basis

• Market Surveys: Appraisers interview builders, developers, and real estate professionals to ascertain typical land-to-building value ratios in a given market.
• Regression Analysis: Can be used to statistically derive land-to-building value ratios from a dataset of comparable sales.

3. Limitations

This method assumes uniformity and stability within the market. Variations in building quality, design, or location can significantly impact the validity of the derived land value.

C. Extraction Method

This method relies on the principle of substitution and the cost principle. It’s applicable when valuing improved properties, particularly in areas with limited vacant land sales data.

• Procedure: Subtracts the estimated depreciated cost of improvements from the total sale price of the improved property.

1. Formula

Site Value = (Sale Price of Improved Property) - (Depreciated Cost of Improvements)

2. Scientific Basis

• Cost Estimation: Utilizes cost manuals (e.g., Marshall & Swift Valuation Service) and local construction cost data to estimate the reproduction or replacement cost of the improvements.
• Depreciation Analysis: Employs methods such as the age-life method, observed condition method, or market extraction method to estimate depreciation due to physical deterioration, functional obsolescence, and external obsolescence.

3. Limitations

The reliability of this method depends on the accuracy of both the cost estimation and the depreciation analysis. Inaccurate depreciation estimates can significantly distort the derived land value.

D. Land Residual Method

The Land Residual Method is a form of the income capitalization approach

• Procedure: The method seeks to isolate the amount of net operating income that can be attributed to the land itself, which can then be capitalized into value. The primary use is to estimate the value of a parcel that has potential for improvements.

1. Formula

Land Value = (Net Operating Income Attributable to Land) / (Land Capitalization Rate)

• A key factor in this calculation is the Land Cap Rate. For this, you should use the

  • Band of Investment Technique: In this you take all investment variables, and make the correct rate adjustment for each to arrive at the Land Cap Rate.

2. Steps

First find Net Operating Income

Next find the Value of the Building = Cost to build improvement

Then you find the Building Cap Rate = Market Rate + Depreciation

Now you solve I = V * R

• I = Building Income
• V = Value of Building
• R = Building Cap Rate
  Finally you find Land Value

3. Limitations

• For a calculation to be accurate, all components have to be calculated correctly.

E. Ground Rent Capitalization Method

Another way to calculate Land Value based on the income approach, the method uses leased fees for the land over a long term to arrive at a property’s value

• Procedure: Find the lease amount for the Land to find property’s value
• Formula:

Land Value = Net Operating Income / Rate

• Net Operating Income is the yearly ground rent

• Rate is a Rate for ground rent in that market.

• Example: Land rent is $120,000 per year with the land rent cap rate for the market is 12%, then land value is $1,000,000

• Limitations:

  • This method is only applicable if a property is leased
  • It has to be compared against other methods to ensure accuracy.

F. Development Method

A method that is applied for large tracts of land with an analysis that is complicated over long periods.

• Procedure:

  • The method uses future values to calculate the present market value
  • The value requires a good development plan, a pricing schedule, all relevant expenses for development, the sales of all parcels, and annual taxes
  • The appraiser must find a proper discount rate to make the value as accurate as possible

  • Experiment

  • Find an expert from a firm that specializes in development and subdivision projects, and find out how the analysis will be carried out for this project

• Limitations:

  • If market is poor, a developer will get a value that is lower than it would be in a strong market
  • It can be flawed if development data is flawed.

G. Depth Tables

This method is used to measure value in relation to depth. It determines that highest values are located in the front of the lot.

Procedure:

• 40% of total value in the front quarter
• 30% of total value in the second quarter
• 20% of total value in the third quarter
• 10% of total value in the last quarter

Experiment:

An easy way to experiment with this method, is to examine two comparable lots and calculate to see if the depth table method has any real impact on value for analysis.

Limitations:

• The method is a rough estimate and doesn’t take into account special needs.

IV. Practical Applications and Experiments

A. Zoning Variance Application

Research a zoning variance application in your local area. Analyze the property based on the four HBU criteria (legally permitted, physically possible, economically feasible, and maximally productive).

B. Paired Sales Analysis

Conduct a paired sales analysis to determine the value contribution of a specific site characteristic (e.g., corner lot, waterfront access).

C. Site Valuation Using Multiple Methods

For a hypothetical property, estimate site value using at least three different methods (Sales Comparison, Allocation, and Extraction). Compare and reconcile the results.

V. Conclusion

A thorough understanding of site valuation techniques is paramount in applying the Cost Approach to Value accurately and effectively. By mastering the principles and methods outlined in this chapter, appraisers gain a crucial competitive edge and make informed❓ real estate valuation decisions.