Site Valuation: Methods and Highest & Best Use

Site Valuation: Methods & Highest & Best Use

Course: Understanding Real Estate Appraisal Regulations: FIRREA & USPAP

Description: This chapter delves into the critical aspects of site valuation within the framework of real estate appraisal regulations, specifically FIRREA and USPAP. It aims to provide a scientific understanding of the methodologies used to determine site value, emphasizing the concept of Highest & Best Use (H&BU) and its significance in ensuring appraisal accuracy and integrity. This knowledge is essential for anyone involved in real estate finance, appraisal, or regulation, equipping them with the necessary tools to navigate the legal and ethical landscape of property valuation.

I. Understanding Separate Site Valuation

• Importance: A separate site valuation is crucial for several valuation techniques, particularly the cost approach and the building residual technique of income capitalization. FIRREA and USPAP mandate transparency and accuracy; therefore, a well-supported site valuation is vital for compliance❓.
• Legal Requirements: Appraisals for property tax assessment and condemnation often require a separate site valuation by law, underscoring the legal significance of this process. This relates directly to the course’s emphasis on understanding the legal landscape.
• Relevance to Appraisal Process: Site valuation is integral to Step 5 of the appraisal process, preceding the application of the three approaches to value.

II. Highest & Best Use (H&BU): The Foundation of Site Valuation

• Definition: The Highest & Best Use of a property is defined as the most probable and legal use of that property, which is physically possible, appropriately supported, financially feasible, and results in the highest value.

  • Formulaic Representation: While H&BU determination isn’t directly quantifiable by a single formula, the decision-making process can be framed as follows:

    H&BU = MAX(Value_Use1, Value_Use2, …, Value_UseN)

    where Value_Usei represents the present value of the expected income stream from use i, adjusted for risk and feasibility constraints.

• USPAP Compliance: An accurate H&BU analysis is critical for USPAP compliance, ensuring that appraisal opinions are credible and well-supported.

• Four Tests of H&BU:
  1. Legally Permissible:
     • Description: The use must be allowed under current zoning regulations, deed restrictions, and other legal constraints.
     • Example: A site zoned for residential use cannot have commercial development as its H&BU unless a zoning change is probable and financially justified.
  2. Physically Possible:
     • Description: The site must be suitable for the proposed use, considering factors like size, shape, topography, soil conditions, and access to utilities.
     • Experiment/Analysis: A soil analysis could be considered an experiment that will determine if physically building is possible.
  3. Financially Feasible:
     • Description: The use must generate sufficient income or benefit to justify the costs of development or operation.
     • Analysis: A feasibility study, incorporating pro forma income statements and discounted cash flow analysis, is often used to determine if a use is financially feasible.
       • Formula: Net Operating Income (NOI) - Operating Expenses = Net Profit
  4. Maximally Productive:
     • Description: Among all feasible uses, the H&BU is the one that generates the highest net return or value for the property.
     • Application: This step involves comparing the potential returns from different uses and selecting the one with the highest present value.
• Interdependency: The four tests are not independent. Legal restrictions can influence economic feasibility, and physical limitations can affect the cost of development.
• H&BU as if Vacant vs. H&BU as Improved:
  • H&BU as if Vacant: Considers the optimal use of the land if it were vacant and available for development.
  • H&BU as Improved: Considers the contribution of existing improvements and the cost of demolition or renovation.
  • Decision Rule: The true H&BU is the one that results in the highest overall value, considering the cost of any necessary demolition or alteration.
• Interim Use:
  • Definition: A temporary use of a property while awaiting a more profitable future use.
  • Example: Farming on land slated for residential development.
• Legal Nonconforming Use:
  • Definition: A use that was legal when established but no longer conforms to current zoning regulations.
  • USPAP Consideration: Appraisers must clearly disclose and analyze the impact of any legal nonconforming use on value.

III. Methods of Site Valuation

• Sales Comparison Approach (Market Data Approach): This approach is detailed in Chapter 3, and is the most important method.
  • Principle: The value of the subject site is estimated by comparing it to similar vacant sites that have recently sold.
  • Formula: Subject Value = Comparable Sales Price +/- Adjustments
  • Elements of Comparison: Adjustments are made for differences in:
    1. Real Property Rights Conveyed: Fee simple, leasehold, etc.
    2. Financing Terms: Cash, seller financing, etc.
    3. Conditions of Sale: Arm’s length transaction, forced sale, etc.
    4. Expenditures Immediately After Sale: Demolition costs, environmental remediation, etc.
    5. Market Conditions Adjustment: Changes in market value since the comparable sale.
    6. Location Adjustments: Differences in neighborhood desirability, access, etc.
    7. Physical Characteristics: Size, shape, topography, soil conditions, etc.
    8. Economic Characteristics: Zoning, development potential, etc.
  • Example: If a comparable site sold for $100,000 but is located in a less desirable area (requiring a -$10,000 adjustment) and has less favorable zoning (requiring a -$5,000 adjustment), the adjusted value for comparison is $85,000.
• Allocation Method:
  • Principle: The value of the land is estimated as a percentage of the total property value, based on typical ratios observed in the market.
  • Formula: Land Value = Total Property Value x Allocation Ratio
  • Example: If similar improved properties in the area typically have land values that represent 20% of the total property value, and the subject property is valued at $500,000, the estimated land value is $100,000.
• Extraction Method:
  • Principle: The value of the land is estimated by subtracting the depreciated cost of the improvements from the total property value.
  • Formula: Land Value = Total Property Value - Depreciated Cost of Improvements
  • Relevance to Cost Approach: Aligned with the cost approach (Chapter 3).
  • Example: A property sells for $600,000, and the depreciated cost of the improvements is estimated at $200,000. The estimated land value is $400,000.
• Development Method (Subdivision Development Analysis):
  • Principle: The value of raw land is estimated by analyzing the costs and revenues associated with developing it into finished lots or building sites.
  • Process:
    1. Estimate the total revenue from the sale of finished lots.
    2. Estimate the costs of development (e.g., infrastructure, construction, marketing).
    3. Discount the net cash flow back to the present value.
  • Formula: Land Value = Present Value of (Total Revenue - Development Costs)
  • Discounted Cash Flow: The discount rate reflects the risk and time value of money.
    • Formula: PV = CF / (1+r)ⁿ where PV is the present value, CF is the cash flow, r is the discount rate, and n is the number of years.
• Land Residual Method:
  • Principle: The value of the land is estimated by allocating a portion of the property’s net operating income (NOI) to the improvements and capitalizing the remaining income to the land.
  • Formula:
    1. Income attributable to Improvements (I_Imp) = Building Value x Building Cap Rate
    2. Income attributable to Land (I_Land) = Total NOI - I_Imp
    3. Land Value = I_Land / Land Cap Rate
  • Example:
    • Total NOI = $100,000
    • Building Value = $800,000
    • Building Cap Rate = 8%

    • Land Cap Rate = 6%

      1. I_Imp = $800,000 * 0.08 = $64,000
      2. I_Land = $100,000 - $64,000 = $36,000
      3. Land Value = $36,000 / 0.06 = $600,000
         * Ground Rent Capitalization:
         • Principle: The value of the land is estimated by capitalizing the ground rent paid under a ground lease.
         • Formula: Land Value = Ground Rent / Cap Rate
         • Example: A property generates an annual ground rent of $20,000, and the appropriate cap rate for land is 5%. The estimated land value is $400,000.
         • Depth Tables:
         • A percentage table which illustrates how the highest value is located in the front part of a lot.
         • Formula: Depth Table (Percentage value) = Distance from Primary Road (Variable feet or meters)
         • Example: If a property lost the rear 25 percent of its depth, and assuming 4-3-2-1 method, the value would reduce by only 10%.

IV. Ethical Considerations and FIRREA/USPAP Compliance

• Objectivity and Independence: Appraisers must maintain objectivity and independence throughout the site valuation process, avoiding any conflicts of interest or undue influence. This is a key component of FIRREA’s emphasis on appraiser integrity.
• Competency: Appraisers must possess the necessary knowledge and experience to perform a credible site valuation, including understanding local market conditions, zoning regulations, and construction practices. USPAP requires appraisers to demonstrate competence.
• Disclosure: All assumptions, limiting conditions, and valuation techniques must be clearly and conspicuously disclosed in the appraisal report, ensuring transparency and enabling users of the report to understand the basis for the appraiser’s opinions.
• Documentation: Appraisers must maintain adequate documentation to support their site valuation opinions, including data sources, calculations, and reasoning. This supports FIRREA and USPAP requirements for transparency.

V. Practical Applications and Experiments

• Case Study: Conduct a case study where participants analyze the H&BU of a hypothetical site in a rapidly developing urban area, considering various zoning scenarios, environmental constraints, and market demand factors.
• Market Survey: Have participants conduct a market survey to collect data on vacant land sales and rental rates in a specific geographic area, then use this data to apply the sales comparison and income capitalization methods.
• Feasibility Analysis: Task participants with preparing a feasibility analysis for a proposed subdivision development, estimating costs, revenues, and discount rates, and determining❓ the value of the raw land.

VI. Conclusion

Site valuation is a complex process that requires a thorough understanding of real estate principles, market conditions, and regulatory requirements. By mastering the methodologies discussed in this chapter and adhering to the ethical guidelines outlined in FIRREA and USPAP, appraisers can provide credible and reliable opinions that support sound real estate decisions.