Optimal Use Determination: Vacant vs. Improved

Optimal Use Determination: Vacant vs. Improved

This chapter delves into the scientific underpinnings of determining the optimal use of a property, specifically addressing the crucial distinction between analyzing a site as if it were vacant versus considering it with its existing improvements. This determination forms a cornerstone of real estate valuation and investment decision-making.

1. Introduction: The Highest and Best Use (HBU) Principle

   The principle of Highest and Best Use (HBU) dictates that a property’s value is derived from its most profitable, likely, and legal use. This principle is fundamental to real estate appraisal and investment analysis. The determination of HBU requires a rigorous analysis considering:

   • Legally permissible uses.
   • Physically possible uses.
   • Financially feasible uses.
   • Maximally productive uses.
     2. Analyzing Land as Though Vacant: A “Blank Canvas” Approach

   2.1. Defining the “As Though Vacant” Scenario

   The “as though vacant” analysis considers the hypothetical scenario where the existing improvements are removed, and the site is available for redevelopment. This approach is essential for identifying potentially more profitable uses that the current improvements may be suppressing.

   2.2. Physical Possibility: Site-Specific Constraints

   The physical characteristics of the land impose fundamental constraints on potential uses. These factors include:

   • Site Size (Area): Affects the scale and type of development possible. Larger sites may accommodate larger structures or different development types.

   • Shape: Irregular shapes can increase development costs and reduce utility. A rectangular shape is generally considered optimal. shape efficiency❓ can be quantified using a Shape Index (SI):

     SI = Perimeter / (2 * √(Area * π)) ; A lower SI indicates a more efficient (closer to circular) shape.
     * Topography: Steep slopes can increase grading and foundation costs, limiting development options.
     * Soil Composition: Soil bearing capacity dictates the type of foundation required and the load-bearing capacity of structures. Soil testing (e.g., Proctor compaction test) determines soil density❓ and suitability.
     * Environmental Conditions: Wetlands, floodplains, or contaminated sites impose significant restrictions and costs.
     * Availability of Utilities: Access to water, sewer, electricity, and gas is critical for most developments. The cost of extending utilities can significantly impact feasibility.

   2.3. Legal Permissibility: Zoning and Regulatory Framework

   Zoning ordinances dictate the permitted uses, density, height restrictions, and setback requirements for a specific property. Legal restrictions can significantly narrow the range of possible uses. An analysis of zoning regulations should also consider the probability of obtaining variances or rezoning. The likelihood of rezoning can be estimated by analyzing past zoning decisions in the area and assessing political and community support.

   2.4. Financial Feasibility: Economic Viability Assessment

   Uses that are physically possible and legally permissible must also be financially feasible to be considered in the HBU analysis. Financial feasibility is typically assessed using discounted cash flow (DCF) analysis or residual land value analysis.

   2.4.1. Residual Land Value Analysis

   This method determines the value of the land by subtracting the cost of development (including construction costs, soft costs, and entrepreneurial profit) from the projected value of the completed project (Value after Completion).

   Land Value = Value after Completion - Total Development Costs

   • Value after Completion can be estimated using sales comparison, income capitalization, or cost approaches.

   • Total Development Costs include:

     • Hard Costs (construction materials and labor).
     • Soft Costs (architectural and engineering fees, permits, financing costs).
     • Entrepreneurial Incentive (developer’s profit margin).

   2.4.2. Discounted Cash Flow (DCF) Analysis

   This method projects the future cash flows of each potential use and discounts them back to the present value to determine the net present value (NPV).

   NPV = Σ [CFt / (1+r)^t] - Initial Investment

   Where:

   • CFt = Cash flow in period t.
   • r = Discount rate (reflecting the risk of the investment).
   • t = Time period.

   The use with the highest positive NPV is generally considered the most financially feasible.

   2.5. Maximally Productive Use: Optimizing Land Value

   The maximally productive use is the use that generates the highest residual land value or NPV, considering the risks and costs associated with each alternative. This requires comparing the financial feasibility of all viable options and selecting the use that maximizes the land’s economic potential.

   2.6. Example: Vacant Land Analysis

   Consider a 1-acre vacant parcel in a growing suburban area. Zoning allows for single-family residential, multi-family residential (up to 12 units/acre), and limited commercial development.

   • Physical Possibility: All three uses are physically possible given the site size and topography.
   • Legal Permissibility: All three uses are legally permissible under current zoning.

   • Financial Feasibility:

     • Single-Family Residential: Residual land value = $200,000.
     • Multi-Family Residential: Residual land value = $300,000.
     • Limited Commercial: Residual land value = $400,000.
       • Maximally Productive: Limited commercial development is the HBU as it generates the highest residual land value.

2. Analyzing the Property “As Improved”: Considering Existing Structures

   3.1. The Contributory Value of Improvements

   The “as improved” analysis considers the value contributed by the existing improvements. The key question is whether the improvements enhance or detract from the property’s overall value.

   3.2. Options for the “As Improved” Analysis

   • Continue the Current Use: Determine if the current use is still the HBU.
   • Renovate/Modify the Existing Improvements: Explore options for improving the current use or adapting the property to a different use.
   • Interim Use: Consider temporary uses that generate income while planning for future redevelopment.
   • Demolish and Redevelop: Determine if demolition and redevelopment would result in a higher value.

   3.3. Demolition Decision: A Cost-Benefit Analysis

   The decision to demolish existing improvements hinges on a cost-benefit analysis. If the value of the land as though vacant, less demolition costs, exceeds the value of the property as improved, demolition is economically justified.

   Demolition Decision: Vacant Land Value - Demolition Costs > As Improved Value

   Demolition costs include:

   • Demolition permit fees.
   • Asbestos abatement (if applicable).
   • Building demolition.
   • Site clearing and grading.

   3.4. Renovation and Modification: Evaluating Value Enhancement

   Renovation or modification is financially feasible if the increased value of the property exceeds the cost of the improvements (including entrepreneurial profit).

   Renovation Decision: Value After Renovation - Renovation Costs > As Improved Value

   3.5. Interim Use: Bridging the Gap

   An interim use is a temporary use that generates income while waiting for the optimal time for redevelopment. Interim uses can help defray holding costs and demolition expenses. An interim use must be legal, physically possible, financially feasible, and prudent given current market conditions, but not necessarily the highest use if the site is ripe for a different use in the near future.

   3.6. Example: “As Improved” Analysis

   Consider a property with an existing single-story retail building in a rapidly developing area.

   • Continuing Current Use: The current retail use generates a net operating income (NOI) of $50,000 per year. The value of the property as improved is estimated at $625,000 (using income capitalization).
   • Demolish and Redevelop: The value of the land as though vacant is estimated at $800,000. Demolition costs are estimated at $50,000.
     • Vacant Land Value - Demolition Costs = $800,000 - $50,000 = $750,000
   • Renovate and Lease to a National Retailer: Renovation costs are estimated at $100,000. The renovated property is projected to generate an NOI of $75,000, resulting in an estimated value of $937,500.
     • Value After Renovation - Renovation Costs = $937,500 - $100,000 = $837,500.

   In this scenario, renovating and leasing to a national retailer is the HBU, as the value of the renovated property, less renovation costs, exceeds the value of the property as currently improved or as though vacant less demolition costs.

3. The Principle of Consistent Use

   The principle of consistent use dictates that land and improvements must be valued based on the same use. It is incorrect to value the land based on a commercial use while simultaneously valuing the improvements based on a residential use, if the commercial development would necessitate the demolition of the residential improvements. This principle ensures that the valuation reflects the property’s most probable and profitable use as a unified entity.

4. Conclusion: Integrating Vacant and Improved Analyses

   The HBU analysis requires a comprehensive evaluation of the property both as though vacant and as improved. By systematically considering the physical, legal, financial, and maximally productive factors, appraisers and investors can make informed decisions that maximize the property’s value. The optimal use is not always immediately obvious and requires a rigorous and data-driven approach. The final step involves integrating these analyses to determine the use that generates the greatest value, considering all relevant factors and constraints.