Appraisal Approaches: Site Valuation & Building Analysis

Appraisal Approaches: Site Valuation & Building Analysis

Introduction:

This chapter, situated within the “Mastering Mortgage Markets & financial❓ Regulations” training course, delves into the crucial appraisal approaches of site valuation and building analysis. Understanding these concepts is paramount for navigating the complexities of real estate finance and ensuring the protection of federal financial interests in real estate-related transactions, aligning directly with the course description and the landmark FIRREA act’s impact on appraisal practices. This chapter explores the scientific principles underlying these approaches, providing a foundation for accurate and reliable real estate valuation.

I. Site Valuation: The Foundation of Appraisal

Site valuation is the process of determining the economic worth of a parcel of land, independent of any improvements upon it. As stated in the provided book content, “A separate valuation of site and improvements may also be required by law, particularly in appraisals for property tax assessment and condemnation purposes.”

A. Why Separate Site Valuation?

• Cost Approach Accuracy: The cost approach to value relies heavily on an accurate site valuation. The formula is:

  • Property Value = Site Value + Cost of Improvements (New) - Depreciation

  If the site value is inaccurate, the entire cost approach is compromised.
  * Income Capitalization (Building Residual Technique): This technique also necessitates an independent estimate of site value to isolate the income attributable to the building itself.
  * Legal & Regulatory Compliance: Certain appraisals, especially those related to property tax assessment and condemnation, are legally mandated to include a separate site valuation. This is directly related to ensuring uniform standards in the appraisal industry to protect federal financial interests as outlined in the course description.

B. Key Principles & Scientific Theories

1. Highest and Best Use: This is the cornerstone of site valuation. The highest and best use is defined as the most probable use of a property that is:

   • Legally Permissible: Complies with zoning ordinances, building codes, and other regulations.
   • Physically Possible: Considers the site’s size, shape, topography, soil conditions, and access to utilities.
   • Economically Feasible: The use must generate sufficient income or benefits to justify its development and operating costs.

   • Maximally Productive: Among all legally permissible, physically possible, and economically feasible uses, this is the use that will yield the highest present value.

     The Highest and Best Use principle is based on the economic theory that rational investors seek to maximize returns on their investments.

2. Principle of Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. Site valuation uses this principle by analyzing the prices of comparable vacant sites. This relates to Sales Comparison Approach discussed in the book content.

3. Principle of Anticipation: The value of a property is based on the present value of future benefits expected to be derived from it. For site valuation, this means considering potential future development possibilities.

C. Methods of Site Valuation

The book content covers the following techniques for site valuation:

1. Sales Comparison Approach (Market Data Approach): The most reliable method. In line with the Sales Comparison Approach discussed in the book content, “Under the SALES COMPARISON APPROACH, the value of the subject property is indicated by the values (sale prices) of similar properties in the market. These similar properties are referred to as comparables.”

   • This approach involves identifying comparable vacant sites that have recently sold and adjusting their sale prices to account for differences between them and the subject site.

   • Formula: Subject Value = Comparable Sales Price +/- Adjustments

   • Elements of Comparison: These factors need to be considered when making adjustments:

     • Real Property Rights Conveyed: Fee simple, leasehold, etc.
     • Financing Terms: Cash equivalent vs. seller financing, etc.
     • Conditions of Sale: Arm’s length transaction vs. forced sale, etc.
     • Market Conditions: Changes in market conditions between the comparable sale date and the appraisal date.
     • Location: Neighborhood desirability, access to amenities, etc.
     • Physical Characteristics: Size, shape, topography, soil conditions, etc.
     • Economic Characteristics: Zoning, development potential, etc.

   • Experiment/Practical Application: An appraiser researches recent sales of comparable vacant lots in the subject’s area. Lot A sold for $100,000 one month ago, but it’s on a busy street, unlike the subject property. Market analysis suggests a $5,000 adjustment for location. Lot B sold for $110,000 six months ago. The market has declined by 2% since then. Additionally Lot B has better soil quality, requiring the subject to be reduced by $3,000. The math would like like this:

     • Lot A: $100,000 + $5,000 = $105,000
     • Lot B: $110,000 - (2% * $110,000) - $3,000 = $104,780
       2. Allocation Method: Estimates land value as a percentage of the total property value. It is mentioned in the book content that, “In allocation, there are these formulas, depending on whether the calculation involves a capitalization rate or an income multiplier (factor).”

   • Often used in mass appraisals (e.g., property tax assessments).

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

   • Experiment/Practical Application: In a residential neighborhood, similar homes typically have land values comprising 20% of their total value. If a comparable property sold for $250,000, the land value would be estimated at $50,000 ($250,000 x 0.20).
     3. Extraction Method: Derives land value by subtracting the depreciated cost of improvements from the total property value.

   • Formula: Land Value = Total Property Value - Depreciated Cost of Improvements

   • Experiment/Practical Application: A property sold for $300,000. The depreciated cost of the building is estimated to be $150,000. The land value would be extracted at $150,000 ($300,000 - $150,000).
     4. Development Method (Subdivision Analysis): Projects the future revenue and costs associated with developing a parcel of land, then discounts those cash flows to arrive at a present value for the land. It is relevant with the Income Approach described in the book content, as the “INCOME APPROACH assumes that the value of property is indicated by the amount of income that the property can generate: the greater the income, the greater the value”.

   • This method is suitable for valuing large tracts of land that are suitable for subdivision into smaller lots.

   • Formula: Land Value = Present Value of (Projected Revenue - Development Costs)

   • Experiment/Practical Application: A developer is considering purchasing a parcel of land for a housing subdivision. The projected revenue from lot sales is $2 million. Total development costs (including construction, infrastructure, marketing) are estimated at $1.5 million. Using a discount rate of 10%, the present value of the profit stream is calculated to be $454,545. This becomes the estimate for the land’s value.
     5. Land Residual Method: Similar to the Income Approach, it is described in the book as “INCOME APPROACH assumes that the value of property is indicated by the amount of income that the property can generate: the greater the income, the greater the value”. It derives land value by subtracting the income attributable to the improvements from the total net operating income (NOI) and then capitalizing the remaining income stream.

   • Formula: Land Value = (Net Operating Income - Income Attributable to Improvements) / Land Capitalization Rate

   • Experiment/Practical Application: A commercial property generates $100,000 NOI. The income attributable to the building (based on its value and an appropriate capitalization rate) is $60,000. Using a land capitalization rate of 8%, the land value is ($100,000 - $60,000) / 0.08 = $500,000.
     6. Ground Rent Capitalization: Estimates land value by capitalizing the ground rent paid under a long-term lease.

   • Formula: Land Value = Annual Ground Rent / Capitalization Rate

   • Experiment/Practical Application: A parcel of land is leased for $20,000 per year. A capitalization rate of 10% is deemed appropriate. The land value would be $20,000 / 0.10 = $200,000.
     7. Depth Table (4-3-2-1 method): Table or percentage that shows value depending on the amount of land on the front part of a lot. “From the above example, we can see that 135 is the most likely multiplier. Thus:

     $1,525 Subject Monthly Rent x 135 = $206,000 (rounded) Value by Income Approach.”

     Case/Example:

     The appraiser assumes that the value of the parcel is as follows:

     1st ¼ = 40% of Value

     2nd ¼ = 30% of Value

     3rd ¼ = 20% of Value

     4th ¼ = 10% of Value

     Based on this rough formula, you will see that the loss of the rear 25 percent (¼th) would only reduce the value by 10 percent

II. Building Analysis: Understanding the Improvements

Building analysis focuses on evaluating the physical and functional characteristics of the improvements on a property. As described in the book, “The COST APPROACH assumes that the value of improved property is indicated by the value of the site, plus the cost (new) to construct the improvements, less any depreciation that the improvements have suffered.” A thorough building analysis is critical for determining the cost of improvements and estimating accrued depreciation.

A. Key Elements of Building Analysis

1. Physical Characteristics: These include the building’s size, shape, design, materials, age, condition, and overall quality.
2. Functional Utility: How well the building serves its intended purpose, considering layout, traffic patterns, room sizes, and features.
3. External Obsolescence: Factors outside the property that negatively impact its value, such as proximity to a noisy highway or industrial area.
4. Energy Efficiency: Features that reduce energy consumption and costs, including insulation, window glazing, and efficient HVAC systems.
5. Special Features: Pools, spas, landscaping, garages, etc., that contribute to or detract from value.

B. Construction Techniques and Materials

Understanding basic construction principles and the properties of different building materials is crucial for accurate building analysis. Some key aspects include:

• Foundation Types: Slab-on-grade, basement, crawl space.
• Framing Systems: Wood framing (platform, balloon, post and beam), steel framing.
• Exterior Finishes: Siding (wood, vinyl, brick), roofing (asphalt shingles, tile, metal).
• Interior Finishes: Wall coverings, floor coverings, cabinetry.
• Mechanical Systems: Plumbing, HVAC, electrical.

C. Depreciation

The cost approach, as described in the book content, relies on accurate depreciation estimates. Depreciation is the loss in value of a property from any cause, including:

• Physical Deterioration: Wear and tear, deferred maintenance.

  • Experiment/Practical Application: An appraiser observes a roof with missing shingles and water damage. The cost to repair the roof is estimated at $5,000, which is deducted as physical depreciation.

  • Functional Obsolescence: Defects in design or function that make the property less desirable.

  • Experiment/Practical Application: A house has only one bathroom for three bedrooms. The cost to add a second bathroom is estimated at $10,000. The appraiser also considers the market resistance to such a layout. Adding a bathroom could make the house more attractive to the target market.

  • External Obsolescence: Negative influences outside the property that reduce its value.

  • Experiment/Practical Application: A property is located next to a busy highway, generating significant noise pollution. The appraiser estimates that this external factor reduces the property’s value by 5%, after researching market comparables of the same size and condition with better exterior obsolescence.

D. Mathematical Representation of Depreciation

Accrued Depreciation is often calculated using the age-life method. This is often a useful method to be used when calculating depreciate as discussed in the book content.

Accrued Depreciation = Effective Age / Total Economic Life x Replacement Cost

E. Integrating Site and Building Analysis

The final step is to synthesize the site valuation and building analysis to arrive at an overall value estimate. This requires considering how the improvements complement the site and how both components contribute to the property’s highest and best use. “Reconciliation is the process of analyzing the appraisal problem, selecting the most appropriate method of the three, and giving it the most weight in determining the final estimate of value.” This concept is mentioned in the book, so that is why it is of upmost importance.