Real Estate's Optimal Utilization: Vacant Land and Improvements

Chapter: Real Estate’s Optimal Utilization: Vacant Land and Improvements

This chapter delves into the core principles of determining the highest and best use (HBU) of real estate, specifically focusing on the interplay between vacant land and existing improvements. We will explore the scientific underpinnings of this analysis, covering legal, physical, economic, and temporal considerations.

1. Highest and Best Use: Foundational Principles

The concept of HBU is central to real estate valuation and decision-making. It is defined as the reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible, and results in the highest value. This concept operates under the assumption of prudent and knowledgeable use.

• Definition Revisited: HBU is not simply what the owner wants to do, but rather what a typical market participant would❓❓ do to maximize value.

• Four Tests:

  • Legally Permissible: The proposed use must comply with all applicable laws, regulations, and private restrictions (e.g., zoning ordinances, environmental regulations, easements).

  • Physically Possible: The site’s physical characteristics (e.g., size, shape, topography, soil composition, availability of utilities) must be able to accommodate the proposed use.

  • Financially Feasible: The proposed use must generate sufficient income❓❓ or other benefits to justify the costs of development and operation, including a reasonable return on investment.

  • Maximally Productive: Among all financially feasible uses, the HBU is the one that generates the highest present value to the land/property owner.

2. Analyzing Vacant Land: The “Blank Canvas”

Vacant land offers a unique opportunity for development, but its potential is constrained by the four tests of HBU.

2.1. Physical Possibilities: Site Analysis

A thorough site analysis is crucial for determining what uses are physically possible.

• Site Size and Shape: An irregularly shaped parcel might require more complex and expensive site preparation compared to a rectangular parcel of the same area.

• Topography and Soil Conditions: Steep slopes or unstable soil can significantly increase development costs and limit the range of possible uses. Geotechnical studies are essential.

• Utilities and Infrastructure: Availability and cost of connecting to utilities (water, sewer, electricity, gas) are critical.

• Environmental Considerations: potential environmental contamination❓❓ (e.g., brownfields) can pose significant challenges and costs. Environmental Site Assessments (ESAs) are necessary.

  Example: A 5-acre parcel with a 30% slope may be physically unsuitable for a dense residential development but potentially suitable for a low-density residential development or recreational use.

2.2. Legal Permissibility: Zoning and Regulations

Zoning ordinances dictate the permitted uses for a specific site.

• Zoning Codes: Specify allowed land uses (residential, commercial, industrial, etc.), building height and setback requirements, parking requirements, and other development standards.

• Building Codes: Regulate the construction and safety of buildings.

• Environmental Regulations: Protect natural resources and limit activities that could harm the environment.

• Private Restrictions: Covenants, conditions, and restrictions (CC&Rs) imposed by developers or homeowner associations can further restrict land use.

  Example: A parcel zoned for “light industrial” use cannot be used for residential development without a zoning change (rezoning).

2.3. Financial Feasibility: Market Analysis and Land Residual Technique

To determine financial feasibility, we analyze the potential income and expenses associated with each physically possible and legally permissible use.

• Market Analysis: Examines the supply and demand for different types of real estate in the subject market area. Identifies potential tenants or buyers, rental rates or sales prices, and vacancy rates.

• Land Residual Technique: This method isolates the value of the land by subtracting the development costs (including profit) from the anticipated market value of the completed project.

  Equation:

  Land Value = Market Value (Completed Project) - Development Costs - Developer's Profit

  LV = MV - DC - DP

  Where:

  • LV = Land Value
  • MV = Market Value of the completed project
  • DC = Development Costs (construction, financing, permits, etc.)
  • DP = Developer’s Profit

• A positive land residual indicates that the proposed use is financially feasible. A negative land residual indicates that the proposed use is not economically viable.

2.4. Maximally Productive Use: Comparative Analysis

Once the financially feasible uses are identified, we compare their respective land values to determine which use generates the highest value. This is the HBU of the vacant land.

• Discounted Cash Flow (DCF) Analysis: A more sophisticated method that considers the timing of income and expenses over the project’s life cycle. The present value of the expected cash flows is used to determine the land value.

  Equation:

  Present Value (PV) = Σ [CFt / (1 + r)^t]

  Where:

  • CFt = Cash flow in period t
  • r = Discount rate (reflecting risk and opportunity cost)
  • t = Time period

• The use with the highest present value is considered the maximally productive use and the HBU.

3. Analyzing Improved Property: Considering Existing Structures

When analyzing improved property, we must consider the value contributed by the existing structures.

3.1. Alternative Uses of Improved Property

Several scenarios are possible:

1. Continue the Current Use: The existing use may be the HBU if it is legally permissible, physically possible, financially feasible, and maximizes the property’s value.

2. Renovate or Alter the Existing Improvements: Modifying the existing structures to enhance the current use or adapt to a more profitable use.

3. Interim Use: Continuing the current use temporarily while awaiting future development opportunities.

4. Demolish and Redevelop: Removing the existing improvements and constructing a new development.

3.2. Demolition Analysis: Does the Building Contribute Value?

The critical question is whether the existing improvements contribute value or detract from the property’s overall worth.

• Decision Rule: If the value of the property as improved is greater than the value of the land as if vacant minus the demolition costs, then the existing improvements contribute value and should not be demolished at that time.

  Equation:

  Value (Improved) > Value (Vacant Land) - Demolition Costs

  If this equation holds true, retaining or modifying the improvement is the best option.

3.3. Modification Analysis: Renovation, Conversion, and Alteration

If demolition is not the HBU, we analyze the potential for modifying the existing improvements.

• Feasibility Criterion: The value after modification (renovation, conversion, or alteration) less the costs of the modification (including entrepreneurial incentive) must be greater than or equal to the value of the property as is.

  Equation:

  Value (After Modification) - Costs (Modification) >= Value (As Is)

• Example: Converting an outdated office building into apartments may increase its value, but the conversion costs must be carefully considered.

3.4. Interim Use: A Temporary Solution

An interim use is a short-term use of the property while awaiting a more profitable future development.

• Motivation: To generate income and offset holding costs until the HBU can be realized.

• Example: Using a vacant lot for surface parking until market conditions support a larger development.

4. Consistent Use Principle

This principle states that land cannot be valued based on one use while improvements are valued based on another use. It implies that land must be valued with a use consistent with that of the improvements.

Example: If the HBU of a site is commercial development, but it currently has a residential building, the land must be valued as a commercial site, and any value of the residential building would be treated as an interim use until the site is redeveloped. The value of the building would be an added premium to the bare commercial land value, but not calculated into it.

5. Practical Applications and Examples

• Case Study 1: Vacant Downtown Parcel: A vacant parcel in a downtown area is zoned for commercial use. Market analysis indicates strong demand for office space but also potential for residential development. The land residual technique is used to compare the land values for each use. The office development generates a higher land value, indicating that it is the HBU.

• Case Study 2: Underutilized Retail Building: A retail building in a declining commercial area is operating at low occupancy. A market analysis reveals potential demand for a mixed-use development with retail on the ground floor and apartments above. A feasibility study is conducted to assess the costs and benefits of converting the building. If the value after conversion exceeds the value “as is” plus the cost of conversion, it may be the HBU.

6. Experiments and Data Collection

Determining the HBU is inherently based on market data and analysis, which may be augmented by the following experiments and activities:

• Surveys of Market Participants: Understanding the requirements of market participants can help reveal the HBU. Developers, businesses, and consumers are appropriate targets.
• Review of Zoning Changes: Reviewing zoning changes over time can help illuminate how HBU changes.
• Review of Development Patterns: This can help determine when the HBU changes, and what circumstances can lead to these changes.
• Sensitivity Analysis: A sensitivity analysis of costs, revenues, and discount rates can help determine the robustness of the HBU conclusion. This involves varying these key parameters to assess their impact on the financial feasibility of different uses.

Conclusion

Determining the HBU of vacant land and improved properties is a complex process that requires careful consideration of legal, physical, economic, and temporal factors. By applying the principles and techniques discussed in this chapter, real estate professionals can make informed decisions that maximize the value of real estate assets.