Optimal Use: Land & Improvements

Chapter: Optimal Use: Land & Improvements

This chapter delves into the scientific principles behind determining the optimal use of land and existing improvements❓ in real estate valuation. This “highest and best use” (HBU) analysis is fundamental for maximizing real estate value. We will explore the theoretical underpinnings, practical applications, and relevant methodologies for this critical aspect of real estate appraisal.

1. Introduction to Optimal Use

The concept of optimal use, or highest and best use (HBU), refers to the most probable use of a property that is:

• Legally permissible
• Physically possible
• Financially feasible
• Maximally productive (results in the highest value)

This analysis is performed from two primary perspectives:

• Land as Though Vacant: Determining the optimal use assuming the land is vacant and available for development.
• Property as Improved: Evaluating the optimal use considering the existing improvements, including whether to retain, renovate, or demolish them.

2. Optimal Use: Land as Though Vacant

This analysis treats the land as a blank slate, focusing on identifying the most profitable use if the property were vacant.

2.1 Physical Possibility

This step involves assessing the physical characteristics of the land that impact its potential use.

• Site Characteristics:

  • Size and Shape: Larger and regularly shaped parcels generally offer more flexibility in development. Irregular shapes can increase development costs and limit usability.
  • Topography: Slope and elevation changes influence construction costs and drainage requirements.
  • Soil Composition: Soil type and bearing capacity affect foundation requirements and construction techniques. Geotechnical investigations (soil testing) are crucial.
  • Environmental Conditions: Presence of wetlands, floodplains, or contaminated sites can severely restrict development possibilities. Environmental site assessments (Phase I, Phase II ESAs) are necessary.
  • Utilities: Availability and capacity of water, sewer, electricity, gas, and telecommunications infrastructure.

• Access:

  • Road Frontage: Sufficient frontage is crucial for access and visibility, especially for commercial properties.
  • Traffic Volume and Patterns: High traffic volume can be beneficial for retail but detrimental if it impedes access. Traffic studies and analysis are often required.
  • Accessibility for Various Transportation Modes: Consideration of access for pedestrians, bicycles, public transportation, and freight vehicles.

Example: A steep, rocky site might be physically unsuitable for a large-scale residential development but could be suitable for a cell tower or a recreational park.

2.2 Legal Permissibility

This step examines the legal constraints on land use.

• Zoning Regulations: Zoning ordinances dictate permitted uses, density, building height, setbacks, parking requirements, and other development standards. Compliance with zoning is paramount.
• Land Use Restrictions: Deed restrictions, covenants, easements, and other private agreements can limit land use. Title searches and legal review are essential.
• Environmental Regulations: Federal, state, and local environmental regulations can restrict development near wetlands, endangered species habitats, or contaminated sites.
• Building Codes: Building codes establish minimum standards for construction, safety, and accessibility.

Example: A parcel zoned for single-family residential use cannot be developed into a commercial shopping center without a zoning change (rezoning).

• Probability of Legal Change: Consider if there is a reasonable probability of a zoning change.
  • Factors: economic demand for change, timing and cost considerations.

2.3 Financial Feasibility

This step assesses the economic viability of potential land uses.

• Market Analysis:

  • Demand: Identifying the demand for various types of real estate in the market area. Market studies analyze population growth, employment trends, income levels, and consumer preferences.
  • Supply: Assessing the existing supply of real estate and the potential for future development. Competitive analysis identifies competing properties and their characteristics.
  • Marketability Analysis: Determining the ability to successfully market and lease or sell the proposed development.

• Cost Estimation:

  • Construction Costs: Estimating the costs of labor, materials, and equipment required to construct the improvements.
  • Development Costs: Including costs for land acquisition, site preparation, architectural and engineering fees, permitting, financing, marketing, and legal expenses.

• Revenue Projections:

  • Rental Income: Projecting rental rates, occupancy levels, and operating expenses for income-producing properties.
  • Sales Revenue: Estimating sales prices and sales volume for for-sale properties.

• Financial Modeling: Using financial models (e.g., discounted cash flow analysis) to evaluate the profitability of each potential land use.

  • Net Present Value (NPV):

    • $NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t}$
      • Where:
        • $CF_t$ = Cash flow in period t
        • r = Discount rate
        • n = Number of periods

  • Internal Rate of Return (IRR): The discount rate at which NPV = 0.

  • Land Residual Technique: This technique isolates the land value by subtracting the cost of improvements and entrepreneurial incentive from the total property value:

    • Land Value = Property Value - (Cost of Improvements + Entrepreneurial Incentive)

Example: A proposed office building might be physically possible and legally permissible, but if market rents are too low and construction costs are too high, the project may not be financially feasible.

2.4 Maximally Productive Use

This step identifies the land use that generates the highest residual land value or the highest return on investment.

• Comparative Analysis: Comparing the financial performance of each financially feasible land use.
• Residual Land Value Analysis: Determining the land value that remains after deducting all development costs and a reasonable profit margin from the anticipated property value. The use with the highest residual land value is considered the most productive.
• Sensitivity Analysis: Testing the sensitivity of the financial results to changes in key assumptions, such as rental rates, occupancy levels, and construction costs.
• Market Data Comparison: Utilizing comparable land sales data to see which use is supported by the market.

Example: A site might be suitable for either an apartment building or a retail center. However, if the retail center is projected to generate a significantly higher residual land value, it would be considered the maximally productive use.

3. Optimal Use: Property as Improved

This analysis considers the existing improvements and evaluates the optimal course of action:

• Retain the existing improvements and continue the current use.
• Convert, renovate, or alter the existing improvements.
• Retain the existing improvements as an interim use.
• Demolish the existing improvements and redevelop the site.

3.1 Analyzing Existing Improvements

• Physical Condition: Assessing the physical condition of the improvements, including structural integrity, deferred maintenance, and functional obsolescence.
• Functional Utility: Evaluating the design and layout of the improvements in relation to current market standards and user needs.
• Economic Performance: Analyzing the revenue, expenses, and profitability of the existing use.

3.2 Decision: Retain, Modify, or Demolish

• Demolition Analysis:

  • Compare the value of the property as improved to the value of the land as though vacant less demolition costs.
  • If (Value as Improved) > (Value as Vacant - Demolition Costs), then the improvements contribute value and should not be demolished at that time.

• Modification Analysis (Conversion, Renovation, Alteration):

  • For modification to be financially feasible, the change must add at least as much value as it costs.
  • Value After Modification - Cost of Modification >= Value “As Is”.
  • This includes entrepreneurial incentive.

Example: A historic building in a prime location might be underutilized as a low-rent office building. A renovation and conversion to luxury apartments could significantly increase its value and generate higher returns.

• The Principle of Consistent Use: Land cannot be valued based on one use while improvements are valued based on another use.
  • Example: Do not combine land value with commercial zoning with the value of a residence on the site.

4. Consistent Use Principle

The principle of consistent use states that land cannot be valued based on one use while the improvements are valued based on another, incompatible use. This ensures that the valuation reflects a realistic and consistent scenario.

Example: A single-family home on a commercially zoned lot cannot be valued by adding the value of the house as a residence to the land value based on its commercial zoning. The house is an impediment to commercial development and would likely be demolished.

5. Application of Highest and Best Use Analysis

The following steps summarize the HBU analysis process:

1. Market Analysis: Understand the market dynamics, demand drivers, and competitive landscape.
2. Property Productivity Analysis: Assess the physical, legal, and economic characteristics of the property.
3. Identify Potential Uses: Brainstorm a range of potential uses for the land as though vacant and the property as improved.
4. Test Physical Possibility: Eliminate uses that are not physically feasible given the site’s characteristics.
5. Test Legal Permissibility: Eliminate uses that are not legally permissible under current regulations.
6. Test Financial Feasibility: Analyze the economic viability of the remaining uses.
7. Determine Maximally Productive Use: Identify the use that generates the highest residual land value or return on investment.
8. Conclude Highest and Best Use: Document the analysis and justify the conclusion, considering both the land as though vacant and the property as improved.

6. Conclusion

Optimal use analysis is a critical component of real estate valuation. By systematically evaluating the physical, legal, financial, and market factors, appraisers can determine the most profitable and supportable use of a property, maximizing its value for owners, investors, and lenders. This chapter provides a scientific framework for conducting this analysis, incorporating relevant theories, methodologies, and practical examples.