Site Valuation: Highest & Best Use and Appraisal Methods

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Chapter 6: Site Valuation: Highest & Best Use and Appraisal Methods

I. Introduction: The Foundation of Value - Land

Land, in its raw or improved state, is the bedrock upon which all real estate value is built. Understanding the principles and methods of site valuation is not merely a technical exercise, but a fundamental requirement for accurate❓ and defensible appraisal conclusions. This chapter explores the critical concept of Highest and Best Use and examines the various approaches employed to determine the value of land, independent of any improvements.

II. Highest and Best Use: The Guiding Principle

A. Definition and Importance:

*   The *Highest and Best Use (HBU)* 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 that results in the highest value (or yields the highest net return) as of the appraisal date.
*   HBU isn't simply what the owner *wants* to do; it's what the market *dictates* will generate the most value.
*   HBU analysis is paramount because:

    1.  It establishes the *basis* for valuing both land and improvements.
    2.  It dictates which *comparable properties* are most relevant for valuation.
    3.  It determines the *appropriate valuation methods* to employ.

B. The Four Tests of Highest and Best Use (HBU): A Hierarchical Approach

The HBU analysis is a stepwise process that considers four distinct tests:

1.  **Legally Permissible:**

    *   This test considers all legal restrictions (zoning ordinances, building codes, environmental regulations, historic preservation laws, deed restrictions) that may affect the property's potential use.
    *   A use that violates legal restrictions cannot be the HBU.
    *   **Example:** A large parcel of land may be most profitable for high-density residential use, but if the area is zoned for single-family residences, that use is legally impermissible and cannot be the HBU.
    *   Legal permissibility is not static and may change, which may alter the outcome.

2.  **Physically Possible:**

    *   This test considers the physical characteristics of the site: size, shape, topography, soil composition, drainage, availability of utilities, access, and environmental conditions.
    *   A use that is physically impossible due to site limitations cannot be the HBU.
    *   **Example:** A steep slope, poor soil bearing capacity, or lack of access may prevent the construction of a multi-story building, even if legally permitted.
    *   Modern engineering solutions may alter what is physically possible.

3.  **Financially Feasible:**

    *   This test considers whether a potential use will generate sufficient income or return to justify the costs of development and operation.
    *   The use must produce a *positive return* on investment.
    *   Factors to analyze: construction costs, operating expenses, market demand, rental rates (if applicable), and potential revenues.
    *   **Example:** Constructing an expensive luxury hotel in an area with limited tourism and low average incomes would likely be financially infeasible, even if legally permissible and physically possible.

4.  **Maximally Productive:**

    *   Among all the uses that pass the first three tests, this test identifies the use that will generate the *highest net return* or the greatest overall value for the property.
    *   This test is critical for selecting the *optimal* use.
    *   **Example:** Two uses may be financially feasible: a retail store or an office building. The use that generates the higher net operating income (NOI) and thus the highest land value is the maximally productive use and the HBU.

C. Mathematical Representation:

Let:

*   *V<sub>L</sub>* = Land Value
*   *I* = Net Operating Income
*   *R* = Capitalization Rate

The maximized *V<sub>L</sub>* equation helps define the HBU.

D. Highest and Best Use “As Vacant” vs. “As Improved”:

1.  **As Vacant:**

    *   Assumes the site is *vacant and available* for any legal, physically possible, and financially feasible use.
    *   This test is critical for identifying potential *redevelopment opportunities*.

2.  **As Improved:**

    *   Considers the *existing improvements* on the property and their contribution to value.
    *   Factors to analyze: physical condition, functional utility, remaining economic life, and cost of demolition (if redevelopment is considered).

    *   If improvements exist, calculate:

        V<sub>I</sub> = Value of Improvement

    *   **Equation for determining whether to continue using improvements:**
    *   If V<sub>I</sub> > CD (Cost of Demolition); CD = 0 for vacant land
        Where CD equals the cost to demolish the site improvements and rebuild the site as if it were vacant.

    *   If V<sub>I</sub> > CD, then leave the site improvements.

E. Interim Use

Interim use refers to a temporary, short-term use of a property that is different from its ultimate HBU. This often occurs when market conditions aren't yet ripe for the most profitable use.

III. Special Considerations in Highest and Best Use Analysis

A. Consistent Use

*   *Principle of Consistent Use:* Land cannot be valued under one use, while the improvements are valued under another. When a property is valued under one set of improvements, it can’t be valued under another set of improvements.
*   For instance, commercial developments with homes in a high density zone should be valued as if both improvements have the same objective.

B. Excess Land vs. Surplus Land

*   *Excess Land:* Land that is severable from the primary site and has its own HBU. Excess land may be sold off.
*   *Surplus Land:* Land that cannot be sold off and is often encumbered by the primary site.

C. Plottage

*   Plottage is the additional value created by combining two or more adjoining parcels into a single larger parcel. The increase of value may come as a result of creating more value by using the property with a larger scale improvement.

D. Legal Nonconforming Use

*   A use that was once legal but no longer complies with current zoning regulations.
*   It can affect value, especially if the use is highly profitable, but generally they’re required to come in compliance if modifications are made to the building.

IV. Methods of Site Valuation: Quantitative Approaches

A. Sales Comparison Approach: The Preferred Method

1.  *Principle:*  The value of land is indicated by the recent sales prices of similar, vacant parcels, adjusted for differences. It relies heavily on the principles of substitution and contribution.
2.  *Procedure:*

    *   Identify comparable land sales (location, zoning, size, topography, utilities).
    *   Verify the sales data to ensure accuracy.
    *   Analyze and adjust comparable sale prices for the *elements of comparison* (see below).
    *   Reconcile the adjusted sale prices to arrive at an indicated value for the subject site.

3.  *Elements of Comparison:* These elements affect the value of properties that make each one different.

    *   **Real Property Rights Conveyed:** Differences in the fee simple interest, leasehold interest, easement, or other property rights.
    *   **Financing Terms:** Adjust the price to reflect cash equivalency if the financing was atypical.
    *   **Conditions of Sale:** Arm’s length transactions, undue influence on either party?
    *   **Expenditures Immediately After Sale:** Costs to cure physical or legal defects affect the market value. These include environmental remediation, rezoning, etc.
    *   **Market Conditions (Time Adjustment):** Adjust for price fluctuations due to changes in market supply and demand.
        * **Formula:** Price X (1 + Appreciation Rate)^Years
    *   **Location Adjustments:** Proximity to amenities, exposure to traffic, view quality, neighborhood characteristics.
    *   **Physical Characteristics:** Site size, shape, topography, soil conditions, frontage, and environmental concerns.
    *   **Economic Characteristics:** The impact of other factors, such as the economy on supply and demand.

4.  *Adjustments:*

    *   Adjustments are *always made to the comparables*, *never* to the subject.

    *   Two Categories:

        1.  **Dollar Adjustments:** Used when the difference in characteristic has a specific impact on revenue.
            This method subtracts the cost of revenue generated by that improvement.

        2.  **Percentage Adjustments:** Useful when economic influences, financing and/or legal differences occur.

B. Allocation Method: Applying a Ratio

1.  *Principle:* Assumes a consistent ratio between land value and total property value in a particular market. It's the process of dividing the total value of the property among its assets.
2.  *Procedure:*

    *   Research the typical land-to-total value ratio for similar properties in the area.
    *   Determine the market value of the subject property (including land and improvements).
    *   Apply the ratio to the total value to allocate a portion to the land.
    *   **Formula:**
    *   Land Value = Total Property Value × (Land Value Ratio)
    *   *Limitations:* Relies on subjective ratios; lacks precision.

C. Extraction Method: Subtracting the Improvements

1.  *Principle:* Land value is derived by subtracting the depreciated cost of the improvements from the total sale price of a comparable improved property.
2.  *Procedure:*

    *   Identify comparable *improved* properties that have recently sold.
    *   Estimate the current *replacement cost* of the improvements.
    *   Estimate the *accrued depreciation* (physical deterioration, functional obsolescence, external obsolescence) of the improvements.
    *   Subtract the depreciated cost of the improvements from the total sale price.
    *   **Formula:**
        *   Land Value = Sale Price – (Replacement Cost – Accrued Depreciation)
    *   *Limitations:* Accuracy depends heavily on accurate depreciation estimates, particularly for older properties.

D. Subdivision Development Method (Anticipated Use): Projecting Profits

1.  *Principle:*  Land value is determined by estimating the revenue generated from dividing the site into smaller land parcels and subtracting costs for developing the site.
2.  *Procedure:*

    *   Develop a *detailed subdivision plan* (number of lots, lot sizes, infrastructure, zoning, etc.).
    *   Project the *sale prices* of the individual lots, consider absorption rates.
    *   Estimate all *development costs* (infrastructure, permits, marketing, overhead).
    *   Project the time frame for development and sales.
    *   Discount all future cash flows to their *present value* using an appropriate discount rate.
    *   **Formula:** V<sub>L</sub> = (Sum of Discounted Lot Sales) - Development Costs
    *   *Limitations:* Highly sensitive to market conditions, cost estimates, and the discount rate applied.

E. Land Residual Method: Calculating Income

1.  *Principle:* Calculates land value based on the principle that land can provide income, and that the value is equal to the amount of the annual income divided by the market rate.
2.  *Procedure:*

    *   The appraiser calculates the income that will come from the land, subtracts the cost for development, and divides by the rate.
    *   **Formula:**
    *   V= (I - Value of Improvement (R)) / R

3.  *Limitations:* Not applicable to single family properties.

F. Ground Rent Capitalization Method: Capitalizing Rental Income

1.  *Principle:*  Applicable when the subject land is leased to a tenant under a *ground lease*. A yearly rent that is paid to the owner is analyzed.
2.  *Procedure:*

    *   Determine the *<a data-bs-toggle="modal" data-bs-target="#questionModal-368481" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">annual ground rent</span><span class="flag-trigger">❓</span></a>* paid by the tenant.
    *   Select an appropriate *capitalization rate* based on market data for similar leases.
    *   Divide the annual rent by the capitalization rate to estimate land value.
    *   **Formula:** Land Value = Annual Ground Rent / Capitalization Rate
    *   *Limitations:* Accuracy hinges on stable ground rents and appropriate capitalization rates.

G. Depth Tables:

1.  *Principle:* A percentage table shows the relation of the value of a lot as a relation to its depth. Most of the value is located at the front.
2.  *Example:* The 4-3-2-1 analysis shows the percentages of value depending on the depth of the lot.
    * 1st quarter = 40%
    * 2nd quarter = 30%
    * 3rd quarter = 20%
    * 4th quarter = 10%

V. Conclusion

Site valuation is an essential component of real estate appraisal. An accurate estimate of value requires careful consideration of the four tests of highest and best use and the application of appropriate valuation methods, including the cost approach, the income approach, and the sales comparison approach. All of these are crucial for making a sound appraisal.

Chapter Quiz

1. The legally permissible use of a property would be affected by:
   a. The average income in the surrounding area.
   b. The age of buildings in the area.
   c. Zoning ordinances.
   d. Physical size of the property.

2. For appraisals based upon the current use of the property, which of the following is a false statement:
   a. The value of the improvements, plus the land, should be the same if the land was vacant.
   b. A land value needs to be estimated.
   c. A highest and best use statement is required.
   d. Comparable market data for each appraisal method.

3. Which of the following is used to determine an increase in value from the combination of two or more sites?
   a. The highest and best use.
   b. Plottage.
   c. The land residual method.
   d. A plottage increment.

4. If the land and existing structure are not the same or considered the highest and best use, the value could be:
   a. Determined by the land value.
   b. Determined by the cost of demolition
   c. The cost of the land less the cost of demolition.
   d. The cost of the land plus the cost of demolition.

5. Which approach is preferred for land valuation:
   a. The sales comparison method.
   b. Ground rent capitalization method.
   c. Development method.
   d. Any valuation.

6. Which element of comparison is the best for value indicator:
   a. Physical characteristics.
   b. Legal characteristics.
   c. Economic conditions.
   d. All are equal.

7. In the development method:
   a. All income is deducted from expenses and compared to the capitalization rate.
   b. The costs of development is deducted to the estimated sales of the finished lots.
   c. A percentage of the market value is added in a ratio to determine the percentage.
   d. The rate of development will not influence the profit value.

8. In most land residual methods, market rent income is attributable to:
   a. Property size and location.
   b. The rate of occupancy.
   c. Depreciated costs.
   d. Land.

9. Which of the following is not an accurate assumption about land income and value in ground rent capitalization:
   a. Its best if this method is long term.
   b. The capitalization rate should not affect the land value.
   c. There can be other factors that determine the value.
   d. The property in the end equals income divided by a rate.

10. The 4-3-2-1 method is best described as:
    a. The value is the rate that decreases depending on the location.
    b. The value diminishes to 1%
    c. The value in the back is worth more than the value in the front.
    d. The value diminishes to the back but not accurately.

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