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THE HEART OF ANY REAL ESTATE APPRAISAL is the highest and best use analysis. According to economic theory, land value is based on its highest and best use as if vacant. The value of the improvements, on the other hand, is based on how they contribute to (or detract from) the value of the land.
Going along with this theory, real estate achieves its highest value when the land and improvements are in balance. However, In the real word, land and buildings rarely form a perfect match.
Some mismatched properties have great potential. Consider, for example, a commercially-zoned property with an old house on it, a remnant from the days before zoning. The house could be rented, converted to a restaurant or a law office, or demolished and replaced with a retail store.
The highest and best use depends on what is legally allowed by planning and zoning regulations, what is physically possible to construct, what is financially feasible in terms of current market conditions, and what produces the most income.
The best decision might be to keep renting the building as a house, especially If there is a tight rental market and lots of vacant stores and office buildings. This is sometimes called the interim highest and best use. However, as the local economy changes, there will come a time when it makes sense to convert the house to commercial use.
Site Value
Estimating site value is an important step in evaluating income property. Economic theory assigns value to land based on its current highest and best use as if vacant and ready for development to that use. This involves looking at the property as if it had no buildings or improvements on it.
Appraisers use a wide variety of techniques to estimate land value, but there are no secret formulas. All value is derived from the market place, which is made up of buyers and sellers who make decisions based on limited information and a variety of personal motivations.
The simplest way to estimate land value is to analyze comparable land sales. If there are no available sales of vacant land, land value can be estimated by subtracting the value of the buildings from comparable improved sales. There are two techniques for doing this. The allocation method is the easiest, which assigns a percentage of value to the improvements. The extraction method is more precise, which calculates the depreciated value of the buildings.
It’s important to understand that the value of land per square foot tends to decrease as parcel sizes becomes larger. Land value per square foot tends to be higher for small parcels and lower for large parcels. Therefore, it’s important to compare lots which are similar in size.
When comparing parcels of dissimilar size, appraisers often use some kind of graphic or statistical analysis. Modern spreadsheet programs make this type of analysis much easier than it used to be.
The Improvements
Based on the theory of highest and best use, buildings and other improvements only have value according to how they contribute to the value of the land. An old worn-out building may detract from the value of the land because it costs money to tear it down and haul it away. At the other extreme, an over-improved building won’t add any value for all the surplus dollars that were put into it.
Buildings, like almost everything else, wear out. Some parts of a building wear out faster than other parts. A concrete foundation might last for a century or more, the roof covering might keep out the rain for twenty to forty years, while carpets might have to be replaced every five to ten years. Even with regular maintenance, buildings contribute less value as they age. This loss of value with age is called physical depreciation. There is no remedy or cure for it.
Buildings, like people, have a life expectancy. Buildings don’t necessarily decrease in value at a steady rate. Good maintenance and periodic upgrades can extend the economic life of a building. Also, a building’s loss in value over time is offset somewhat by the rising cost of replacing it.
Buildings go out of style and become obsolete, regardless of how well they have been cared for. Even if the building is in good shape, the floor plan may be awkward and the fixtures outdated. Some buildings suffer from botched remodeling jobs. Other buildings are just badly designed to begin with. This loss of value due to diminished functional utility is called functional depreciation. Some functional problems can be solved by remodeling. Others cannot.
Another type of functional depreciation is caused by over-improvement. Some building owners sink a lot of money into remodeling and upgrading an old building – far beyond what is typical for similar buildings in the neighborhood. While the owner may recover this investment over time, they will find it difficult to get their money back with a quick re-sale. This principal also applies to some high value homes and to trophy properties acquired for prestige rather than their return on investment.
Expert Reports
Smart buyers make their purchase offer contingent on the approval of a professional building inspection report. If the building is made out of wood, it’s standard practice for the buyer to get a pest report as well. Smart sellers order these reports in advance and make necessary repairs before putting their property on the market.
Expert reports help protect the buyer from making a bad investment and help protect the seller from being sued for non-disclosure of property defects. Expert reports cover a wide range of potential problems including roofs, wells, septic systems, structural stability, handicapped access, energy efficiency, hazardous materials and zoning compliance. Some buyers order an appraisal report and make their offers contingent on the property appraising for a certain value.
Some buildings are located under aircraft flight paths, next to railroad tracks or downwind from industrial plants. The resulting noise, vibrations and odors can affect the value of these buildings. This loss of value caused by external forces is called external depreciation. An oversupplied real estate market or a depressed economy can also cause external depreciation.
Hazards and contamination can also affect value. Buyers should ask for professional inspections if they suspect the presence of lead paint, asbestos, harmful chemicals, radiation or leaking underground storage tanks.
The Americans With Disabilities Act of 1990 (ADA), which became effective January 26, 1992, requires many types of commercial buildings to accommodate people who use wheelchairs, are blind or have other types of disabilities. Contact your local building department or hire an expert in the field of ADA compliance for specific requirements.
A visit to the local planning and building department is an important step in investigating any type of real estate. Some local zoning ordinances require off-street parking, fire sprinklers and bracing for unreinforced masonry structures. Other communities have strict design control ordinances. In many cases, hiring a permit specialist will help you navigate the legal labyrinth and expedite the permit process.
Value-Enhancing Views and Frontages
Ocean, river and lake views can add substantial value to hotels, restaurants and high-end residential income properties. However, views don’t contribute much value to warehouses and gas stations. A premium view or location could even be a problem for some types of real estate, such as affordable housing, by causing rents to rise and creating pressure for conversion to other uses.
When evaluating a view, consider proximity, height, width, orientation, obstructability and permanence. Using orientation as an example, a view with a southern exposure might support an outdoor dining area on a restaurant, where a windy and less sunny northern exposure would not. Views that can be blocked by buildings or trees aren’t as valuable as unobstructable views.
Retail stores gain value from the type of frontage and exposure they have to automobile and pedestrian traffic. The direction and timing of this traffic can be critical. Urban location experts put donut shops on the way to work and video stores on the way home.
The Cost Approach
The cost approach is a method of estimating value by combining the site value with the depreciated replacement cost of the buildings and other improvements. The cost approach can be useful for appraising properties which are unusual or complex, and when there are no comparable sales or income data.
The cost approach can also help buyers decide whether to buy, build or remodel. In an oversupplied (buyer’s) market, it’s generally cheaper to buy than to build. In a undersupplied (seller’s) market, it may be cheaper to build than to buy.
The Sales Comparison Approach
The sales comparison approach is a method of estimating value by comparing the property with recent sales of similar properties. This is the most common and widely-accepted appraisal approach.
The simplest sales comparison method is called rank analysis. The first step is to find and confirm the sales of similar properties and rank them in order of sale price. The next step is to look at this hierarchy of comparable sales and determine which are superior, similar and inferior to the property being appraised. This establishes a range of value. The most probable value is usually somewhere in the middle of this range. This sounds simple, but it’s the way that most buyers and sellers actually arrive at a sale price.
A fancier type of sales comparison analysis is the adjusted sales comparison approach – the most common method for appraising residential properties. This technique adjusts the comparables by adding and subtracting dollar amounts for various features to make them more like the property being appraised. These adjustments are supposed to represent market reaction. The problem with this method is it involves a lot of guessing. The only way to support these dollar adjustments is to conduct a statistical analysis using a large number of sales, and few appraisers do this.
For some income properties, the sales comparison analysis uses units of comparison, such as price per apartment unit or price per square foot of rentable space.
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