Land Valuation in the Raw
Master the ABCs of Determining Highest and Best Use and Land Value.
The valuation of raw land presents unique challenges. The analyst is working with a blank canvas of sorts, forced to analyze a variety of factors and make rational assumptions about a site’s best potential use.
At a minimum, a broker should be able to perform a base level of analysis for a client and should know what to look for in evaluating a formal analysis. (For complicated assignments or when regulations require it, hiring a more experienced valuation professional is recommended.) The valuation process essentially consists of two parts: determining the highest and best use for the land and applying the appropriate valuation technique.
Highest and Best Use
The ultimate value of a parcel of raw land depends on determining its highest and best use. Unfortunately, when looking at a piece of raw land, highest and best use often is a matter of perspective. For example, the highest and best use for a developer might be a shopping center, for an environmentalist a nature preserve, for a housing advocate a low-income apartment project, and for a neighbor a high-end single-family subdivision.
The highest and best use generally is the use that is reasonably probable, physically possible, supported by the market, and returns the highest value to the land. The final estimate of highest and best use should be defensible, the logic internally consistent, and the conclusions well supported and documented by facts as well as opinions.
Owners frequently have strong opinions of the highest and best use of their land. But emotional attachment, the original intent for purchase—even if it was bought 20 years ago—and misconceptions about the market can cloud an owner’s judgment. Development proposals therefore should be analyzed objectively. Many concepts come from architects or land planners and are focused more on design than economic issues.
Several factors are involved in exploring highest and best use. It is critical to consider the impact of value when evaluating each of these factors.
Several physical factors play an important role in determining land use.
Land size, often overlooked, is a key determinant of the highest and best use. For example, a one-acre site could not support a 30,000-square-foot manufacturing facility, as there would not be enough space for parking or sufficient loading and unloading space.
Physical shape, including width and depth, also is a critical factor. Irregularly shaped parcels (such as a narrow strip or land with a jagged property line) generally have lower physical utility (and therefore value) than square or rectangular-shaped parcels. Many big-box retailers have specific width and depth requirements for standard prototypical buildings. Parcels that do not meet these needs often are dismissed outright as potential development sites.
Appraisers sometimes overlook topography, but developers consider it early on, given the cost either to cut or fill a parcel. For instance, steep grades add significantly to development costs. Parcels that are below grade may lack visibility and can have drainage problems.
Geotechnical considerations include subsurface conditions such as the presence of underlying rock, water, or the suitability of soils to support construction. Soil borings or soundings are the only ways to get a true picture of a site’s subsurface conditions. However, clues can be drawn from development on neighboring parcels or Department of Agriculture soil maps. The presence of wetlands also can have a dramatic impact on value. Filling these areas, if permitted at all, is costly and time-consuming.
Additionally, the potential for environmental contamination must be explored, as developers and lenders may not consider such a property as a matter of policy. A phase one environmental report is the best way to determine potential contamination; analysts working without such reports should note underground storage tanks and potential contamination from adjoining sites.
These physical factors may dictate the future development of the site and must be considered in an analysis upfront. Some physical issues can be handled (slopes cut, subsurface rock removed), while some are incurable (site size, dimensions). The cost of the remedies needs to be considered in the valuation process.
Regulatory and Legal Issues
Another area to investigate when considering land usage is regulatory and legal requirements.
Zoning is of critical importance in estimating the value of a parcel of raw land. However, the cost and probability of changing the zoning (or, in the case of unzoned land, establishing zoning) should be considered. This can be accomplished by interviewing the local planner, administrator, or elected official.
The availability of utilities, the cost to bring utilities to the site, and the capacity to provide service need to be evaluated. Just because water and sewer lines exist at the property line does not automatically guarantee adequate service capacity. Water/sewer moratoriums can lengthen development time significantly and may suggest a highest and best use that requires less water/sewer demand.
Associated with the physical factors mentioned earlier, specific permits for filling, moving, or modifying wetlands may be required. If part of the site is classified as a wetland under the jurisdiction of the Army Corps of Engineers and this wetland needs to be filled or crossed, the permit process can be time-consuming and costly.
Impact fees and special assessments charged by local governments also can have a great impact on land value. Many local municipalities now charge fees related to new development. These fees may include charges for parks, libraries, water and sewer, police and fire, and schools. The cost of such fees may preclude certain types of development.
Deed restrictions may preclude certain land uses and typically are disclosed in a title policy. A survey that identifies the location of easements also should be reviewed if available.
Location and Market Factors
The selected highest and best use obviously should be supported by market demand, yet this is where most analyses fall woefully short of support. For example, if the analyst believes that an apartment project is the highest and best use of a parcel, a detailed study of the apartment market is required. This analysis should detail supply considerations (rent and occupancy levels), future demand factors (factory openings/closings, demographics) and competing projects that are planned or under construction. Most reports provide a brief synopsis of the market but do not relate market trends to the specific uses or a specific site.
The analyst should be familiar with basic market trends of a given real estate sector. For example, industrial users are likely to seek locations in planned business parks, apartment development may be focused on serving the seniors market, and hotels often concentrate near interstate interchanges.
Of course the site’s general location within a given market also needs to be considered. Retail requires access and visibility from major roadways and often needs to be located near other retail uses. Adjoining land uses will influence future development potential. This influence, known as "externality," can be either positive or negative on the subject site.
Site-specific attributes of location to consider include the number of access points, ease of entry (location of traffic signals), visibility from roadways, traffic counts, and length of frontage.
Often, after looking at physical, regulatory, and location factors, one use clearly will provide the greatest return. If a variety of uses could be supported, the uses that would provide the highest price will be the highest and best use.
The Valuation Process
After sifting through all of the variables and deciding on a highest and best use for a parcel, how do you value the land? Several valuation options exist, though some are less common than others.
The sales comparison approach is the standard valuation method for raw land. The sales of "comparable" raw land parcels are analyzed to provide an estimate of value for the subject property.
The critical success factor in this approach lies in finding truly comparable sales. In land valuation, comparatively few sales of commercial land are closed in a given market. Therefore, adjustments are required for differing characteristics to provide for truer comparability.
Finding comparable sales data can be a frustrating process. Real estate appraisers keep a database of comparable sales information and may be willing to share it. Local assessors typically are well informed of land sales, and the county registrar of deeds’ office also is a good resource. In large metropolitan areas, commercial databases sell comparable information. As a practical matter, new construction projects of a similar highest and best use also can provide a potential source of comparable sales.
An analyst also can look to active listings of raw land as an indicator of value. However, these listings do not represent a closed transaction and are by nature priced higher than the final sale price. If a number of similar sites are on the market, the situation may represent a supply balance and should be considered in the valuation process. A sufficient number of comparable sales should be identified to paint a true picture of the market. In certain cases, only one or two sales may be available, but this data set is so small that misleading results can occur. Under ideal circumstances, three to five sales should be presented.
After the comparable sales have been identified, the analyst should physically inspect each property to get a true feel for the site and neighborhood. In addition, a party familiar with the transaction (buyer, seller, broker, attorney) should be interviewed to determine relevant factors involved in the pricing.
The adjustment process is utilized to make an "apples to apples" comparison of the comparable sales to the subject. The typical unit of analysis is price per square foot or acre of land, price per square foot of building, or price per unit (for apartments or hotels). Sales are selected that were purchased with the intent to develop the same highest and best use as the subject.
Adjustment to the sales should reflect similar issues addressed in the highest-and-best-use analysis, including parcel size and shape, zoning, and utility availability. In addition to these factors, two other issues must be explored. The comparable sale must be adjusted to account for timing of the sale. For example, a sale that occurred three years ago should be adjusted for market changes, including the real estate market, inflation/deflation, and interest rates. Also consider financing, since land sometimes is purchased with seller financing as an inducement, resulting in a higher price.
The adjustment process is subjective, but is required to provide an analytic framework. For example, the subject property may be five acres in size and a comparable sale 2.5 acres. The analyst should consider that the market will pay less on a per-acre basis for a larger land parcel than a smaller one. But, even though the sale is 50 percent of the subject size, it is unlikely that a 50-percent adjustment would be warranted.
Adjustments to comparable sales should be made in the inverse to the subject property. For example, if a comparable sale is considered superior to the subject property, the sale price of the comparable sale would be adjusted downward. Adjustments typically are made on a price or percentage basis.
The adjustment process provides the analytical framework and discipline to consider all of the diverse factors that influence a site’s value.
A second valuation method—though far less frequently used—is the residual method. The value of a finished building is estimated and the cost of physically constructing the building, including the builder’s profit, then is deducted. The remaining (residual) amount then is attributed to the land. The residual method is not commonly used, as the cost of construction adds another variable that is inherently difficult to quantify. However, the residual method does provide an alternative to the sales comparison approach when no comparable sales can be found.
For a large land parcel, where subdivision into smaller individual parcels will take place, the typical valuation method is to utilize a discounted cash-flow analysis. Subdivision analysis is used not only for single-family tracts, but also for larger multiuse planned unit developments, retail parcels with outlots, and industrial/ business parks. This analysis will take into account the cash flows received from the sale of individual parcels over time and discount those proceeds back to yield a net present value.
The analyst must be aware of four critical factors. First is the estimated timing of parcel sales and the value/price increase assumptions. Next is to account for holding costs, including infrastructure improvements, real estate taxes, special assessments, marketing and management, sales commissions and closing costs, and special assessments related to infrastructure bonding. Third, the analyst must estimate the absorption period of individual parcels. Finally, an appropriate discount rate must be selected and applied to the cash flows over time (available from published sources or from interviews with investors). A discounted cash-flow analysis is prepared, taking into account these four factors, to yield a net present value of the site.
The discount rate for raw land should, by nature, reflect the high degree of risk inherent in this investment type. For example, a discount rate selected for an A-rated triple net lease tenant would be considerably lower than for a land deal. A land deal carries a high degree of risk, including sale risk, lack of predictable income stream, timing of the income, and carrying costs. Often, selected discount rates for land deals will exceed 20 percent.
When valuing raw land, an analyst must use subjective judgment to consider a wide variety of factors. Brokers can earn a fee ranging from a few hundred dollars for a simple parcel analysis to more than $5,000 for more complex assignments. However, various states have regulations regarding valuation services. To accurately determine the highest and best use, outside professionals often are required and a landowner may be unable or unwilling to manage the process. A broker also can earn a fee for coordinating the process—including the oversight of engineers, surveyors, and environmental specialists.