Site Valuation Fundamentals

Chapter 4: Site Valuation Fundamentals

This chapter delves into the critical aspects of site valuation, a fundamental skill for real estate appraisers. As highlighted in the course description, mastering valuation techniques is essential for success in this field. We will explore the theoretical underpinnings of site valuation, focusing on its practical application within the context of the Sales Comparison, Cost, and Income approaches to value. We will address how site valuation is intrinsically tied to appraisal standards and ethics, especially when dealing with property tax assessments and condemnation purposes. This chapter also emphasizes the data analysis skills needed to estimate land value accurately.

4.1. The Importance of Separate Site Valuation

As indicated in the “Mastering Real Estate Appraisal” course description, a thorough grasp of valuation techniques is paramount. Often, a separate site valuation is crucial for employing specific appraisal approaches, such as the Cost Approach and the Building Residual Technique (a variation of the Income Approach).

• Cost Approach: This approach calculates value by summing the site value, the cost of new improvements, and subtracting depreciation. An accurate site valuation is therefore a necessary input for the Cost Approach.
• Building Residual Technique (Income Approach): This technique isolates the land income from the total net operating income (NOI) of an improved property and capitalizes this income to determine land value. An accurate site valuation, therefore, is crucial for determining the total property value❓❓ using this technique.
• Legal Requirements: As the introductory book content mentions, separate site valuations are legally mandated in specific scenarios like property tax assessments and eminent domain (condemnation) appraisals. The appraisal assignment’s scope explicitly requires this separation.
• Highest and Best Use (HBU) Analysis: Determining the highest and best use of a property often necessitates considering the site’s potential uses as if vacant. A separate site valuation aids in this analysis.

4.2. Highest and Best Use: The Cornerstone of Site Valuation

The concept of Highest and Best Use (HBU) is central to all real estate valuation, particularly for sites. The HBU is the most probable and legal use of the land that is physically possible, appropriately supported, financially feasible, and results in the highest value.

• Legal Permissibility: The proposed use must conform to current zoning regulations, building codes, and other relevant legal restrictions. This includes evaluating restrictions relating to easements, rights of way, and any other limitations affecting the land use.
• Physical Possibility: The site must be physically capable of supporting the proposed use. Factors like soil type (bearing capacity, drainage), topography (slope, elevation), and access to utilities (water, sewer, electricity) play crucial roles.
• Financial Feasibility: The proposed use must generate sufficient income or return to justify the investment. This necessitates analyzing the cost of development versus the anticipated income or value generated by the completed project.
• Maximum Productivity: Among all legally permissible, physically possible, and financially feasible uses, the chosen HBU must yield the highest net return or value for the site.

Example:

Consider a vacant parcel zoned for either a single-family home or a duplex. While constructing a luxury single-family residence might be physically possible and legally permissible, the market demand and return may be significantly lower than building a well-designed duplex that maximizes rental income. In this scenario, the duplex represents the highest and best use.

Experiment:

To demonstrate the HBU, conduct a market study on two hypothetical sites. For each site, explore at least three potential uses. Analyze the legal constraints, physical limitations, and economic feasibility of each use. Quantify potential returns (e.g., NOI for income-producing properties, sales prices for residential developments). Compare the returns from each potential use to determine the HBU for each site.

4.3. Valuation Methods for Sites

Several established methods are used to determine the value of a site. Each method relies on different data inputs and valuation principles.

4.3.1. Sales Comparison Approach (Market Approach)

The Sales Comparison Approach is the most widely accepted and reliable method when sufficient comparable sales data are available. This approach directly relates to what the book content mentions about using comparable properties:

• Principle: The value of the subject site is derived by comparing it to recent sales of similar sites in the same market area.

• Process:

  1. Identify Comparable Sales: Locate recent sales of sites with similar characteristics (size, zoning, location, topography, etc.)
  2. Adjust for Differences: Adjust the sale price❓s of the comparables to account for differences between them and the subject site. Adjustments are made based on various factors like:
     • Property Rights Conveyed: Was the land sold with full fee simple rights, or were there restrictions like easements or leases?
     • Financing Terms: Favorable or unfavorable financing can influence the sale price. Adjust for non-market financing.
     • Conditions of Sale: Were there any unusual circumstances (e.g., forced sale, related parties)?
     • Market Conditions: Adjust for changes in market conditions between the sale date of the comparable and the valuation date of the subject site.
     • Location: Adjust for differences in neighborhood desirability, access, and proximity to amenities.
     • Physical Characteristics: Adjust for differences in size, shape, topography, soil conditions, and other relevant physical attributes.
     • Formula:

  Subject Value = Comparable Sales Price +/- Adjustments

• Mathematical Representation of Adjustments:

  • Adjusted Sales Price (ASP) = Sales Price (SP) + Adjustments
  • Adjustment can be positive (adding value) or negative (subtracting value). A detailed explanation of adjustments are discussed in Sales Comparison Approach in valuation (chapter 9).

4.3.2. Allocation Method

The Allocation Method estimates site value as a percentage of the total improved property value. This method is often applied when sufficient sales data for vacant sites are unavailable.

• Principle: A typical ratio of land value to total property value is established based on market analysis of comparable properties.
• Process:
  1. Determine the total market value of the improved property (using other appraisal approaches).
  2. Research the typical ratio of land value to total value for similar properties in the area. This ratio is often expressed as a percentage.
  3. apply❓ the ratio to the total property value to derive the estimated land value.

• Formula:
  Land Value = Total Property Value x Allocation Ratio

  • Where Allocation Ratio = Land Value / (Land Value + Improvement Value)

• Limitations: This method assumes a uniform relationship between land and improvement values, which may not always hold true. It is less precise than the Sales Comparison Approach.

4.3.3. Extraction Method

The Extraction Method estimates land value by subtracting the depreciated value of the improvements from the total property value.

• Principle: The total property value represents the sum of the land value and the depreciated value of the improvements.

• Process:

  1. Determine the total market value of the improved property (using other appraisal approaches).
  2. Estimate the depreciated cost of the improvements. This involves calculating the replacement cost new (RCN) of the improvements and then subtracting accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
  3. Subtract the depreciated cost of improvements from the total property value to arrive at the estimated land value.
     * Formula:

  Land Value = Total Property Value - Depreciated Cost of Improvements

  Depreciated Cost = RCN - Accrued Depreciation

• Limitations: This method is highly sensitive to the accuracy of depreciation estimates. Accurately quantifying depreciation can be challenging, especially for older or non-conforming properties.

4.3.4. Development Method (Subdivision Development Analysis)

The Development Method is used to value large, undeveloped parcels of land suitable for subdivision.

• Principle: The value of the raw land is derived from the anticipated proceeds of the sale of subdivided lots, less all costs associated with development.

• Process:

  1. Determine the highest and best use for the land (e.g., residential subdivision).
  2. Develop a detailed subdivision plan, including the number of lots, lot sizes, and infrastructure requirements.
  3. Estimate the market value of the finished lots.
  4. Estimate all costs associated with development, including:
     • Construction costs (roads, utilities, infrastructure)
     • Marketing and sales expenses
     • Legal and administrative fees
     • Taxes and insurance
     • Developer’s profit
  5. Discount the projected cash flows to their present value to account for the time value of money.

• Formula: (Simplified Example)

  Land Value = Present Value of (Total Revenue from Lot Sales - Total Development Costs)
  The full land development method requires discounting of sales and cost figures to take into account the time value of money. A future payment or expense can be discounted to its present value by multiplying it times a reversion factor. The reversion factor depends on the selected discount rate, and the length of time until the payment will be made or received.

• Example: If total costs to complete the project are C dollars at time t, the present value can be calculated PV = C / (1+r)t, where r is the discount rate.

• Limitations: This method requires extensive market research, accurate cost estimates, and a realistic discount rate. Small changes in these inputs can significantly affect the estimated land value.

4.3.5. Land Residual Technique

The Land Residual Technique is an income capitalization method that isolates the income attributable to the land and capitalizes this income to determine the land value.

• Principle: The total net operating income (NOI) of an improved property is allocated between the land and the improvements.

• Process:

  1. Determine the total net operating income (NOI) of the improved property.
  2. Estimate the value of the improvements (using the Cost Approach or other methods).
  3. Determine the appropriate capitalization rate for the improvements. This rate reflects the required rate of return on the investment in the improvements.
  4. Calculate the income attributable to the improvements: Income (Improvements) = Value (Improvements) x Capitalization Rate (Improvements).
  5. Subtract the income attributable to the improvements from the total NOI to determine the income attributable to the land: Income (Land) = Total NOI - Income (Improvements).
  6. Determine the appropriate capitalization rate for the land. This rate reflects the required rate of return on the investment in the land.
  7. Capitalize the income attributable to the land to derive the estimated land value: Land Value = Income (Land) / Capitalization Rate (Land).
     * Formula:
     Land Value = (NOI - (Improvement Value x Improvement Cap Rate)) / Land Cap Rate

• Limitations: This method is highly sensitive to the accuracy of income and expense projections, as well as the selection of appropriate capitalization rates.

4.3.6. Ground Rent Capitalization

Ground Rent Capitalization values the land based on the income generated from a ground lease. A ground lease is a long-term lease where the tenant leases the land and constructs improvements on it.

• Principle: The value of the land is directly related to the income (ground rent) it generates.

• Process:

  1. Determine the annual ground rent paid by the tenant.
  2. Determine the appropriate capitalization rate for the land, reflecting the risk and required rate of return.
  3. Capitalize the ground rent to derive the estimated land value: Land Value = Ground Rent / Capitalization Rate.

• Formula:

  Land Value = Ground Rent / Land Cap Rate

• Limitations: This method is only applicable when a ground lease exists. The terms of the ground lease (e.g., length, rent escalation clauses) can significantly impact the land value.

• The method often involves discounting a stream of income that may not be level.

4.4. Ethical Considerations

Site valuation demands a strong ethical compass. Appraisers must remain impartial and avoid undue influence from clients or other parties. As outlined in the description of the course, it is key to adhere to the principles and ethics of the appraisal profession. An independent, unbiased valuation is essential, especially in situations like property tax assessments and condemnation proceedings where significant financial implications for property owners exist.

4.5. Practical Applications and Examples

4.5.1. Residential Appraisal

In residential appraisals, the Sales Comparison Approach is the primary method for site valuation. Locate comparable vacant lots in the same neighborhood as the subject property. Adjust the sale prices of the comparables for differences in size, location, and other relevant characteristics.

4.5.2. Commercial Appraisal

A site is being considered for a fast-food restaurant. The appraiser gathers the following data:Estimated building cost: $500,000Projected NOI: $100,000Building cap rate: 10%Land cap rate: 8%Land value = (NOI - (Improvement Value x Improvement Cap Rate)) / Land Cap RateLand value = ($100,000 - ($500,000 x 0.10)) / 0.08Land value = $625,000

4.6. Experiment

To solidify the concepts covered in this chapter, conduct the following exercise. Obtain data on a specific geographic area.Identify five comparable sites that have recently sold.Collect data on the sale price of each site, as well as any relevant attributes (size, zoning, location, etc.).Apply the Sales Comparison Approach to estimate the value of a hypothetical subject site.

4.7. Importance in Appraisal Process

The material covered is vital to appraisers. Appraisers do not care what the lender’s loan amount is or what percentage of appraised value they feel comfortable with. Neither of these has anything to do with value nor do appraisers need to know them. They are purely lenders loan considerations.

By mastering the site valuation fundamentals presented in this chapter, you will equip yourself with a critical toolkit for accurate and ethical real estate appraisal, thereby enhancing your career as a professional real estate appraiser.