Site Valuation Methods: Cost Approach Application

Chapter 7: site valuation❓ Methods: Cost Approach Application

Course: Land Valuation: Highest & Best Use

Description: Unlock the secrets of land valuation! This course delves into determining the highest and best use of land, legally nonconforming uses, consistent use principles, and methods like sales comparison, allocation, and extraction. Master the techniques to maximize property value and make informed investment decisions. Transform your understanding of real estate appraisal and unlock lucrative opportunities!

7.1 Introduction: The Cost Approach and Site Valuation

The cost approach to value is a crucial valuation technique, especially relevant when assessing properties with unique characteristics or limited market data. As highlighted in the book content, a distinct site valuation is fundamental to the effective application of the cost approach. This chapter will delve into the scientific principles and practical application of site valuation within the framework of the cost approach, connecting it directly to the course description’s emphasis on maximizing property value through informed appraisal techniques.

The cost approach operates under the principle of substitution: a prudent buyer will pay no more for a property than the cost to acquire an equivalent site and construct a substitute improvement, less depreciation. This hinges upon a separate and accurate determination of site value. The cost approach, according to the book content, can be expressed by the following formula:

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

Therefore, an inaccurate site valuation directly compromises the accuracy of the entire cost approach. It’s also needed in building residual technique of income capitalization.

7.2 Theoretical Foundations: Highest and Best Use and Site Valuation

A crucial underpinning for all site valuation methods, particularly within the cost approach, is the concept of Highest and Best Use (HBU). As addressed in the book content and course description, HBU is the reasonably probable and legal use of land, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.

7.2.1 Four Criteria for Highest and Best Use:

1. Legally Permissible: The use must conform to zoning regulations, environmental laws, and any other legal constraints. This is critical because the cost approach should reflect what is legally possible to build on the site.
2. Physically Possible: The site’s size, shape, topography, soil composition, and access to utilities must accommodate the proposed use. Engineering principles dictate what types of structures can be realistically built on the site.

3. Financially Feasible: The use must generate sufficient income or benefits to justify the costs of development. Discounted cash flow (DCF) analysis, based on the principle of anticipation, can be used to analyze the financial viability of various❓ potential uses. This includes calculating Net Present Value (NPV), which is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. A positive NPV suggests that the proposed use is financially feasible. The formula for NPV is:

   • NPV = ∑ (Cash Flow / (1 + Discount Rate)^Time Period) - Initial Investment

4. Maximally Productive: Among all feasible uses, the HBU is the one that maximizes the site’s value. This often requires sophisticated market analysis and consideration of various competitive uses. The principle of anticipation implies that the market participants will give value based on future expected benefits.

The interplay between these four criteria, especially feasibility and productivity, determines the optimal use for the site, directly impacting its value and forming the bedrock of the cost approach. As stated in the book content “the appraiser must analyze highest and best use of the property as improved, and also of the property as if vacant.”

7.3 Site Valuation Methods for the Cost Approach: A Scientific Examination

Several accepted methods can be used to determine site value for the cost approach. The book introduces some of these methods, including sales comparison, allocation, extraction, and the development method. We will now examine these and other applicable methods in more scientific detail:

7.3.1 Sales Comparison Approach (Preferred Method):

• Principle: This method relies on the principle of substitution, suggesting that a buyer will pay no more for a site than the cost to acquire a similar substitute. This aligns directly with the overall principle underpinning the Cost Approach.

• Process:

  1. Identify comparable vacant sites that have recently sold. The book says that “the more similar the comparables are to the subject property, the more reliable they are as indicators of value.”

  2. Analyze and adjust the sales prices of the comparables for any significant differences relative to the subject property. These adjustments may include:

     • Time of Sale: Account for market fluctuations using paired sales analysis or regression analysis. For example, if comparable property sold six months ago and values have increased 1% per month, the price should be increased by 6%. A simplified formula can be applied. Adjusted Price = Sale price x (1 + Market Trend). The book refers to the “market conditions adjustment.”
     • Location: Assess neighborhood desirability and proximity to amenities using Geographic Information Systems (GIS) and spatial analysis.
     • Physical Characteristics: Account for variations in size, shape, topography, soil quality, and access to utilities. These are the “physical differences” that need adjustment according to the book. If one site needs 100,000 USD in site prep and the other doesnt, that amount should be factored in.
     • Zoning and Restrictions: Consider the permitted uses and density restrictions imposed by zoning regulations. Legal restrictions reduce available uses and therefore value. These need to be accounted for in sale price.
     • Terms of Sale: Adjust for any non-market financing terms or seller concessions. According to the book, comparable sales prices need to be adjusted for changes in market conditions, and differences in terms of sale.
       3. Reconcile the adjusted sales prices to arrive at an indicated value for the subject site.

• Mathematical Representation (Simplified):

  • Site Value = Σ (Adjusted Sale Price of Comparable) / Number of Comparables

• Experimentation & Analysis: An experiment might involve analyzing a dataset of recent land sales, applying different adjustment methodologies (e.g., paired sales vs. regression analysis), and comparing the resulting value indications to identify the most reliable and supportable approach. This speaks to how adjustments work in the Sales Comparison Approach as discussed in the book.

7.3.2 Allocation Method:

• Principle: The allocation method assumes that a typical ratio exists between the land value and the total property value in a given market area.

• Process:

  1. Research market data to determine the typical land-to-value ratio for similar improved properties.
  2. Multiply the subject property’s overall value (estimated using other appraisal methods) by the established ratio to derive the site value.
     * Mathematical Representation:
  • Site Value = Overall Property Value × Land-to-Value Ratio
  • Experimentation & Analysis: A hypothetical experiment could be designed where land values are allocated on new house sale data, and these values are then compared to the sale prices of actual vacant lots. Any discrepancy in the values should be explained, because this method is inherently inaccurate and should only be used in situations where the more accurate methods are impossible or impractical.
  • Theoretical Limitations: This method relies on broad generalizations and may not accurately reflect the unique characteristics of the subject site.

7.3.3 Extraction Method:

• Principle: Similar to the cost approach done in reverse. The method recognizes that the value of the land is what is “left over” after deducting the depreciated value of the improvements from the total property value. As the book content notes, depreciation estimates are difficult and therefore this method should only be used with low depreciation or easy to calculate deprecation.

• Process:

  1. Estimate the total value of comparable improved properties using the sales comparison or income capitalization approach.
  2. Estimate the depreciated cost of the improvements (using cost data and depreciation analysis).
  3. Subtract the depreciated cost of improvements from the total property value to arrive at an implied land value.

• Mathematical Representation:

  • Site Value = Total Property Value - Depreciated Cost of Improvements
  • Experimentation & Analysis: You could design an experiment in a neighborhood where many teardowns occur. The prices after demolition, should roughly equal the sale prices after improvements minus depreciation for that region, but again the actual prices are more valuable and there should be an explanation for the difference between these prices.

7.3.4 Land Residual Technique:

• Principle: Capitalize income, using the income approach. A property’s income is attributable to land and the improvements on it. It is possible to figure out how much is attributable to land by calculating the costs associated with construction, if known, and deducting that from the entire property.

• Process:

  1. Estimate the potential Net Operating Income (NOI) that the property can generate.
  2. Estimate the construction costs of the improvements, which includes a capitalization rate for the improvements. The equation to figure out this value is: Improvement Value = Construction costs / capitalization rate.
  3. Deduct the income attributed to improvements from the potential NOI.
  4. Capitalize the income from the land to determine the land value: Land value = (Total potential NOI – attributed income) /land cap rate.
     * Experimentation and Analysis: Using a region’s building data and cost data, these values can be compared to actual values to see how the land value relates to the income generating potential.

7.3.5 Development Method (Discounted Cash Flow Analysis):

• Principle: This method relies on the principle of anticipation, where the present value of the land is determined by the expected future cash flows from developing and selling finished lots or units. The book content refers to “an absorption rate” for the project.

• Process:

  1. Develop a comprehensive development plan, including:

     • Subdivision layout and unit mix.
     • Detailed cost estimates (construction, infrastructure, marketing, etc.).
     • Pricing schedule and absorption rate projections.
       2. Project future cash flows, accounting for revenues and expenses over the development period.
       3. Discount the projected cash flows back to the present using an appropriate discount rate, reflecting the risk and opportunity cost associated with the development.
     • Mathematical Representation (Simplified):
  • Site Value = Present Value of (∑ (Projected Revenues - Projected Expenses) / (1 + Discount Rate)^Time Period)
  • Experimentation & Analysis: This method is highly sensitive to the accuracy of the input assumptions. Experimentation involves performing sensitivity analyses, varying key parameters (e.g., discount rate, absorption rate, construction costs), and observing the resulting impact on the indicated land value.
  • Scientific Considerations: The discount rate should be justified based on market data and risk assessments. The absorption rate projections should be supported by market analysis and feasibility studies. As the book says “the appraiser must create a sound development plan, calculate a realistic pricing schedule”.

7.3.6 Ground Rent Capitalization:

• Principle: The land is being leased in a long-term lease. A rent paid by the tenant to the landlord is the ground rent, which then can be capitalized to evaluate the land using the income approach. As the book mentions “provisions for escalation of rent” need to be considered.

• Process:

  1. Determine the accurate income potential, which is the rent being paid by the tenant.

  2. Determine the correct capitalization rate based on relevant market conditions and data.

  3. Using the formula Value = NOI/Capitalization Rate, determine the accurate value for the land.

• Analysis: As the book indicates there can be additional factors to consider for the ground rent method, such as time remaining on lease, and provisions for escalation of rent, which need to be considered.

7.4 Practical Applications and Examples

7.4.1 Application in the Cost Approach:

Let’s assume we’re appraising a residential property using the cost approach. We’ve determined:

• Cost to construct a new, equivalent improvement = $400,000
• Accrued depreciation = $50,000

The remaining step is to value the site. If, using the sales comparison approach, we determine the site is worth $150,000, then:

• Property Value = $150,000 (Site Value) + $400,000 (Cost) - $50,000 (Depreciation) = $500,000

This represents the value indication using the cost approach, heavily reliant on an accurate site valuation.

7.4.2 Identifying Highest and Best Use:

A hypothetical site is zoned for either a single-family home or a small office building. Based on market research and cost analyses:

• Single-Family Home: Land value is $200,000. Construction costs = $300,000. Potential resale value = $600,000. Profit margin = $100,000.
• Office Building: Land value is $250,000. Construction costs = $500,000. Potential rental income justifies a value of $800,000. Profit margin = $50,000.

In this scenario, an office building, despite having a higher land value, is not the best use due to lower potential profits. The higher profit margin indicates a single-family home is the most value driver.

7.5 Conclusion: Mastering Site Valuation for Optimal Appraisal

This chapter has provided a scientifically grounded exploration of site valuation methods within the context of the cost approach, emphasizing its dependence on sound appraisal principles, particularly highest and best use analysis. By grasping these theoretical frameworks and employing rigorous analytical techniques, appraisers can generate more reliable and defensible value conclusions, thereby maximizing property values and contributing to informed investment decisions, which aligns directly with the goals set forth in the course description.

As also stated in the book, the appraiser also estimates what it would cost to replace any existing structures, and adds this amount to the site value. The cost of replacing the structures is estimated as of the date of valuation.

Finally, the appraiser estimates the difference in value between the existing improvements and the cost of replacing them (depreciation), and deducts this amount to arrive at the final value indicator. estimating❓ accrued depreciation is often the most difficult part of applying the cost approach to value, especially for older improvements or improvements that do not conform to the highest and best use of the land as if vacant.