Appraisal Matters

So up to know I’ve explained the what, but not the how.  Let’s fix that.

How I Would Handle the Value Range Problem

Using our $15,000 to $70,000 per acre sale range example, what I would do is create a ranking table for the subject and the sales.  I’d rank each feature on a 1 to 5 scale.  The total would give me some idea of how each sale compares to the subject and every other sale.  But that’s just a start.

One key thing is missing from the above.  All of the characteristics have the same weight using a simple scaling grid, but that’s not the way market participants think.  One purchaser might view soil with a greater weight than another and so on.  In your verification, try to get that type of information.  What characteristics did they consider to be more important than others?  When you’ve verified all your sales and gotten this type of information, you might see some market tendencies.

Another question you can ask is whether the purchaser found out something after the fact that would have changed their purchase price.  “If you were to buy the property back then knowing what you now know about it, would you have paid the same price?”  That’s a key question to ask.  If the answer is “yes”, you’ve found support for an adjustment.  You’ve found support for a ranking weight adjustment.  You’ve also explained why there may be some outlier sale price per acre and how to handle it.

A Check and Balance

There is a little technique that you can use to provide a check and balance on your final value conclusion.  I call it the the land to gross sellout ratio.  It’s really just a builder’s rule of thumb.

If you find out the sale prices of the homes a developer intends to build on a site (or better yet, the prices for what they actually built), add them up.  You can also take an average.  That’s the denominator.  The numerator is the sale price.  Then just do the math on your comparables and look at the range.

Let’s do an example.  You see that a developer bought a property for $100,000 and expected to build five homes that will sell for $200,000 each.  That’s $1 million in revenue.  Taking $100,000 and dividing it by $1 million is 10 percent.  You’re saying that raw land is worth 10 percent of what the income will be.  Let’s say we have four other sales with ranges between 7 and 15 percent.  Now that’s a range you can work with!  If you conclude a market value that would have a land to gross sellout ratio of 11 percent, you could simply put together a quick table that shows the ratios for your sales and where your subject fits into the matrix.  Maybe 11 percent falls in the second position of the five sales if you ranked their ratios from low to high, for example.  You’re in the range and you’ve supported your conclusion.

I use this technique whenever I appraise residential subdivisions.  I explore it in depth in my upcoming Subdivision Analysis online seminar I’m developing for appraisal education provider McKissock (a shameless plug, I’ll admit:)  Still… the point is that you can reconcile a huge range in sale prices by proper due diligence, considering intangible sale factors and using these two techniques.  Appraising vacant land doesn’t have to be that risky, even though land development is.

John Simpson, MAI

Let’s take a look at the land from its futuristic orientation.  By that I mean that the property will have to receive approvals, site improvements, building improvements and find users (tenants and/or owners) that span a substantial amount of time into the future, usually years.

Risky Business

Even children know that anything that takes years to come to fruition is a lot riskier than something that exists today.  A bird in the hand is worth two in the bush, as they say.  The word “future” is synonymous with risk.  The longer you have to wait, the more variables can get in the way to change your chosen path.

Many aspects about development risk you already know quite well.  Every one of us knows that the economy can change, sometimes for the worse and sometimes for the better.  Let’s add a change in supply to the list, not as in land supply but as in home or end-user building.  While you’re in the process of obtaining approvals for development, some major national builder may decide to start building in the same town.  Maybe they’ll start building next door or across the street.  National residential home builders prefer to buy lots from subdividers (developers who buy raw land, obtain the approvals, install site improvements and then sell the whole project to home builders), so if there’s something already in the pipeline, it doesn’t mean the developer who is trying to obtain those approvals will developer their own homes.  So, surprise… XYZ national builders is going to open up and turn your lovely project from profit to loss.

Another risk factor is the unknown of the approval process.  Maybe you’re the lucky one who is trying to obtain approvals for a subdivision that houses a roosting area of endangered birds.  Maybe you didn’t know the land had an environmental problem; you did pay for a Phase 1 environmental site assessment before you bought it, right?  Perhaps you didn’t know the water table was so high.  What if your conceptual use doesn’t fit into the new Master Plan that just came out and was voted into law?  Maybe you need financing and the lenders just aren’t lending (we’re now all experts in that).  Could a natural disaster happen that changes the way governments view new development?  This is only the “short” list… I didn’t want to strain my fingers.

How Developers View Risk

For developers, it’s really quite simple.  The higher the risk, the higher the profit they need to make the time, effort and cost worthwhile.  That’s why entrepreneurial profit is included as a line item in any cash flow projection.  Still, there’s a relationship between the discount rate used in the subdivision development method (which is a risk rate) and entrepreneurial profit (the return for taking that risk), so there’s a trade-off.  Raising the discount rate and lowering the entrepreneurial profit has the same basic effect as lowering the discount rate and raising entrepreneurial profit.  Of course, the amounts are important, too, but I just wanted to put that fact out there for thought.

Back to Appraisal Theory

So getting back to the appraisal arena, future risk means the following:

• A higher discount rate if you perform the subdivision development method
• A strong tendency to use historical sales data to avoid the nebulous nature of the future
• Dismissing listings that are available today but may not be in a year or two
• Higher allocation for entrepreneurial profit

This all sounds good, but when you are faced with, say, five land sales that range between $15,000 and $70,000 per acre and you can’t see a physical difference between them, how does the above help?  Well, owners view risk differently.  They have different levels of expectations for how their dreams will turn out for the property; as a result, entrepreneurial profit expectations vary.  They view locations differently too.  In other words, there are many subjective elements that explain differences in land values between comparable sales that y0u never see in improved property transactions.  Even though we appraisers have to assume “competent” and “knowledgeable” buyers as part of the definition of market value, this is frequently not the case when it comes to land purchasers. This is where verifying the sale comes into play.

This argument is the single most important aspect that is typically left out of an appraiser’s report.  Why were these particular sales presented?  What sales were excluded?  Why?  How would the market and market participants view this property?  How did they view the sales?

By not answering these questions, the appraiser can wind up selecting a market value in the aforementioned example range of $15,000 to $70,000 per acre that could be way off.  That’s why land valuations are inherently harder than improved property valuations and why the appraiser’s business risk is so much higher.  There’s just a lot of variables for the appraiser to deal with.

In Part 4, I’ll explain how I would handle all these variables… assuming I got paid well enough to do so.

John Simpson, MAI

As indicated in Part 1, there are lots of things that can be wrong with a piece of land that will impact its development potential and its value.  I’ve already covered many of the key reasons in the following posts:

• Soils – The Realities of Marina Land Part 2
• Wetlands – The Realities of Marina Land Part 3
• Tidal Wetlands – The Realities of Marina Land Part 4
• Flood Zone and Zoning – The Realities of Marina Land Part 5

Ah, but I’ve only just begun to scratch the surface… so to speak.  Let’s add some more topics to the list.

Soils Redux

Although I talk about soils in the above marina land blog, there’s a lot more to say.  They are important for another reason – growing crops.  Agricultural land is a whole world different than what I call development land.  Whereas agricultural land is all about crop yields and crop types (mostly due to the soil; we humans can change everything else), development land is all about the number of lots you can get from it (generally for residential homes).  It’s like the difference between a science and an art.  I’ve found agricultural purchasers are extremely knowledgeable about soil (the science) and developers are knowledgeable about home building (the art).  As you might guess, my point is that they are two different markets and they deserve to be treated as two different highest and best uses.

Water Table

The closer the water table is to the surface, the less chance you’ll be able to build a basement or an underground parking garage.  Pretty simply, huh?  I’m sorry to say that appraisers aren’t engineers and we just can’t consider this except on the rare occasion where we have a small lot and a study is already made available to us.

All of these things affect whether the land is fully buildable or has excess land or surplus land.  It’s important because surplus land does not have a market value anywhere near buildable land/excess land.

Access

Most people don’t view access as a big deal.  As long as there’s a road, there isn’t a problem.  Although the exception to the rule, if you don’t have good access, your property will suffer.  Case in point the residential “paper lot” subdivision that was approved but couldn’t get the county to extend the road.  Another example is the property that was not allowed a single driveway access because the New Jersey Department of Transportation forbade it (because there was a limit on the number of driveways that were permitted on the highway and it was over the limit).  Yes, these were valuation assignments of mine.  It’s the difference between developable and undevelopable land and a big market value versus a tiny one.

The Rest of the List

I could go on one site feature after the next, but I think you know the basics.  You get the idea.  What’s important is that you need to check that whatever the feature is that it doesn’t impair the value, use or marketability of the property or anything you will develop on it.  I suppose that summarizes the physical characteristics investigations.

The point is it takes a long time to make the necessary phone calls and inquiries to determine if there isn’t a problem.  This is another reason why valuing vacant land is harder than improved properties.

In Part 3, I’ll delve into risk and future development potential.

John Simpson, MAI

There is one very, very large disconnect between owners/purchasers of vacant land and appraisers.  It’s so large that it’s the reason why I do few vacant land appraisals.  The disconnect is that owners/purchasers of land think appraising it is easy and just because it’s vacant, the appraisal fee should be less than an improved property.  This is pure fantasy because one of the hardest property types to appraise is vacant land, for reasons I shall explain in detail.

It’s What You DON’T See That Makes It Difficult

Let me itemize most of the reasons why appraising vacant land is more difficult than appraising an existing commercial property:

• The zoning will likely allow many uses such as office, industrial, apartments, retail or some other types.  That’s a low of possibilities to consider whereas with a commercial property, what you see is what you get.  Appraisers often need to test each use and each use takes time to i investigate the rental rates, operating expenses, capitalization rates, etc.
• In addition to “principal permitted” uses, there are also “conditional” uses and “special exceptions”.  The latter two require some degree of additional local governmental approval, which can range from easy to impossible.  It takes time to do the research.
• For each type of use, the range of potential improvements is staggering in number.  There are many variances on the themes of townhouses, single family homes, apartments, shopping centers or other commercial properties.
• It may look like a simple piece of land but there can be a whole bunch of things wrong with it that will greatly constrain what you can build there, if anything at all.  Each of these things takes time to research.
• There is no cash flow generated from the land (I’m assuming no land lease), so you’re looking into the future for all incomes and expenses.  That future may be years off.  We all know how cloudy the crystal ball is when you ask it to work overtime.
• The “market” is made up of many prospective buyers.  If you put ten of them in a room, how many would see the property’s development potential differently?  If you answered ten, you get a gold star.
• It is not uncommon to have things outside the boundaries of the property greatly impact the development potential.  The best example is a municipal moratorium on water and sewer.  No water, no development.  No sewer, no development (in most cases).  You get the point.

It’s worth mentioning again that even with all these items, market participants expect appraisal fees to be lower than improved properties.  Since it’s so difficult to develop vacant land, why should the appraisal fee be lower?  The reason is simple – appraisers can’t get more money for their analyses, so what they do is cut all the corners they can.  The result is almost always a product that can’t stand up to the scrutiny of a good review appraiser.  You get what you pay for in America.

In Part 2, I’ll dive into what can be wrong with a piece of land that affects its development potential and adversely impacts its value.

John Simpson, MAI