Analyzing Legally Permissible, Physically Possible, and Financially Feasible Uses

Chapter: Analyzing Legally Permissible, Physically Possible, and Financially Feasible Uses

This chapter delves into the crucial first steps of highest and best use analysis: identifying legally permissible, physically possible, and financially feasible uses for a property. This process involves a rigorous and systematic evaluation of various options to narrow down the range of potential uses that will be subjected to further scrutiny.

1. Legally Permissible Uses: Navigating the Regulatory Landscape

The first filter in determining the highest and best use is legal permissibility. A use, no matter how physically suitable or financially lucrative, cannot be considered if it violates existing laws and regulations.

• Zoning Ordinances: These are the primary legal constraints on land use. Zoning ordinances dictate the permitted uses within specific geographic areas, often categorized by residential, commercial, industrial, agricultural, or mixed-use designations. Examples include:
  • Single-family residential (R-1) zones: Restricting use to detached single-family dwellings.
  • Commercial (C-2) zones: Allowing retail stores, offices, and restaurants.
  • Industrial (M-1) zones: Permitting manufacturing, warehousing, and distribution facilities.
• Building Codes: Building codes regulate the construction, alteration, and maintenance of structures. They ensure safety, structural integrity, and accessibility. Key aspects covered by building codes include:
  • Occupancy classifications: Determining the allowable use and related safety requirements of a building (e.g., assembly, business, educational, residential).
  • Fire safety: Requiring specific fire-resistant materials, sprinkler systems, and fire exits.
  • Accessibility standards: Mandating compliance with the Americans with Disabilities Act (ADA) and other accessibility regulations.
• Environmental Regulations: Environmental regulations aim to protect natural resources and mitigate pollution. They can significantly impact land use decisions. These regulations encompass:
  • Wetland protection: Restricting development in or near wetlands to preserve their ecological functions.
  • Endangered species acts: Limiting land use to protect critical habitats of threatened or endangered species.
  • Air and water quality regulations: Requiring permits and mitigation measures for activities that generate air or water pollutants.
• Deed Restrictions: Private agreements that limit land use, often found in residential subdivisions. Deed restrictions can dictate setbacks, building heights, architectural styles, and other aspects of development.
• Easements: Legal rights granted to another party to use a portion of the property for a specific purpose (e.g., utility easements, access easements). These easements can restrict the developable area of a site.

Analyzing Legal Permissibility:

1. Comprehensive Research: Thoroughly investigate all applicable codes, ordinances, and regulations. This involves consulting with local planning departments, legal professionals, and environmental consultants.
2. Probability of Change: Assess the likelihood of changes to existing regulations. Consider factors such as economic demand for change, political climate, and community sentiment. For example, a zoning variance might be possible if there is a strong public need for a particular use and minimal negative impacts on surrounding properties. The probability of a zoning change should be quantified, if possible, using statistical methods.
3. Cost and Timing of Change: If regulatory changes are deemed probable, estimate the costs and time required to obtain the necessary approvals. This involves considering application fees, legal expenses, and potential delays due to public hearings or appeals. This is a crucial step, as the time value of money can significantly affect the overall feasibility of a project.

4. Conservation Easements: Legal agreements limiting land use to protect conservation values. These easements might restrict development to some limited degree as agreed upon by contract.
   * Formula to quantify the impact of legal restrictions:

   Let:

   V_UR = Value under restricted use
   V_UUR = Value under unrestricted use
   C_C = Cost of compliance with legal restrictions
   P_A = Probability of obtaining approval for a change in legal restrictions.
   C_A = Cost of attempting a change in legal restrictions

   Then:

   V_UR = V_UUR * P_A - C_C - C_A * (1 - P_A)

   This formula offers a scientific, quantitative approach to assess the monetary impact of legal restrictions on property value.

Example:

A parcel of land is zoned for single-family residential use, but a developer believes there is potential for rezoning to allow for a small retail center. The developer would need to determine the probability of rezoning approval, the costs associated with the rezoning process (application fees, legal expenses, etc.), and the potential increase in value if the rezoning is successful. This analysis would help determine whether pursuing the rezoning is financially feasible.

2. Physically Possible Uses: Evaluating Site Suitability

The next step is to determine which uses are physically possible given the characteristics of the site. This involves a detailed assessment of the site’s physical attributes and their impact on development potential.

• Site Size and Shape: The dimensions and configuration of a site significantly affect the type and scale of development that can be accommodated. Irregularly shaped parcels can be more challenging and costly to develop than regularly shaped parcels of the same size.
• Topography: Steep slopes, floodplains, and other topographic features can limit developable areas and increase construction costs.
• Soil Composition: Soil characteristics influence foundation❓ design, drainage, and landscaping. Unstable soils or the presence of hazardous materials can require costly remediation measures.
• Availability of Utilities: Access to essential utilities (water, sewer, electricity, gas, telecommunications) is crucial for most types of development. The cost of extending utility lines to a remote site can be prohibitive.
• Access and Visibility: Ease of access and visibility are particularly important for commercial properties. The number and placement of curb cuts, traffic patterns, and signage opportunities can significantly impact a site’s attractiveness to businesses.
• Environmental Conditions: The presence of wetlands, endangered species habitats, or contaminated soil can impose significant constraints on development.
• Subsurface conditions: Soil bearing capacity, depth to bedrock, and the presence of groundwater all influence foundation design and construction costs.

Analyzing Physical Possibility:

1. Site Inspection: Conduct a thorough on-site inspection to assess the site’s physical characteristics.
2. Topographic Survey: Obtain a topographic survey to determine elevations, slopes, and drainage patterns.
3. Geotechnical Investigation: Conduct a geotechnical investigation to evaluate soil composition and subsurface conditions. This typically involves soil borings and laboratory testing.
4. Environmental Assessment: Perform an environmental assessment to identify potential environmental hazards. This may include a Phase I Environmental Site Assessment (ESA) to review historical records and a Phase II ESA to collect soil and water samples for analysis.
5. Utility Availability Assessment: Contact utility companies to determine the availability and capacity of utility services.
6. Accessibility Analysis: Analyze traffic patterns, curb cuts, and other access features to determine the site’s accessibility.

Example:

A developer is considering building a multi-story office building on a site with steep slopes. A geotechnical investigation reveals unstable soils that would require extensive soil stabilization measures. The developer also finds that extending utility lines to the site would be very expensive. Based on these physical constraints, the developer might conclude that a multi-story office building is not physically possible and explore alternative uses that are more suited to the site’s characteristics, such as a low-density residential development.

• Formula to quantify the cost impact of physical constraints:

  Let:

  C_B = Base construction cost for a typical site
  C_PC = Additional cost due to physical constraints
  A = Area of the site
  F_S = Slope factor
  F_Soil = Soil stability factor
  F_Water = Water table factor

  Then:

  C_PC = A * (C_B * (F_S + F_Soil + F_Water))

  This formula quantifies the incremental construction cost incurred by specific physical constraints.

3. Financially Feasible Uses: Evaluating Economic Viability

Once legally permissible and physically possible uses have been identified, the next step is to determine which of these uses are financially feasible. This involves assessing the economic viability of each potential use by comparing the expected revenues to the costs of development.

• Market Analysis: Conduct a market analysis to determine the demand for various types of real estate in the subject area. This involves studying demographics, employment trends, vacancy rates, rental rates, and other market indicators.
• Cost Estimation: Estimate the costs of developing each potential use. This includes land acquisition costs, construction costs, financing costs, and operating expenses.
• Revenue Projections: Project the revenues that each potential use is likely to generate. This includes rental income, sales revenue, and other sources of income.
• Financial Modeling: Develop a financial model to analyze the profitability of each potential use. This model should incorporate revenue projections, cost estimates, and financing assumptions. Common financial metrics used in this analysis include:
  • Net Present Value (NPV): The present value of future cash flows, minus the initial investment. A positive NPV indicates that the project is expected to be profitable.
    • Formula: NPV = Σ (CFt / (1 + r)^t) - Initial Investment, where CFt is the cash flow in period t, r is the discount rate, and t is the time period.
  • Internal Rate of Return (IRR): The discount rate that makes the NPV of a project equal to zero. The IRR represents the effective rate of return on the investment.
  • Return on Investment (ROI): A measure of the profitability of an investment, expressed as a percentage.
    • Formula: ROI = (Net Profit / Cost of Investment) * 100%
  • Payback Period: The amount of time it takes for an investment to generate enough cash flow to recover the initial investment.
• Sensitivity Analysis: Conduct a sensitivity analysis to assess the impact of changes in key assumptions on the financial feasibility of each use. This involves varying assumptions such as rental rates, construction costs, and vacancy rates to determine their effect on NPV, IRR, and other financial metrics.
• Land Residual Technique: This technique isolates the value of the land by subtracting the cost of improvements and entrepreneurial profit from the total project value. The use that results in the highest positive land residual is considered the most financially feasible.

Analyzing Financial Feasibility:

1. Market Research: Gathers relevant data on market demand, supply, and competitive conditions for different land uses.
2. Cost and Revenue Estimation: Accurately estimate costs (construction, operating) and potential revenues for each viable land use option.
3. Financial Pro Forma Development: Construct detailed pro forma financial statements for each land use scenario to project cash flows, profitability, and returns.
4. Financial Metrics Calculation: Calculate NPV, IRR, ROI, and payback period for each land use alternative.
5. Risk Analysis: Assess and quantify the risks associated with each land use (market, regulatory, environmental) and adjust financial projections accordingly.

Example:

A developer is considering two potential uses for a vacant site: a retail shopping center and an apartment complex. The developer conducts a market analysis and determines that there is strong demand for both types of real estate in the area. The developer then estimates the costs and revenues associated with each use and develops a financial model. The model shows that the apartment complex has a higher NPV and IRR than the retail shopping center. Based on this analysis, the developer concludes that the apartment complex is the more financially feasible use.

• Formula for Land Residual Technique:

  Let:

  V = Total Project Value (after completion)
  C = Cost of Improvements (construction, etc.)
  P = Entrepreneurial Profit
  L = Land Value (residual)

  Then:

  L = V - C - P

  This equation demonstrates how land value is derived as a residual after accounting for development costs and required profit.

By systematically analyzing legally permissible, physically possible, and financially feasible uses, appraisers and developers can narrow down the range of potential uses and focus their efforts on the most promising options. This rigorous process is essential for maximizing real estate value and making informed investment decisions. This chapter provides a clear framework for conducting this analysis, ensuring that all relevant factors are considered.