Site Valuation Techniques: Cost Approach Focus

Site Valuation Techniques: Cost Approach Focus - A Scientific Introduction

Accurate real estate valuation demands a robust understanding of site characteristics and their contribution to overall property value. This is particularly crucial in the application of the cost approach to value, a fundamental appraisal methodology. The cost approach posits that the value of an improved property is derived from the sum of the site value and the depreciated replacement cost of the improvements. Thus, a precise and independent site valuation becomes a scientific imperative when employing this approach, as mandated in many property tax assessment and condemnation appraisals. This chapter, a critical component of “Mastering Neighborhood and Site Analysis in Real Estate Appraisal,” addresses this scientific necessity by focusing on methodologies specifically tailored to determine reliable site values for effective use in the cost approach. The course itself empowers practitioners with the tools to analyze neighborhood dynamics and site characteristics, thereby contributing to more accurate appraisal reports and a stronger competitive advantage.

The chapter will systematically explore established site valuation techniques, including the sales comparison, allocation, extraction, development, land residual, and ground rent capitalization methods. Emphasis will be placed on understanding the theoretical underpinnings and practical application of each technique, with a particular focus on the sales comparison method as the most reliable and scientifically valid approach. The objective is to equip the appraiser with the ability to critically evaluate market data, adjust comparable sales for relevant elements of comparison (e.g., property rights, financing terms, location, physical characteristics), and synthesize data to arrive at a defensible and replicable site value estimate.

Furthermore, this chapter will delve into the integral relationship between highest and best use analysis and accurate site valuation. It will detail how identifying the legally permissible, physically possible, economically feasible, and maximally productive use of the site as if vacant is a prerequisite for selecting the appropriate valuation method and interpreting market evidence. By mastering these concepts and techniques, the learner will be able to refine their appraisal expertise, improve the quality and defensibility of their appraisal reports, and ultimately elevate their professional standing in the real estate appraisal industry as highlighted in the course description.

Chapter 6: Site Valuation Techniques: cost approach❓ Focus

Introduction

This chapter delves into the core of site valuation, specifically emphasizing its critical role within the Cost Approach to real estate appraisal. As highlighted in the course description (“Mastering Neighborhood and Site Analysis in Real Estate Appraisal”), accurate site valuation is paramount for precise appraisal reports and achieving a competitive edge in the industry. The Cost Approach, a fundamental valuation technique, necessitates a separate and independent site valuation as a primary component. This chapter will equip you with the knowledge and skills to execute this critical appraisal step.

I. The Necessity of Separate Site Valuation in the Cost Approach

The Cost Approach to value operates on the principle that a buyer will pay no more for a property than the cost to acquire an equivalent site and construct a substitute structure. This approach hinges on the ability to accurately estimate:

• Site Value: The value of the land as if vacant and available for its highest and best use.
• Replacement Cost New: The cost to construct a new improvement with equivalent utility to the existing structure, using current materials, designs, and engineering.
• Accrued Depreciation: The loss in value of the existing improvements due to physical deterioration, functional obsolescence, and external obsolescence.

The basic formula for the Cost Approach is:

Property Value = Site Value + Replacement Cost New - Accrued Depreciation

Since the formula requires an independent site value, the Cost Approach cannot be accurately applied without a separate estimate of the site’s value. As the book content states “As noted earlier in this chapter, the cost approach requires a separate valuation of the site.” This is also needed for Tax assessments.

The Cost Approach is most applicable when the improvements are:

• Relatively new.
• Do not suffer from significant depreciation.
• Represent the highest and best use of the site.

II. Highest and Best Use: The Foundation of Site Valuation

A. Definition and Significance
* The highest and best use (HBU) of a site is the most probable and legal use that is physically possible, appropriately supported, financially feasible, and results in the highest value.
* It is crucial to define HBU because it directly influences land value and guides the appraiser in choosing comparable properties for the sales comparison❓ Approach (when applicable). The book content emphasizes that for older improvements it is hard to conform to the highest and best use of the land.
* HBU analysis is grounded in the principle of anticipation, meaning that value is based on expected future benefits.

B. The Four Tests of Highest and Best Use
1. Legally Permissible
* The proposed use must comply with all applicable zoning regulations, building codes, environmental restrictions, and private deed restrictions.
* Scientific Principle: Legal restrictions act as constraints on the potential uses and, consequently, the value of the site.
* Example: A site zoned for single-family residential use cannot be valued based on its potential for commercial development.
2. Physically Possible
* The site’s physical characteristics must be suitable for the proposed use. This includes considerations like size, shape, topography, soil conditions, access to utilities, and environmental hazards.
* Scientific Principle: Physical limitations impose constraints on the types of improvements that can be constructed on the site.
* Experiment: Conduct a soil percolation test to determine if the soil is suitable for a septic system if public sewer service is unavailable.
3. Financially Feasible
* The proposed use must generate sufficient income or benefits to justify the costs of development.
* Scientific Principle: The principle of supply and demand dictates that an oversupply of a particular type of property will negatively impact its financial feasibility.
* Formula:

        ```
        Profitability = Projected Revenue - Development Costs - Operating Expenses
        ```

        Where Profitability > 0 indicates financial feasibility.
    *   **Example:** A market analysis might reveal an oversupply of office space, making the construction of a new office building financially unfeasible.
4.  ***Maximally Productive***
    *   Among all the legally permissible, physically possible, and financially feasible uses, the one that generates the highest net return or value is considered the maximally productive and, therefore, the highest and best use.
    *   **Scientific Principle:** The *principle of increasing and decreasing returns* applies. Value increases with investment up to a point, after which further investment yields diminishing returns.
    *    **Experiment:** Conduct a *sensitivity analysis* by varying key assumptions (e.g., rental rates, occupancy levels) to determine the impact on project profitability and identify the use that consistently yields the highest return.

C. HBU “As Vacant” vs. “As Improved”
* HBU As Vacant: Determines the most profitable use assuming the site is vacant and available for any development.
* HBU As Improved: Considers the existing improvements and determines whether the current use maximizes value or if a change is warranted. This involves assessing the cost of demolition or renovation.

The content in the book notes: For improved property, the appraiser must analyze highest and best use of the property as improved, and also of the property as if vacant.

A. **Interim Use Analysis:**

The book content notes "An interim use is a current highest and best use that is viewed as only temporary." In real-world application, an interim use may involve generating revenue during the transition period from land purchase to long-term project initiation. This could encompass establishing parking lots, pop-up retail stores, or temporary storage facilities, to yield short-term returns while awaiting zoning approvals or funding for the envisioned project. This concept aligns with the "Mastering Neighborhood and Site Analysis" course description, as interim use analysis requires a keen awareness of neighborhood dynamics to capitalize on opportunities and mitigate potential negative impacts.

III. Site Valuation Techniques: Cost Approach Focus

The following techniques are critical for determining site value in the context of the Cost Approach.

A. Sales Comparison Approach (Preferred Method)
* The most reliable method, involving analyzing recent sales of comparable vacant land parcels.
* Scientific Principle: The principle of substitution suggests that a buyer will pay no more for a property than the cost to acquire an equally desirable substitute.

B. **Sales of Improved Property**

*Sales of improved property can be used as comparables for site valuation, but with modifications to account for the value of structures on the site. This is done by deducting the cost of demolishing the existing improvements from the sales price of the property to arrive at an indicator for the value of the site as if vacant.

*   **Procedure:** Adjust the comparable sales for differences using the *elements of comparison*.
*   The book notes: Sales prices of comparables must be adjusted to account for any differences between the comparables and the subject property, including physical differences, changes in market conditions, and differences in the terms of sale.
*   **Elements of Comparison and Scientific Justifications:**
    1.  ***Real Property Rights Conveyed:*** Adjust for differences in fee simple estate, leased fee estate, easements, or other rights. The legal rights dictate the value.
    2.  ***Financing Terms:*** Adjust for non-market financing, such as below-market interest rates or seller concessions.
         *   Formula: Adjust the sale price by the difference between the market interest rate and the financing rate, capitalized over the loan term.
    3.  ***Conditions of Sale:*** Adjust for sales that were not arm's-length transactions (e.g., sales between relatives). Consider if it's an arm's-length transaction.
    4.  ***Expenditures Immediately After Sale:*** For immediate or future repairs after the sale, adjust accordingly.
    5.  ***Market Conditions Adjustment (Time):*** Adjust for changes in market conditions between the date of sale of the comparable and the appraisal date.
        *   Formula: `Percentage Change in Market Value = (Current Index / Previous Index) - 1`
    6.  ***Location Adjustments:*** Account for differences in neighborhood desirability, access, amenities, and exposure.
    7.  ***Physical Characteristics:*** Adjust for differences in size, shape, topography, soil conditions, frontage, and access.
    8.  ***Economic Characteristics:*** Qualities such as income, operating expenses, lease provisions, management, and tenant mix are used to analyze income-producing properties.
*   **Example:**A comparable lot sold for \$100,000 but is located in a more desirable location. Market research suggests a 10% premium for location. The adjusted sale price would be \$90,000.

B. Allocation Method (Secondary)
* Estimates land value by allocating a percentage of the total property value to the land. The book content notes that allocation uses percentages of appraisals and requires calculations to use with an A=BC Formula.
* Reliant on establishing a typical land-to-value ratio for similar properties in the market.
* Scientific Principle: Based on the principle of contribution, the value of each component (land and improvements) contributes to the overall value of the property.
* Formula:*

    ```
    Land Value = Total Property Value * Allocation Percentage
    ```
*   **Example:** If comparable sales suggest that land typically accounts for 20% of the total property value, and the subject property is valued at $500,000, the indicated land value is $100,000.
*   **Limitations:** Accuracy depends on the reliability of the allocation percentage.
*  **Experiment:** Perform a cluster analysis of similar properties to derive the typical land-to-value ratio.

C. Extraction Method (Secondary)
* Estimates land value by subtracting the depreciated cost of improvements from the total property value.
* The book content notes this can be especially important in Urban areas with high traffic.
* Formula:

    ```
    Land Value = Total Property Value - Depreciated Cost of Improvements
    ```
*   **Example:** A comparable property sold for \$600,000. The depreciated cost of the improvements is \$400,000. The extracted land value is \$200,000.

D. Depth Tables (Supplementary):
* Provides a standardized technique, such as “4-3-2-1” table, to correlate the value of land to its depth.

Note: The development, land residual, and ground rent capitalization methods are generally more applicable for income-producing properties and less frequently used in valuing residential sites for the Cost Approach.

IV. Practical Application: Integrating Site Valuation into the Appraisal Process

A. Uniform Residential Appraisal Report (URAR)
* The URAR form requires the appraiser to provide a clear and concise description of the site and its relevant characteristics.
* The site valuation section of the URAR provides space for:
* Dimensions, Site area, Shape, View, Specific Zoning Classification, Zoning Description, Zoning Compliance, Utilities, and more
* In addition, external factors such as easements, encroachments, environmental factors, and land use must be checked and explained.
* The URAR requires the highest and best use to be evaluated.

B. Utilizing Mobile Technology
* Leverage mobile apps for data collection (e.g., measuring site dimensions, capturing photos, accessing property records) to enhance efficiency and accuracy.
* Use GIS (Geographic Information Systems) apps to map site characteristics, identify comparable properties, and analyze neighborhood trends.

**Formula Example:**

Let's assume you're valuing a residential site and find three comparable sales, and need to adjust for site size:

*   **Comparable 1:** Sold for \$250,000, site size 10,000 sq ft
*   **Comparable 2:** Sold for \$270,000, site size 12,000 sq ft
*   **Comparable 3:** Sold for \$230,000, site size 8,000 sq ft

The subject property site size is 9,000 sq ft.

*   **Step 1: Calculate the value per sq ft for each comparable:**

    *   Comp 1: \$250,000 / 10,000 sq ft = \$25/sq ft
    *   Comp 2: \$270,000 / 12,000 sq ft = \$22.50/sq ft
    *   Comp 3: \$230,000 / 8,000 sq ft = \$28.75/sq ft

*   **Step 2: Analyze the market to determine the most representative value per sq ft.** Let’s assume, after analyzing other factors, you determine \$25/sq ft is most appropriate.

*   **Step 3: Multiply the subject property's site size by the representative value/sq ft:**

    *   9,000 sq ft * \$25/sq ft = \$225,000

Therefore, based on the size adjustment, the indicated site value is \$225,000 (further adjustments would be required for other differences).

V. Conclusion

Mastering site valuation techniques, particularly with a focus on the Cost Approach, is critical for accurate real estate appraisal and achieving a competitive edge in the industry. By understanding the principles of highest and best use, carefully selecting and adjusting comparable properties, and integrating technological tools, you can ensure precise and reliable site valuations.

Key Takeaways:

• The Cost Approach requires a separate and accurate site valuation.
• Highest and best use analysis is the foundation for site valuation.
• The Sales Comparison Approach is the preferred method for site valuation.
• Accurate appraisal reports result from mastering site valuation techniques.