Real Estate Appraisal: Chapter 6 Site Valuation

Terms in this set (79)

The principle of anticipation states that the value of property is affected by the potential future benefits of its ownership.

So when analyzing highest and best use, the appraiser must always consider the possible future uses of the property.

A site's legal restrictions, economic circumstances, and even physical characteristics are all subject to change.

Zoning and other laws can become more restrictive, or less so.

The supply of and the demand for particular types of properties can go up or down.

Physical characteristics, such as the availability of water, can also change.

Highest and best use analysis requires the appraiser to evaluate the likelihood of any changes that may affect the potential use of the property.

Example:
A site is zoned for office buildings of up to 3-stories. The area is suitable for office development; this it may appear that a 3-story office building would be the highest and best use of the site. However, if the site is likely to be rezoned in the near future to allow for 10-story office buildings, it may be more profitable to wait and develop the site more intensively after the new zoning take effect, rather than to immediately develop a 3-story office building that will shortly become an under-improvement. In this case, the current highest and best use of the land may be to do nothing and simply hold it for speculation.

When conditions are such that a change in legal, physical, or financial restrictions on property use seems likely to occur, an appraiser should take this into consideration when determining highest and best use.
Highest and best use may vary, depending on whether land is vacant (or assumed to be vacant) or improved.

For this reason, appraisers make a distinction between the highest and best use of land as if vacant, and the highest and best use of property as improved.

To determine the highest and best use of land as if vacant, the appraiser assumes that any existing improvements on the land do not exist.

The highest and best use becomes the use that would result in the highest value if the land were vacant and ready for any kind of development.

In the case of property that actually is vacant land, this assumption simply reflects the true state of affairs.

But improved property may also be analyzed in this manner.

Example:
A property is improved with a single-family residence. If vacant, the value of the site for residential use would be $120,000. However, the zoning allows for commercial development, and the site would be worth $240,000 if vacant and available for commercial development. In this case, the highest and best use of the land as if vacant would be commercial use. The fact that the land is already improved for residential use has no effect on this determination.

The highest and best use of the property as improved takes into account the contribution of existing improvements, and also the cost of their removal (if necessary) to allow for some different use.

Example:
Using the facts of the example above, assume the value of the property (land and buildings) as currently improved for residential use is $360,000 ($120,000 land value plus $240,000 value contribution from the improvements). Also assume that is would cost $30,000 to remove the existing structure to allow for commercial use can be calculated as follows:

$240,000 Value of land if vacant & available for commercial development
-$30,000 Cost to remove existing improvements
=$210,000 Value of property as improved for commercial use

These figures indicate that the highest and best use of the property as improved is the current residential use, since the value of the property as improved ($360,000) is higher for residential than for commercial use.

In considering the highest and best use of property as improved, keep in mind that existing improvements do not necessarily add to the value of the property, and may actually detract from it.

Even when an improvement is physically sound, it may be functionally obsolete, and the necessary cost of removing it to make way for a newer structure could have a negative impact on overall property value.

Example:
In an area where there is a strong demand for upper-end housing, but little or no supply of vacant land for new development, existing homes in good condition may be purchased and then razed to make way for more luxurious residences. Even though the existing residences are perfectly livable, they represent a negative contribution to value, since the building lots would be worth more if they were vacant.
For appraisal purpose, there can be only one highest and best use.

When a property's highest and use as if vacant is different from its highest and best use as improved , the appraiser must determine which one should serve as the basis of the appraisal.

This is actually an easy procedure, since highest and best use is simply the use that results in the highest value.

If he highest and best use of the land as if vacant results in a higher value than the highest and best use of the property as improved, then it is the true highest and best use of the property.

(Of course, the opposite is also true.)

•Vacant land value >

Improved property value
+Demolition costs
=True highest & best use (VACANT)

•Vacant land value <

Improved property value
+Demolition costs
=True highest & best use (IMPROVED)

Example:
In preceding examples, we looked at a property whose value for its highest and best use as improved ($360,000 for residential use) was greater than the adjusted value for its highest and best use as if vacant ($210,000 for comerical use). An appraiser in this case would conclude that the highest and best use of the subject property was residential use, since it resulted in the highest value.

Remember though, that the value indicated by the highest and best use of the land as if vacant may need to be adjusted to reflect the costs of removing existing improvements.

Comparing the highest and best use of land as if vacant to the highest and best use of property as improved helps determine whether an existing use should continue or not.

If the existing use is not the true highest and best use (because the adjusted value of the land as if vacant is greater than the value of the property as improved), then a change in the use of the property is indicated.
For any given use, there is usually an optimum amount of land associated with the use.

When a parcel of land includes more land than is necessary to support its highest and best use, it is said to contain excess land.

Excess land is land that is not needed for the highest and best use of the site.

Example:
The zoning in a residential neighborhood are the minimum size. In this case, a 6,000-square-foot building lot located in the neighborhood would contain excess land, since the extra 1,000 square feet would not be necessary to support a house that was typical of other houses in the neighborhood (the highest and best use of the site).

On a per-square-foot basis, the value of excess land is less than the value of the portion of the site that is needed to support its highest and best use.

In the example above, the 6,000-square-foot lot is 20% larger than average for the neighborhood.

But that 20% is excess land, so the value of the site would be less than 20% higher than the neighborhood's average site value.

In valuing a site, the appraiser must also consider whether any excess land is adaptable for some other use.

The highest and best use of the excess land may be different from the highest and best use of the total site.

Example:
The highest and best use of a 2-acre site is for a grocery store. However, the amount of land needed to support the grocery store use is only one acre. If the site can be subdivided, the excess one acre of land may have value for some other use, such as a drug store or gas station.

A concept related to excess land is the concept of plottage.

Plottage refers to the increase in value that results from combining two or more lots to allow for a more profitable highest and best use.

If two lots are worth more when combined than they were separately, the added value is called the plottage value or plottage increment.

Example:
Two adjoining lots are each valued at $40,000. They are each too small to support a building of the size typical in the neighborhood. But if the two lots are combined, the resulting parcel is comparable in size to other neighborhood sites, and the value of the combined property is $100,000. The extra $20,000 in value is the plottage value.
Site analysis should initially start with determining if the site is considered a surplus or excess site.

Excess Land:

•If improved: Land not needed to serve or support the existing improvement

•If vacant: Land not needed to accommodate the site's primary H&BU

•May be subdivided, sold separately and valued separately

•May have its own H&BU

•Excess site is land or site area that is not necessary to support the use of the existing improvements situated on the subject property.

However, it may have its own highest and best use for expansion of the current improvement or for sale to another.

Example:
The owner of a house has an additional lot next to the house which he uses as a large side yard. If the additional lot has its own unique legal description or could be legally divided from the site on which the house is situated, then the site is like considered excess. In such case, the contributory value of the excess land determined by Sales Comparison Approach using similar site comparables in the same market (less any cost of subdividing) based on the Principle of Substitution.

Surplus Land:

•Additional land that allows for future expansion of the existing improvement(s)

•Cannot be subdivided separately

•Does not have its own highest and best use (H&BU)

•Surplus site is the portion over and above what is necessary for the highest and best use of the subject property, and does not have a stand-alone highest and best use.

Example:
Consider a house that is built across two lots accommodating a larger yard area. If the extra yard cannot be legally divided or does not significantly contribute to the expansion of the current improvements, the extra yard is likely surplus and with little to no contributory value.
There are 6 commonly recognized methods for appraising the value of land.

1. Sales Comparison
2. Land Residual
3. Ground Rent Capitalization
4. Subdivision Development
5. Allocation
6. Extraction

The comparison method, considered the most reliable, uses sale of similar vacant parcels to determine the value of the subject land or site.

Underlying ideas:

• Site is valued as though vacant and ready for its legal optimum, of highest and best use

• Appraisal techniques, numbers and formulas may be used to provide a foundation for judgement; but
never a substitute for judgement

• The market decides how much a site is worth or market value; "The market talks and the appraiser listens!"

The land residual and ground rent capitalization methods analyze the income attributable to the land, and calculate the value of the land by capitalizing its income.

In the subdivision development method, the appraiser analyzes the costs of subdividing and developing land into building lots, then deducts these costs from the anticipated sales price of the lots to arrive at the value of the raw land.

Allocation and extraction are used to value the land component of improved property, either by applying a ratio of land value to total property value (allocation) or deducting depreciated improvement value from total property value (extraction).

Since the sales comparison method is by far the most reliable, it is the preferred method.

Generally, the other methods are used when the sales comparison method is impossible or impractical due to a lack of adequate comparable sales data or because many properties need to be valued quickly and cheaply (such as for tax assessment purposes).

Other methods may also be used to support the value estimated determined by the sales comparison method.

Residential appraisers rely primarily on the sales comparison method for site valuation, as long as adequate comparable sales data are available.

Allocation and extraction are also used in residential appraisals, with extraction generally preferred over allocation.

Commercial (general) appraisals may use any of the six methods for valuing land or sites.
Adjustments must be made, or at least considered, for each element of comparison (location, date of sale, etc) that may affect the value of the subject property.

The adjustment is always applied to the price of the comparable, rather than to the subject property.

If the comparable is superior in some respect, its price is adjusted downward; if it is inferior to the subject property, its rice is adjusted upward.

Example:
A comparable lot sold recently for $90,000. Based on market analysis, you determine that the location of the lot makes it $10,000 more valuable than the subject lot. Because the comparable is superior in location , its price is adjusted downward.

$90,000
- $10,000
=$80,000

The indicated value of the subject lot is $80,000.

Depending on the data, adjustments will either take the form of a dollar amount or a percentage of the comparable's sales price.

When the adjustment is a percentage, the dollar amount of the percentage is calculated and then added to or subtracted from the comparable's price.

Example:
The sales price of a comparable lot is $90,000. Market data suggests that the subject is worth 10% less than the comparable, due to changes in the market since the date of the comparable sale. The amount of the adjustment is 10% of $90,000 (0.10 x $90,000), or $9,000. Since the comparable is more valuable, the adjustment is made by subtracting the difference in value form the comparable's sales price.

$90,000
- $9,000
=$81,000

The indicated value of the subject lot is $81,000.

When calculating percentage adjustments, the order in which the adjustments are calculated can affect the results of the calculation.

For this reason, adjustments are normally calculated in a particular order or sequence.

The sequence used to calculate the adjustments will depend on the appraiser's analysis of the market, but in general, adjustments for property rights, financing and sale terms, and market conditions are made first, before adjustments for locations and physical characteristics.

Example:
An appraiser determines that a comparable's sales price must be adjusted downward by 10% to account for the value of financing concessions in the comparable sale. In addition, the subject property is worth $5,000 more that the comparable due to superior utility service. The sales price of the comparable is worth $100,000. In this case, the amount of the adjustment for financing terms will depend on whether it is made before or after the adjustment for utilities. If the adjustment for financing terms is made first, the result is as follows.

$100,000
x 10% (0.10)
=$10,000 financing adjustment

$100,000
-$10,000
=$90,000 Value adjusted for financing

$90,000
+$5,000
=$95,000 Value adjusted for financing and utilities

If the adjustment for utilities is made first, the result is a different indicated value for the subject lot.

$100,000
+$5,000
=$105,000 Value adjusted for utilities

$105,000
x 10% (0.10)
=$10,500 Financing adjustment

$105,000
- $10,500
=$94,500 Value adjusted for financing and utilites
Allocation is a method of estimating the land value for an improved property.

Investigate market standard ratio; what % that site represents of the total price

Example:
•From the market typically find:

- Total Property 100%
- less (-) improvements 80%
- equal (=) site 20%

• Then apply the site % to the total property values typical of subject type and location to find estimated contribution of the site.

This method assumes that a certain percentage of a property's value is attributable to its improvements and the remaining percentage is attributable to the land.

In other words, it assumes that similar properties will have similar ratios of land value to building value.

For example, if a typical building value to land value ratio is 3 to 1 (the buildings are typically worth 3 times as much as their lots), the 25% of the property's total value is allocated to the land, and 75% to the improvements.

This means 75% of the property's value is attributable to the building and 25% is attributable to the land.

$250,000 × .25 = $62,500 value of the land.

If the value of the property as a whole can be established, then determining the value of the land is simply a matter of multiplying by the appropriate percentage.

Example:
An appraiser has estimated that a property is worth a total of $600,000, and that the ratio of building value to land value for similar properties is 3:2 (3 to 2). In this case, 60% of the property's value is allocated to the improvements, and 40% is allocated to the land.

$600,000
x 40% (0.40)
=$240,000 Allocated land value

Allocation suffers from two serious drawbacks.

1. In order to determine the correct ratio or percentage to apply, it is necessary to have market data: how much have builders and developers paid for land in relation to the value of the improvements that they constructed?

But if reliable market data are available, there is no reason to resort to allocation; the sales comparison method is always preferable when adequate comparable sales data exist.

2. It is inherently inaccurate.

At best, an allocation percentage will represent an average for a particular type of property.

Lots of the same size and type (such as residential), with equal value, can be improved with buildings of different sizes, styles, and functionality.

The allocation method does not take this variation in the value of improvements into consideration.

Allocation alone is not a very reliable indicator of land or site value.

Accordingly, it is used only when more reliable methods are impossible (due to lack of market data) or impractical (as in the case of property tax assessment, where the values of thousands of properties must be allocated between land and improvements).

As a result, the allocation method is only used in certain circumstances:

•When more reliable methods aren't available due to lack of market data,

•For property tax assessment, or
As a double-check on a value estimate obtained through another method.

Allocation is also used sometimes to check the validity of the values indicated by other methods of land valuation.
Extraction is another method that is sometimes used to value land when data for comparable sales of vacant land are not available.

In a sense, extraction is the cost approach to value in reverse.

Estimate of site value based on deducting the estimated contribution of improvements from total property sales prices

Example:
•From the market typically find:

- Sale of Similar property $10,000
- less (-) improvements contribution 6,000
- equal (=) site contribution $ 4,000

• This is done for several properties similar to subject situation to provide the site value estimate.

In the cost approach, appraisers add the value of the land to the depreciated cost of the improvements to arrive at the total value of the property.

With the extraction method, the depreciated cost of improvements is subtracted from the total value of the property to arrive at the value of the land.

The extraction method is applied to comparable sales of improved property when comparable sales of vacant land are not available.

By extraction, the appraiser estimates the value of the land component of the comparable sale, and then uses the data to estimate the land value of the subject property.

Extraction cannot be considered reliable unless the value of the comparable improvements:

1. Can be reliably estimated.

Value of the comparable improvements must be reliably estimated

2. Is very small in relation to the total value of the comparable property.

Value of the comparable improvements must be very small in relation to the total value of the comparable property

•Extraction used most commonly in second situation.

The most common use of extraction is probably for rural properties, where the value of land tends to represent a higher percentage of the total property value.

Example:
A comparable rural property sold recently for $650,000. The appraiser estimates that the depreciated value of the comparable's improvements is between $80,000 to $100,000. By extraction, the value of the comparable's land is in the range of $550,000 to $570,000. Because the improvements represent a fairly small portion of the total value, extraction yields a range of land values that varies by less than 5%, even though the appraiser was only able to estimate improvement value to within a range of 25%.
The subdivision development or land development method is used to value vacant land when the highest and best use of the land is to be used for subdivision and development.

Used for land with near-term subdivision potential.

Finding how much a developer would pay for the land considering potential revenue from development, less allowance for direct and indirect outlays, profit, and time delay.

Example:
(oversimplified)

• Revenue: 100 lots @ $5,000 = $500,000

• Less Development expense & Profit incentive: $400,000

• Net to the Land: $100,000

• Present worth @ xx% for # years: $65,000

• Note: time delay & profit must be included!

• General layout is a discounted cash flow analysis

In this method, the appraiser estimates the future of the developed lots, and then subtracts the costs of development to arrive at the current value of the land.

Example:
It is estimated that a certain property can be subdivided and developed into 10-building lots at a total cost (including developer's profit) of $1,000,000. The lots are projected to sell for $200,000 apiece, or a total of $2,000,000. The value of the undeveloped land is estimated by subtracting the development costs from the anticipated sales of finished lots.

$2,000,000
-$1,000,000
=$1,000,000 Land Value

Because the process of developing and selling the lots may require several years to complete, the subdivision development method often requires that cash flows (projected future sale and expenses) be discounted to arrive at the present value of the land.

Discounting is a means of calculating the present value of an expected future amount.

Discounting takes into account the ability of money to earn interest through investment.

Example:
If you place $100 in an investment that earns 10% interest per year, your investment will pay back $110 after one year ($100 original investment, plus $10 interest). The present value of $100 is equivalent to a future value of $110.

Discounting calculates the amount of interest that an investment could have earned, and deducts it from the amount of the future payment to arrive at the present value. Discounted present values are typically determined by using a financial calculator.
The land residual method is typically used to estimate the alnd value of commercial income-producing property.

Its is a form of the income capitalization approach to value.

Income capitalization measures value as a function of income.

Used when a total property total market net income is known or estimated, and land and building capitalization rates may be found in the market.

Example:
•If we find a 2% recapture, or "return of"
rate and 8% "return on" investment in the market, and ...

• Net Operating Income: $100,000

• Less income to the Building: 35,000
(if building value $350,000 x 10% bldg. capn' rate(RB))

• Residual to the land: $ 65,000

• Land Value: (V=I/RL );
$65,000 ÷ 0.08 = $812,500

The basic formula for income capitalization is:

Value (V) x Capitalization Rate (R) = Income (I)

This formula can also be expressed as:

Income (I) ÷ Capitalization Rate (R) = Value (V)

Example:
A property's net annual income is $12,000. If market data indicates a capitalization rate of 10%, then the value of the property can be estimated by income capitalization as follows:

V = I ÷ R
V = $12,000 ÷ 0.10 (10%)
V = $120,000 Indicated value of property

To apply the land residual technique, the appraiser must be able to reliably determine 4-critical pieces of data:

1. The value (depreciated cost) of the improvements

2. The market capitalization rates for land

3. The market capitalization rates for buildings

4. The property's total net operating income

By multiplying the building capitalization rate by the value of the improvements, the appraiser can determine the amount of the property's income that is attributable to the improvements (I = V x R).

This amount is then subtracted from the total net income of the property to find the amount of income of the property to find the amount of income that is attributable to the land.

Finally, the land income is converted to a value figure by means of the land capitalization rate.

Example:
The highest and best use of a parcel of land is determined to be a retail shopping center. The cost of construct the improvements is estimated at $1.2 million, and the property is projected to generate net annual income of $208,000. Market data indicate capitalization rates for this type of property to be 8% for land and 12% for improvements. The first step is to calculate the income attributable to the improvements by multiplying the improvement capitalization rate times the value of the improvements.

I = V x R
I = $1,200,000 x 0.12 (12%)
I = $144,000 Income attributable to improvements

Next, the improvement income is subtracted from the total net income to find the income attributable to the land.

$208,000
- $144,000
= $64,000 Income attributable to land

Finally, the land income is capitalized by dividing it by the land capitalization rate.

V = I ÷ R
V = $64,000 ÷ 0.80 (8%)
V = $800,000 Indicated land value
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