Determining Optimal Use: Vacant vs. Improved

Determining Optimal Use: Vacant vs. Improved

Introduction

This chapter delves into the critical aspect of Highest and Best Use (HBU) analysis: determining whether a property’s optimal use involves the land as vacant or considering the existing improvements. This decision significantly impacts property valuation and investment strategies. We will explore the scientific principles, practical applications, and analytical techniques used to make informed judgments about a property’s HBU in both scenarios.

I. Land as Though Vacant: Physical and Legal Possibilities

A. Blank Slate Principle: Vacant land (or land analyzed as vacant) represents a “blank canvas” for development. The HBU is the most profitable and probable use, but is legally allowed and physically possible.

B. Physical Constraints: The following physical characteristics are essential to consider:

site size❓ and Shape: Irregular shapes can increase development cost❓s and reduce utility compared to regular shapes.
Topography and Soil Composition: Affects construction feasibility and cost. For example, steep slopes might necessitate extensive grading, while unstable soils may require soil remediation techniques.
Availability of Utilities and Support Services: Water, sewer, electricity, and other essential services are critical. Proximity to transportation infrastructure (roads, rail) is also important.
Environmental Considerations: Wetlands, floodplains, or contaminated soil may restrict development.
Accessibility: Ease of access for vehicles (including large trucks) and pedestrians is crucial, especially for commercial and industrial properties. The number and placement of curb cuts can significantly impact traffic flow and site accessibility.

C. Legal Constraints: Zoning ordinances, building codes, environmental regulations, and private restrictions (e.g., deed restrictions, conservation easements) dictate permissible uses.
Zoning Ordinances: Dictate allowable land uses (residential, commercial, industrial, agricultural), density restrictions (e.g., floor area ratio (FAR)), and building height limitations.
Building Codes: Set standards for construction materials, structural integrity, fire safety, and accessibility.
Environmental Regulations: Protect natural resources and regulate pollution. Examples include wetlands protection laws and regulations governing hazardous waste disposal.
Deed Restrictions: Private agreements that limit the use of property. For example, a deed restriction might prohibit the construction of certain types of buildings or limit the number of dwelling units.
Conservation Easements: Legal agreements that restrict development to protect natural resources.

D. Probability of Change: Evaluate the likelihood of zoning changes or variances based on economic demand and local political factors.
Mathematical Modeling of Change Probability: While predicting regulatory changes is difficult, one could consider a probability-weighted scenario analysis. For example:

Expected Value (EV) = (Probability of Change) * (Value with Change) + (Probability of No Change) * (Value without Change)

II. Location and Economic Demand

A. Location Analysis: A property’s location strongly influences its HBU. Analyze:
Growth Patterns: Identify the direction and rate of land use growth in the area.
Linkages to Demand: Determine the sources of demand for various land uses in the location (e.g., proximity to employment centers, retail hubs, transportation).
Competitive Position: Compare the property’s location to competing sites, considering factors like visibility, accessibility, and surrounding amenities.

B. Market Analysis: Essential to see where the subject property could be placed.

C. Distinguishing Physical Use from Motivations:
Conservation/Preservation: Motivations, not uses. The physical use might be “leave vacant” or “do not change improvements.”
Assemblage: A motivation for acquiring property, not a use in itself. The combined parcel’s HBU needs to be analyzed.
Speculation: A motivation (profit from price increase), not a use. The interim use should still be analyzed for HBU.

III. Financial Analysis of Alternative Uses (as Though Vacant)

A. Eliminating Non-Feasible Uses: Remove alternatives that are not legally permissible or physically possible.

B. Present Residual Land Value: Calculate the residual land value for each remaining alternative use. This involves estimating the total project value and subtracting development costs (construction, soft costs, and entrepreneurial incentive) to arrive at the land’s contribution to the project’s value.
Residual Land Value (RLV) = Project Value - Total Development Costs
Where Total Development Costs include construction costs, financing costs, marketing costs, and developer’s profit.

C. Timing Considerations: Crucial because not all uses will be financially feasible today. Uses that aren’t positive right now could be in the future.
Future Land Value: Forecast land value for potential future uses, considering market trends and expected demand shifts.
Present Value Analysis: Discount future land values to their present value using an appropriate discount rate that reflects the risk and holding costs associated with delaying development.
Present Value (PV) = Future Value / (1 + Discount Rate)^Number of Years

D. Example: Land with current apartment residual land value of $6/sq ft. If the land is held for seven years and is then used for retail at a land value of $20/sq ft, using a discount rate of 10%, the present value is calculated as:
PV = 20 / (1 + 0.10)^7 = $10.26/sq ft

IV. Maximum Productivity of Land as Though Vacant

A. Highest Residual Land Value: The HBU is the use that generates the highest residual land value.

B. Alternative Valuation Methods:
Capitalization of Residual Income: Capitalize the residual income to the land (net operating income attributable to the land) using market-derived capitalization rates.

Land Value = Residual Income / Capitalization Rate

Comparable Land Sales: Compare the subject property to comparable land sales with similar HBU conclusions. Adjust for differences in location, size, and other relevant characteristics. If apartment land is currently selling for $3.50/sq ft, and retail land is estimated to sell for $7.50 in 5 years with a 20% discount rate, the present value calculation will be as follows:
Present Value of Retail Land = $7.50 / (1 + 0.20)^5 = $3.01/sq ft.

V. Conclusion of HBU (Land as Though Vacant)

A. Ideal Improvement: Identify the ideal improvement that is:
Supported by Market Analysis: Consistent with market demand and feasibility studies.
Maximizes Market Demand: Takes full advantage of the site’s potential.
Conforms to Market Standards: Aligns with current market preferences and area characteristics.

B. Specificity: Define the ideal improvement with appropriate specificity (e.g., number of stories, units, square footage).

VI. Alternative Uses of the Real Estate as Improved

A. Contributory Value: Consider the value added by existing improvements, not just land as vacant.

B. Alternative Uses:
Retain Current Use: Continue the existing use as the HBU.
Convert/Renovate: Modify the existing improvements to enhance the current use or change to a more productive use.
Interim Use: Continue the current use as a temporary measure until a future, higher use becomes feasible.
Demolish and Redevelop: Remove the existing improvements and redevelop the site.

VII. Analyzing the Property as Improved

A. Demolition Analysis: Consider demolition the most extreme modification. If the value of the property “as improved” is greater than the value of the site “as vacant” less demolition costs, then the existing improvements contribute value❓❓ and demolition is not currently the HBU.
Decision Rule: Demolish if Value (Vacant) - Demolition Cost > Value (Improved)

B. Modification Analysis: If demolition is ruled out, test the feasibility of modification (conversion, renovation, alteration).
Value Added vs. Cost: The change must add at least as much value to the property as it costs, including entrepreneurial incentive.
Net Benefit = Value (After Modification) - Cost (Modification) - Value (As Is)
Accept modification if Net Benefit >= 0

C. Feasibility Testing: Any modification must still meet all four tests of HBU (legally permissible, physically possible, financially feasible, and maximally productive).

D. Current Use: If all other alternatives are eliminated and the current use remains financially feasible, the current use is the HBU of the property as improved.

E. Deferred Maintenance: Address the impact of deferred maintenance on the financial feasibility of the current use and the need for repairs to maintain competitiveness.

VIII. Consistent Use Principle

A. Definition: Land cannot be valued based on one use while improvements are valued based on another.

B. Application: Value land as though vacant for its HBU. If the improvements are inconsistent with the HBU, they may contribute value, reduce value (due to demolition costs), or have no value.

C. functional obsolescence❓❓: Adjust for functional obsolescence in the cost approach if the improvements are not consistent with the HBU.

D. Example: If a single-unit residence on commercially zoned land has a residential value of $450,000 and a commercial land value of $500,000, do not add the commercial land value to the residential building value. The HBU is commercial, and the residence will be demolished.

IX. Application of Highest and Best Use Analysis

A. The Eight-Step Process:
Property Productivity Analysis: Examines the legal, physical, and location characteristics of the property.
Market Area Analysis: Studies broader economic trends and demographic factors.
Competitive Property Survey: Identifies and analyzes competing properties.
Demand Analysis: Forecasts future demand for various land uses.
Site Use Alternatives: Generates a range of potential uses for the site.
Tests of Highest and Best Use: Applies the four tests (legal permissibility, physical possibility, financial feasibility, maximal productivity) to each alternative use.
Highest and Best Use Conclusion: Selects the optimal use based on the analysis.
Reconciliation of Value Indications: Combines value estimates from different approaches, considering the HBU conclusion.

X. Conclusion

Determining whether to analyze a property as vacant or improved is a pivotal step in HBU analysis. By systematically considering physical constraints, legal restrictions, location factors, financial feasibility, and the consistent use principle, appraisers can arrive at well-supported conclusions about a property’s optimal use and ultimately, its value.