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Identifying Optimal Use: Vacant vs. Improved
Chapter: Identifying Optimal Use: Vacant vs. Improved
This chapter delves into the crucial step of identifying the optimal use of a property, considering the scenarios of vacant land versus an improved site. We will explore the scientific principles and practical applications involved in determining the highest and best use (HBU) in each situation. The HBU, defined as the most probable use of a property that is physically possible, legally permissible, financially feasible, and results in the highest value, is a cornerstone of real estate valuation.
1. Analyzing Vacant Land: A “Blank Canvas” Approach
A. Concept: When evaluating vacant land, we treat it as a “blank canvas,” free from existing constraints of improvements. This allows us to explore the full spectrum of potential uses.
B. Physical Possibility: This is the first filter in determining HBU. Several factors define physical possibility:
1. Site Characteristics:
* Size and Shape: Irregularly shaped parcels, though of the same size, can be more costly to develop and offer less utility than regularly shaped ones.
* Topography: Steep slopes may preclude certain types of development or necessitate costly grading.
* Soil Composition: Unstable soils may require expensive remediation before construction.
* Availability of Utilities: Proximity to water, sewer, electricity, and gas is essential. Lack of access may render a use physically impossible or financially infeasible.
* Environmental Conditions: Presence of wetlands, endangered species habitats, or contaminated sites can restrict use.
2. Accessibility: Ease of access for vehicles (including large trucks for industrial properties) and pedestrians is critical.
3. Visibility: Crucial for commercial properties. However, excessive traffic can hinder accessibility.
C. Mathematical Considerations for Site Suitability:
1. Site Density Calculation:
* D = B / S
* Where:
* D = Density (e.g., units/acre, floor area ratio)
* B = Buildable Area (sq. ft.)
* S = Site Area (sq. ft.)
2. Cut and Fill Volume Estimation: Essential for assessing grading costs. This involves calculating the volume of earth to be moved. Various methods exist, including:
* Average End Area Method: V = L/2 * (A1 + A2)
* Where:
* V = Volume of cut or fill
* L = Distance between cross-sections
* A1 and A2 = Areas of cut or fill at each cross-section
* Prismoidal Formula (more accurate): V = L/6 * (A1 + A2 + 4Am)
* Where:
* Am = Area of the mid-section
D. Legal Permissibility: Zoning ordinances, building codes, environmental regulations, and deed restrictions significantly restrict the range of legally permissible uses. The appraiser must investigate if there is a reasonable probability of zoning changes, considering the economic demand and associated costs.
1. Example: A site zoned for single-family residential use might be ideal for a high-rise apartment building, but this is impossible until the zoning is changed. The likelihood and cost of rezoning must be considered.
E. Economic Feasibility: From the remaining uses that are both physically possible and legally permissible, we need to ascertain which uses are financially feasible.
1. Residual Land Value Analysis: This is a crucial step in determining economic feasibility. It involves estimating the value of the completed project and subtracting all development costs (including construction, financing, marketing, and entrepreneurial profit) to arrive at the residual land value.
* RLV = V - DC
* Where:
* RLV = Residual Land Value
* V = Value of the completed project
* DC = Development Costs (total)
2. Timing of Use: Some uses might not be currently feasible but could become so in the future.
* Present Value Calculation: To compare future land values, we need to discount them back to the present.
* PV = FV / (1 + r)^n
* Where:
* PV = Present Value
* FV = Future Value
* r = Discount Rate (reflecting risk and holding costs)
* n = Number of Years
F. Maximum Productivity: Of the financially feasible uses, the HBU is the use that produces the highest residual land value. Rates of return can also be applied to capitalize the residual income to the land from those uses into their respective values. Comparable land sales data can provide additional insight.
G. Ideal Improvement: If a building is appropriate, the appraiser should define the “ideal improvement” - a hypothetical building that meets market demands and maximizes the site’s potential.
H. Distinguishing physical use❓ from Motivations: Conservation, preservation, and assemblage are motivations, not physical uses of land. They influence the legal permissibility and financial feasibility of different uses, but the physical use must still be defined (e.g., “leave the land vacant,” “limited development”).
2. Analyzing Improved Property: Considering existing structures❓
A. Concept: Analyzing an improved property considers the value contributed by the existing improvements. Several alternative uses are considered:
1. Retain and continue the current use.
2. Convert, renovate, or alter the existing improvements to enhance the current use or change the use to a more productive one.
3. Retain the existing improvements and continue the current use as an interim use.
4. Demolish the existing improvements and redevelop the site.
B. Demolition Analysis: The first step is often to determine if the existing improvements contribute value. If the value of the improved property is less than the value of the site as though vacant minus demolition costs, then demolition is economically justified.
1. Demolition Decision Rule:
* If V_improved > (V_vacant - DC_demolition), then retain/modify improvements.
* If V_improved < (V_vacant - DC_demolition), then demolish improvements.
* Where:
* V_improved = Value of the property as improved
* V_vacant = Value of the site as though vacant
* DC_demolition = Demolition Costs
C. Modification Analysis (Conversion, Renovation, Alteration):
1. For any modification to be feasible, the increase in value must be greater than or equal to the cost of the modification (including entrepreneurial incentive).
* V_modified - DC_modification >= V_as_is
* Where:
* V_modified = Value after modification
* DC_modification = Cost of modification
* V_as_is = Value of the property as is
2. Each modification must be physically possible, legally permissible, financially feasible, and maximally productive.
D. Continued Current Use: If all other alternatives are eliminated, the current use remains the HBU if it’s financially feasible and maximizes value. Deferred maintenance and potential repairs should be analyzed.
3. The Principle of Consistent Use
A. Concept: Land cannot be valued based on one use while the improvements are valued based on another.
B. Application: If the existing improvements are not the HBU, any increase or decrease in value they contribute is attributed to the improvements, not the land.
C. Example: A single-family home on a commercially-zoned lot. You cannot add the residential value of the house to the commercial value of the land. The commercial value of the land reflects the cost of removing the house.
4. Practical Applications and Experiments
A. Case Study: Industrial Site
1. Scenario: An older industrial building is located on a large parcel of land in a transitioning urban area.
2. Experiment:
* Step 1: Determine the value of the site as though vacant, considering various potential uses (e.g., residential, retail, modern industrial). Residual land value analysis is performed for each.
* Step 2: Determine the value of the property as improved.
* Step 3: Calculate demolition costs.
* Step 4: Compare V_improved with (V_vacant - DC_demolition) for each potential vacant-site use.
* Step 5: If demolition is not justified, explore renovation options for the existing industrial building or conversion to another use. Calculate the costs and potential value increases.
* Conclusion: The HBU might be:
* Demolishing the building and developing a residential complex.
* Renovating the building for modern industrial use.
* Converting the building into a mixed-use development (retail/residential).
* Continuing the existing industrial use as an interim use until market conditions favor redevelopment.
B. Sensitivity Analysis: In real-world applications, it’s essential to conduct sensitivity analysis. This involves varying key assumptions (e.g., discount rates, development costs, rental rates) to assess how the HBU conclusion might change. Monte Carlo simulation can also be used to account for uncertainty in input variables.
5. Conclusion
Determining the optimal use of a property requires a rigorous and scientific approach. By carefully considering physical possibilities, legal constraints, financial feasibility, and maximum productivity, and by understanding the interplay between vacant land and improved property analyses, we can arrive at a well-supported HBU conclusion, which is fundamental to accurate real estate valuation and investment decisions. The use of mathematical formulas and sensitivity analyses helps to ensure that the conclusions❓ are robust and defensible.
Chapter Summary
The chapter “Identifying Optimal Use: Vacant vs. Improved” within the “Maximizing Real Estate Value: Highest and Best Use Analysis” training course focuses on determining the most profitable and legally/physically viable use of a property, considering it both as if it were vacant land❓ and with its existing improvements.
Key Scientific Points and Conclusions:
-
Vacant Land Analysis: The chapter emphasizes analyzing vacant land (or improved land as if vacant) to identify its highest and best use by considering physical, legal, and locational factors.
- Physical Possibility: site characteristics❓ such as size, shape, topography, soil, utilities, and accessibility significantly constrain development options. Irregular shapes or poor access can increase development costs❓ and limit suitability for certain uses.
- Legal Permissibility: Zoning ordinances, land use regulations, and conservation easements restrict potential❓ uses. The probability of zoning changes and economic demand for such changes must be investigated.
- Location Analysis: The location dictates potential uses based on economic demand, growth patterns, linkages to demand sources, and competitive position. Dynamic features, such as growth rates, must be considered.
- Financial Feasibility: Alternative uses are subjected to financial analysis, focusing on present residual land value❓. The timing of development is critical, as a currently infeasible use might become profitable in the future. A discount rate reflecting risk and holding costs is applied to future land values.
- Maximum Productivity: The highest and best use is the one yielding the highest residual land value after deducting improvement costs. Alternative methods include capitalizing residual income using market-derived rates of return or comparing land sales with similar highest and best use conclusions.
- Ideal Improvement: If new construction is the highest and best use, the appraiser must define the “ideal improvement,” specifying characteristics like building❓ type, size, and features, based on market analysis. This ideal helps in estimating depreciation in the cost approach.
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Improved Property Analysis: The chapter then addresses the highest and best use of a property with existing improvements, considering several options:
- Continue Current Use: Retain existing improvements and continue current use.
- Modify Improvements: Convert, renovate, or alter existing improvements to enhance current use or change to a more productive use.
- Interim Use: Continue the existing use as an interim measure until redevelopment.
- Demolish and Redevelop: Demolish existing improvements and redevelop the site.
- Demolition Decision: Demolition is considered if the value of the property as improved is less than the value of the site as vacant minus demolition costs.
- Modification Feasibility: Any modification (conversion, renovation, alteration) must add more value than its cost, including entrepreneurial incentive. It must also meet the four tests of highest and best use.
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Consistent Use Principle: This principle dictates that land and improvements cannot be valued based on different uses. When using the cost approach, functional obsolescence adjustments are needed when the improvements are not consistent with the highest and best use as if vacant. The value any improvements create in this scenario, is attributed to the improvements.
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Distinction between Use and Motivation: The chapter emphasizes that highest and best use relates to the physical use of land, not the motivations of owners/users.
- Conservation or preservation are motivations, while the physical use might be “leave land vacant.”
- Assemblage is a motivation for acquisition, not a use of the real estate itself.
- Speculation is a motivation to profit from price increases, not a use of the land.
Implications:
- A rigorous highest and best use analysis is crucial for accurate property valuation and informs investment decisions.
- Failing to properly analyze all four criteria (legally permissible, physically possible, financially feasible, maximally productive) can lead to inaccurate conclusions.
- Timing considerations are critical, as market conditions can change, altering the financial feasibility of different uses over time.
- The appraiser must carefully consider whether existing improvements contribute to value or detract from it, justifying potential demolition or modification.
- Understanding the distinction between the physical use of land and the motivations of owners/users is essential for avoiding logical fallacies in the analysis.
- The interplay of the four criteria of highest and best use, are practically organized into eight steps that mirror the process of market and marketability analysis.
