Site Valuation: Highest & Best Use Analysis

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Chapter 6: Site Valuation: Highest & Best Use Analysis

I. Introduction

The estimation of land or site value is a fundamental component of the appraisal process. Whether appraising vacant land, or an improved property where a separate site valuation is required for techniques like the cost approach or by legal mandate (e.g., property tax assessment, condemnation), a robust understanding of site valuation is critical. This chapter delves into the methodologies for accurately determining site value, with particular emphasis on the overarching concept of Highest and Best Use (HBU).

II. Highest and Best Use Analysis: A Scientific Foundation

A. Definition of Highest and Best Use (HBU)

The Highest and Best Use (HBU) is the cornerstone of real property valuation. It’s more than just a general opinion; it’s a scientifically derived conclusion based on rigorous analysis and market data. It is defined as the reasonably probable❓ and legal use of a property that results in the highest present value, as of the date of the appraisal. This definition contains multiple layers of analysis:

*   **Reasonably Probable:** The use must be realistically achievable given current market conditions and constraints.
*   **Legally Permissible:** The use must comply with all applicable zoning ordinances, building codes, environmental regulations, and private restrictions (e.g., deed restrictions).
*   **Physically Possible:** The site must be suitable for the proposed use in terms of size, shape, topography, soil bearing capacity, and access to utilities.
*   **Economically Feasible:** The use must generate sufficient revenue to cover all operating expenses, capital costs (including construction), and provide a reasonable return on investment (ROI).
*   **Maximally Productive:** Among all feasible uses, the HBU is the one that yields the greatest net return or benefit.

B. Purpose of HBU Analysis in Appraisal

1.  **Value Maximization:** HBU *dictates* the market value of the property.  Potential buyers will pay a price reflecting the economic benefits of the most profitable and permissible use.
2.  **Guidance for Valuation Techniques:** HBU informs the selection of appropriate valuation methods.  For example, if the HBU is for income-producing purposes, the income capitalization approach becomes paramount.
3.  **Comparable Selection:** HBU provides the criteria for identifying comparable properties.  Comps should have a similar HBU to the subject property.

C. The Four Tests of Highest and Best Use: A Scientific Elimination Process

The determination of HBU is a systematic process of elimination based on four sequential tests:

1.  **Legally Permissible:**

    *   **Zoning Regulations:** *Zoning codes* define permitted uses, density restrictions, height limitations, setback requirements, parking ratios, and other development standards.
    *   **Environmental Regulations:** Environmental Impact Assessments (EIAs) may be required to assess the potential impacts of development on air quality, water resources, endangered species, and other environmental factors.
    *   **Deed Restrictions:**  *Restrictive covenants* in deeds can limit the use of the property (e.g., minimum house size, architectural style, prohibitions on commercial activity).

2.  **Physically Possible:**

    *   **Site Size and Shape:**  Sufficient area and dimensions to accommodate the proposed improvements.
    *   **Topography and Drainage:**  Suitable slope and drainage to prevent flooding or erosion.
    *   **Soil Conditions:**  Adequate *bearing capacity* to support the structural loads of the building. Soil tests (e.g., *Proctor compaction test*, *Atterberg limits*) may be required to determine soil properties. *Equation*: $Bearing Capacity (q_a) = \frac{q_u}{SF}$, where  $q_u$ = unconfined compressive strength and *SF* = Safety Factor (typically 3).
    *   **Access to Utilities:**  Availability of water, sewer, electricity, natural gas, and telecommunications services.

3.  **Economically Feasible:**

    *   **Market Demand:** Sufficient demand for the proposed use in the relevant market area. Market studies analyzing supply and demand dynamics are crucial.
    *   **Operating Expenses:** Costs of operation, property taxes, insurance, maintenance, and management.
    *   **Capital Costs:** Land acquisition costs, construction costs, financing costs, and development fees.  *Equation*:  $Net Operating Income (NOI) = Gross Revenue - Operating Expenses$.  The NOI must be sufficient to cover capital costs and provide a reasonable ROI.
    *   **Discounted Cash Flow (DCF) Analysis:**  Projections of future revenue and expenses are discounted back to present value to assess economic viability. *Equation*: $Present Value (PV) = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t}$, where $CF_t$ = cash flow in year t,  r = discount rate, and n = number of years.

4.  **Maximally Productive:**

    *   The remaining feasible uses are compared to determine which yields the highest net present value (NPV).
    *   This often involves financial modeling of different development scenarios, considering factors such as rental rates, occupancy rates, and operating expenses.
    *   The use with the highest NPV is deemed the HBU.

D. The Principle of Anticipation

This principle states that value is based on the expectation of future benefits. In HBU analysis, this means considering potential changes in zoning, market conditions, or physical characteristics that could impact the future use of the property. This involves:

*   **Market Trend Analysis:**  Identifying emerging trends in demographics, employment, and consumer preferences.
*   **Political Risk Assessment:**  Evaluating the likelihood of changes in zoning regulations, tax policies, or government infrastructure projects.

E. Interim Use

An Interim Use is the temporary use of a property until its ultimate HBU becomes viable. This often involves generating some income while the property appreciates in value or market conditions improve. Examples include parking lots on land slated for future development or agricultural use on land intended for residential development.

III. HBU for Vacant vs. Improved Land

A. HBU as Vacant

Determining the HBU “as if vacant” involves disregarding any existing improvements on the property and analyzing the site as if it were raw land. This analysis focuses on:

*   **Optimal Improvement Type:**  Identifying the type of building or development that would maximize the land's value (e.g., retail, office, residential).
*   **Density and Scale:**  Determining the appropriate size and density of the improvements, consistent with zoning regulations and market demand.

B. HBU as Improved

This analysis considers the existing improvements and evaluates whether they contribute to or detract from the property’s overall value. Factors to consider include:

*   **Functional Obsolescence:**  Whether the existing improvements are outdated or inefficient compared to modern standards.
*   **Economic Obsolescence:**  Whether the improvements are no longer suitable for the current market or neighborhood.
*   **Superadequacy:**  Whether the improvements are larger or more luxurious than what is typical for the market.

C. Legal Nonconforming Uses (Grandfathered Uses)

If zoning regulations change, a pre-existing use may become nonconforming. A “legal nonconforming use” is a use that was legally established before the zoning change and is allowed to continue, subject to certain restrictions (e.g., limitations on expansion or reconstruction).

D. True Highest and Best Use

The “true” HBU is determined by comparing the value of the property “as if vacant” (with the optimal new development) versus the value of the property “as improved” (with the existing improvements). This requires:

*   **Estimating the Cost of Demolition:**  If the HBU as vacant is more valuable, the cost of demolishing the existing improvements must be factored into the analysis.
*   **Considering Renovation Costs:** If the HBU is to retain and renovate the existing improvements, the cost of renovation must be compared to the potential increase in value.

E. The Principle of Consistent Use

This principle dictates that when valuing land and improvements separately, they must be valued for the same use - the True Highest and Best Use.

F. Excess and Surplus Land

*   **Excess Land:** Land that has the potential to be sold off and developed separately. This land would affect value.
*   **Surplus Land:** Land that does not have the potential to be sold off and developed separately, this land would not affect value.

G. Plottage

Plottage is the increase in value when two or more adjacent sites are combined to form a single larger site. This occurs when the larger site can support a more profitable development than the individual sites could. This increase in value can be quantified.

H. HBU in Residential Appraisal

In residential appraisals, it is frequently assumed that the existing use of the property is its HBU. However, the appraiser must confirm this by:

*   Verifying that the market data supports demand for similar types of buildings
*   Comparing value of the improved property to value if redeveloped at highest & best.

IV. Methods of Site Valuation

A. sales comparison approach❓❓ (Most Reliable Method)

The sales comparison approach involves analyzing recent sales of comparable vacant land parcels to determine the value of the subject site. This involves:

1.  **Data Sources:**

    *   Multiple Listing Services (MLS)
    *   Real estate brokers
    *   County records
    *   Online databases (e.g. FNC, CoreLogic)

2.  **Elements of Comparison:** The sale price of comparable is adjusted as necessary to account for the difference between comparable sales and the subject.
    *       Real Property Rights Conveyed
    *       Financing Terms
    *       Conditions of Sale
    *       Expenditures Immediately After Sale
    *       Market Conditions
    *       Location
    *       Physical Characteristics
    *       Economic Characteristics

B. Allocation Method

This method assumes a typical ratio between the value of land and the value of improvements in a given market.

Equation: Land Value = Total Property Value * (Land Ratio / (Land Ratio + Improvement Ratio))

C. Extraction Method

Land Value is found by subtracting depreciated improvement from the total value of the property.

Equation: Land Value = Total Sales Price - Improvement Value

D. Development Method (Subdivision Analysis)

The development method, or subdivision analysis, is used for valuing land suitable for subdivision. It involves estimating the total revenue from selling finished lots, subtracting development costs (including construction, marketing, and financing), and discounting the net income back to present value.

E. Land Residual Method

This method is used when the land generates income, and land has the potential to generate more income. It involves calculating the residual income attributable to the land after deducting the return required by the improvements. The land value is then determined by capitalizing the residual income. This is generally for commercial sites.

Equation: Land Value = (Total Net Operating Income (NOI) - (Improvement Value * Improvement Capitalization Rate)) / Land Capitalization Rate

F. Ground Rent Capitalization

This method is used when the land is leased under a ground lease (long-term lease where the tenant owns the improvements).

Equation: Land Value = Ground Rent / Capitalization Rate

G. Depth Tables

Depth tables estimate land value as the difference between different portions of a property’s land that is based on its proximity to the street. They are mainly of historical interest and are no longer reliable, due to their failure to accurately assess the value of large commercial sites that are located away from the street.

V. Conclusion

Accurate site valuation requires a deep understanding of HBU principles and the appropriate application of various valuation methods. The sales comparison approach is generally the most reliable technique, but the other methods can be useful in certain circumstances or as a check on the sales comparison results. The appraiser must carefully consider all relevant factors, including legal restrictions, physical characteristics, economic feasibility, and market trends, to arrive at a credible and supportable opinion of site value.

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