Site Valuation Methods and the Cost Approach

Chapter 6: Site Valuation Methods and the Cost Approach

Course: Mastering Depreciation: Unlocking Property Value

Description: This chapter delves into the critical aspect of site valuation, particularly within the context of the cost approach to real estate appraisal. Understanding site valuation is paramount for accurately estimating depreciation and, ultimately, unlocking the true value of properties. We’ll explore various methods, underlying scientific principles, and practical applications, all aligned with the course’s emphasis on identifying and measuring depreciation.

6.1 Introduction: The Significance of Site Valuation

In real estate appraisal, the site refers to the land itself, prepared for use (e.g., cleared, graded, with utilities). A separate site valuation is often crucial for:

• The Cost Approach: As highlighted in the book content, the cost approach relies heavily on accurately determining the value of the site separately. This is because the value of the improvements is added to the site value, and any depreciation is then subtracted.
• Building Residual Technique (Income Capitalization): While covered in more detail in later chapters, the book content mentions its reliance on site value.
• Legal and Regulatory Compliance: As the book content mentions, appraisals for property tax assessment and condemnation purposes often require separate site valuation due to legal mandates.
• Highest and Best Use Analysis: The most profitable use of a vacant site dictates the site’s inherent value. Determining whether to continue current improvements or pursue new construction requires knowing site value as if vacant.
• Understanding Depreciation: Site value can influence how depreciation of improvements is perceived. For instance, if a site is underutilized compared to its potential, the existing improvements might appear functionally obsolete, leading to higher depreciation estimates.

Relating to the Course Description: The accuracy of depreciation estimates directly depends on the precision of the underlying site valuation. A flawed site valuation leads to inaccurate calculations in the cost approach, hindering the ability to “accurately estimate depreciation and unlock the true value of properties.”

6.2 Foundational Concepts: Highest and Best Use

Before delving into site valuation methods, it’s essential to understand Highest and Best Use (HBU). The HBU is the most probable and legal use of a property, as if vacant or improved, that is physically possible, appropriately supported, financially feasible, and results in the highest value.

• Scientific Principle: The concept is rooted in economic principles of supply and demand, scarcity, and utility. The market dictates value based on the most advantageous use considering limitations.
• Formulaic Representation: While HBU is not directly quantifiable by a single formula, its impact can be indirectly assessed through income capitalization.
  • V = I / R where V is value, I is net operating income, and R is the capitalization rate for the HBU. Comparing V across different potential uses helps determine the HBU.
• Types of HBU:
  • HBU as if Vacant: The most profitable use assuming the land is currently vacant.
  • HBU as Improved: The most profitable use considering the existing improvements.
  • True HBU: To which the site is actually used (existing use).

Experiment/Practical Application: A local zoning change now allows for building heights up to 20 stories on a site formerly restricted to 10 stories. Analyze the profitability of each building height considering construction costs, rents, demand, etc. The optimal building height will be the one that returns the highest site valuation.

6.3 Site Valuation Methods: A Deep Dive

This section covers different approaches to valuing a site in scientific depth.

6.3.1 Sales Comparison Approach

• Principle: Relies on the principle of substitution, stating that a rational buyer will pay no more for a property than the cost of acquiring a substitute property of equal utility.
• Scientific Justification: Grounded in market analysis and statistical comparison. Accurately adjusting comparable sales for differences establishes a data-driven value estimate.

• Process:

  1. Identify Comparable Sales: Select recently sold vacant sites that are similar to the subject property (size, location, zoning).
  2. Analyze Comparables: Thoroughly investigate and verify sales data.
  3. Make Adjustments: Adjust the sales prices of the comparables based on relevant differences compared to the subject site.
  4. Reconciliation: Combine results from comparable values by weighting their comparability with the subject site to determine the final site value.

• Formula:
  Subject Site Value = Comparable Site Sale Price +/- (Price Adjustment of Legal Characteristic +/- Price Adjustment of Physical Characteristic +/- Price Adjustment of Economic/Market Characteristics)

• Adjustments: Adjustments can be quantitative (dollar amounts) or qualitative (relative rankings).

  • Quantitative Adjustments: Based on measurable differences (e.g., lot size, frontage).
  • Qualitative Adjustments: Used when quantitative data is unavailable or unreliable (e.g., superior view, better access).

  • Common Adjustment Categories

  • Real Property Rights Conveyed: (Fee simple, leased fee, etc.). Adjustments should be equal to the difference in market value attributable to the partial interest as compared to a fee simple interest.

  • Financing Terms: Adjust for favorable or unfavorable financing compared to market terms.

  • Conditions of Sale: Adjust if the comparable sale was not an “arm’s length transaction”. (Did buyers and seller act with the same degree of knowledge in the market at that point?)

  • Expenditures Immediately After Sale: Did the new buyer immediately tear something down, or make alterations immediately after the sale date?

  • Market Conditions: Adjust for price changes between the comparable sale date and the appraisal date using paired sales analysis.

  • Location: Adjustments can be used to give weight to market participants opinions about a site’s location, and the general location in the market.

  • Physical Characteristics: (Size, shape, topography, soil, frontage, drainage.)

    • Formula: Size Adjustment = (Subject Site Size - Comparable Site Size) * Market Value per Unit Area. This assumes a direct linear relationship which may not always hold true.

  • Economic Characteristics (Zoning, available utilities, deed restrictions)

• Experiment/Practical Application: Collect sales data on five comparable vacant lots near the subject site. Quantify the differences in size, zoning, and frontage for each comparable. Calculate the required adjustments, and apply them to estimate the value of the subject site. Present a detailed reconciliation explaining the rationale for your final value conclusion.

6.3.2 Allocation Method

• Principle: Based on the typical ratio of land value to total property value observed in the market for similar properties.
• Formula: Site Value = Total Property Value * Allocation Ratio.
• Scientific Basis: Rooted in statistical analysis of market data to determine typical ratios. This approach relies on the assumption that similar property types maintain similar value relationships.
• Example (As Presented in the Book Content): If land values are commonly 25% of total property value in an area, multiply the total property value by .25 to determine the implied land value.
• Critique: This method is only considered to be a supplement approach as it relies on other approaches for inputs.
• Weaknesses: Lacks precision and is highly dependent on the accuracy of the total property value estimate and the validity of the assumed ratio. This method should only be used to verify, and not as a core valuation technique.
• Experiment/Practical Application: For 10 similar improved residential properties in the subject’s neighborhood, determine the total value and land value (using the Sales Comparison Approach). Calculate the average land-to-total-value ratio. Apply this ratio to a subject’s value estimate. How does the result compare to land values found through the Sales Comparison Approach?

6.3.3 Extraction Method

• Principle: If you understand the costs of improvements, the land value can be extracted by subtracting those costs from the total value of a property.

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

• Scientific Foundation: Relies on accurate cost estimating and depreciation analysis. Errors in either will directly impact the reliability of the site valuation.

• Process:

  1. Determine the overall value of a comparable improved property using market-derived approach.

  2. Estimate the current replacement cost of the improvements.

  3. Estimate the amount of accrued depreciation for the improvements as of the date of valuation.

  4. Subtract the amount of accrued depreciation from the current replacement cost to derive the current value of the improvements.

  5. Subtract the current value of the improvements from the sale price to determine the value of the land.

• Example The book content presents an example. If we understand that an improved property is worth $650,000 and determine that the depreciated value of the improvements is $100,000 the site value is $550,000

• Limitations:

  1. Difficult to reliably estimate depreciation, particularly for older properties.

  2. Requires market to accept “hypothetical conditions”, which can introduce risk of error.
     * Experiment/Practical Application: Analyze a property recently sold with the intent to demolish the current building. Utilize different depreciation methods (age-life, cost-to-cure, market extraction) to estimate the current value of the improvements and then calculate the implied site value. Compare results.

6.3.4 Development Method

• Principle: Estimates site value by discounting future revenues derived from the development of the site. This method is often applied to the subdivision of land, with future cash flows discounted to arrive at the land’s present value.

• Formula: Site Value = Present Value of Future Revenues - Development Costs.

• Scientific Foundation: Relies on financial principles of discounted cash flow (DCF) analysis. Requires accurate forecasting of revenue, expenses, discount rates, and development timelines.

• Formula: The present value PV of a set of N future cashflows CFs can be calculated using a discount rate r with the following formula:
  PV = ∑ [CFn / (1+r)^n]
  Where n ranges from 1 to N.

• Process:

  1. Determine HBU for the site.

  2. Create a detailed development plan (site plan, construction specifications).

  3. Estimate future revenue (sales prices of finished lots or units).

  4. Estimate all development costs (construction, marketing, financing, etc.).

  5. Determine appropriate discount rate based on market risk.

  6. Discount future cash flows to present value.

• Discount Rate (r) Determination: The selection of the discount rate is critical and reflects the investor’s required rate of return given the risk associated with the project. This can be determined through market extraction (analyzing the returns of similar projects) or through build-up methods (adding risk premiums to a base rate).

• Limitations: Highly sensitive to assumptions about revenue, expenses, and discount rates. Requires advanced appraisal skills and market knowledge.

• Experiment/Practical Application: You have a 5 acre property you plan to subdivide into 5 lots, to be sold one per year over the next 5 years, at the end of each year. The sales price for each lot is $100,000. Development costs, are estimated to be $50,000 per lot, incurred immediately. The investor has a required rate of return of 10%. Using the table of reversion factors in the book content, determine the market value of your land, based on the Development Method.

6.3.5 Land Residual Method

• Principle: Capitalizing the income attributable to the land after allocating a portion to the building.
• Formula:
  1. Ib = Vb * Rb (Calculate Income Attributable to Buildings)
  2. Il = It - Ib (Calculate Income Attributable to Land)
  3. Vl = Il / Rl (Calculate Land Value)

where Ib is the income attributable to the buildings, Vb is the value of the buildings, Rb is the capitalization rate for the buildings, Il is the income attributable to the land, It is the total net operating income, and Rl is the capitalization rate for the land.

• Scientific Basis: Economic theory states income capitalization to determine value. This method isolates land income by accurately allocating costs and risks, and then capitalizes those expenses to determine an accurate land value.

• Process:

  1. Estimate the net operating income (NOI) of the property.

  2. Estimate the value of the building.

  3. Determine a market-derived capitalization rate for similar buildings.

  4. Calculate the income attributable to the building (Building Value x Building Cap Rate).

  5. Subtract the building income from the total NOI to find the income attributable to the land.

  6. Determine a market-derived capitalization rate for land.

  7. Capitalize the land income to arrive at the land value.
     * Limitations: Accurate allocation of income between land and building is challenging. Sensitive to changes in cap rates.
     * Experiment/Practical Application: You have a shopping center with a projected NOI of $208,000. Market rate for land is 8%, and buildings are capitalized at 12%. Determine land value, and building income with the Land Residual Method. Compare values with Allocation/extraction Methods.

  6.3.6 Ground Rent Capitalization

• Principle: Capitalizes the ground rent received from a land lease to estimate the land value.

• Formula: Land Value = Ground Rent / Ground Rent Capitalization Rate
• Scientific Basis: Ground rent represents the income stream solely attributable to the land. Capitalization converts this income stream into a present value estimate.
• Limitations: Only applicable when a ground lease exists. Accuracy depends on the market rate of return for leased land and if it was an “Arms-Length” transaction.
• Experiment/Practical Application: You have land you lease out at $50,000 per year with a 50-year lease. What is the estimated land value, based on Ground Rent Capitalization, with a market rate of 10%? Compare values with previously mentioned methods.

6.4 Depth Tables and Plottage/Assemblage

• Depth Tables: Recognize the front portion of a lot is often more valuable (higher exposure) and is only an auxiliary method to assist with the Sales Comparison Approach.
  40-30-20-10 Method

  Value = Front ¼ (40%) + Next ¼ (30%) + Next ¼ (20%) + Rear ¼ (10%)
  * Plottage: Combining two lots increases overall value. Assemble 2, 3, or 4 lots, and analyze.

6.5 Conclusion: Mastering Site Valuation for Accurate Depreciation

Accurate site valuation is not merely a preliminary step; it’s a fundamental requirement for reliable depreciation analysis and appraisal accuracy. By mastering the techniques and principles discussed in this chapter, appraisers can confidently “unlock the true value of properties” and provide informed investment decisions.