What's the Value of the Land? By Kenneth J. Jones, CTA, SCGREA Director, Chief Instructor of the Institute of Real Estate Technologies The valuation of a parcel of vacant land is arguably one of the most challenging, complex assignments which can be undertaken; it can be likened to the artist standing before a blank canvas asking, "What can I make of this vacant space?". There are numerous, seemingly countless possible categories of considerations which include 1) all of the possible and probable legal uses to which a parcel of land might reasonably be put, 2) the physical constraints of the tangible land such as its location, topography, shape, accessibility, mineral(s), ecological/environmental limitations, availability of utilities, as well as 3) the economic consideration of measuring market supply and demand factors for certain specific types of developmental potential, if any. Let's remember that, for appraisals that are being made for the purpose of estimating Market Value (as defined in USPAP), it is the duty of the appraiser to estimate the reasonably probable price that a typical buyer would be most likely to pay, and that the typical seller could reasonably anticipate receiving as payment as of a specific date, with both parties being well informed or well advised as to all of the uses and limitations of the parcel of land in question, and that both would be acting in what each believes to be their own best interest without the influence of undue stimulus. What's so important about reminding ourselves of the USPAP Market Value definition is, that it serves to remind us that it's the appraiser's responsibility to arrive at that value estimate by means of the same valuation technique(s) employed by typical market participants, because, failing to do so may likely result in a considerably different final value estimate than would be reached by those typical market participants. As a point of fact, while land valuation assignments tend to require the gathering of copious amounts of data and their analyses, which is no small task, all too often the tremendous effort expended in that process is wasted because of substantially inaccurate conclusions of value resulting from the application of an inappropriate valuation methodology; the valuation methodology almost exclusively used by appraisers in the valuation of all vacant land is the sales comparison approach, an over-simplistic methodology that often fails to account for underlying economic influences that tend to determine the price paid for land. Worse, is that it's also out of touch with the manner in which actual market participants arrive at the value of land which typically involves their consideration of the certain economic factors beyond mere supply & demand. A further complication caused by this problem is that the inaccurate valuation estimate then tends to carry over into inaccurate conclusions of highest and best use. However, before getting into the discussion of more appropriate land valuation concepts, we should first acknowledge a market reality, which is that, virtually all land transactions that meet the USPAP definition of Market Value tend to fall into 1 of the following 2 general categories: 1) Land which is bought with the intention of immediate development for a specific use, hereinafter being referred to as productive land, and 2) Land which is bought without the intention of immediate development for a specific use, rather, being bought with the intention of keeping it in its current vacant state for an indeterminate time until such time as the market would demand that it be developed for a currently undetermined use; perhaps to be considered a speculative purchase, hereinafter being referred to as non-productive land. In order to enable us to understand the different techniques used to estimate the value of either productive or non-productive land, it will also be necessary to acknowledge the fundamental concepts of our general economic system which, including the real estate market, is embodied within the Classical Economic school of thought that recognizes that there are 4 components or agents, all of whose individual presence are essential to the production of anything; these 4 components/agents, commonly referred to as the Agents in Production, are Labor, Capital, Coordination (Management) and Land. Under this, our system of economics, we recognize that the value of the Land component/agent is residual, meaning that, when the total sales price for the item produced is received, the value of the Land component/agent is what is left over after paying for the costs of Labor, Capital and Coordination (Management); the residual value attributable to the contribution of the Land component/agent in the creation of the item produced is referred to as Excess Productivity. This leads us to the realization that we should also have a working understanding of the economic principle of Contribution, or Contributory Value, which recognizes that, a component of a whole entity only has value to the extent that it contributes to the value of that whole OR by the amount which the value of the whole is diminished/reduced by the removal/absence of that component. In consideration of the productive and non- productive vacant land sales, the questions to be answered are: 1) What valuation technique/concept is typically used by typical market participants when transacting productive land? 2) What valuation technique/concept is typically used by typical market participants when transacting non-productive land? 3) What are the underlying economic concepts of each? 4) How and why do they differ from each other? NON-PRODUCTIVE LAND: Of the 2 categories, the more easily addressed is the valuation technique and underlying economic concepts most commonly recognized by typical participants in the transaction of non-productive land. As we've established, non-productive land is not being bought for the purpose of immediate development, rather, to be held for an indeterminate time to be developed with improvements of an undetermined nature, thus, it could reasonably be said that non-productive land tends to be bought for speculation. Therefore, 1. Since typical market participants in this type of transaction tend not to consider any definable economic factors/influences, other than those of general supply and demand, in the process of negotiating and arriving at a price which concludes in the meeting of the minds, and 2. Since these typical market participants tend to solely rely upon the prices paid for other parcels of vacant land which fall within the same category of non-productive/speculative transactions, compensating/adjusting those sales prices for physical, financial, and legal differences between the transactions of the sold parcels and that of their subject parcel, there cannot practically, nor ethically be any other way in which to estimate the present value of non-productive land than to emulate the valuation methodology of the typical market participants whose described valuation methodology can be emulated through the application of the sales comparison valuation methodology. PRODUCTIVE LAND: Having recognized that emulating the actions of typical market participants is both the role and responsibility of the appraiser, then, adherence to this ethic requires the appraiser to consider and explore the possibility that sales prices/values for both types of land transactions (productive and non-productive) might not be arrived at using the same valuation technique. The existence of this possibility, therefore, mandates that the appraiser explore and understand any and all other valuation techniques/concepts that might exist so that the appraiser can employ those methods in carrying out their ethically competent and legal responsibilities when undertaking the appraisal assignment of both productive and nonproductive land. Having explored, analyzed and participated in transactions of both productive and non-productive lands, I've found it a general truth that typical market participants involved in productive land transactions consider land as a component part of a greater entity using the same concept as previously described in the classical observation of the Agents in Production. The following scenario duplicates a common daily occurrence of the practical application of this methodology: From a current market analysis, a developer believes that there may be sufficient market demand to warrant further economic study into the possible construction of a 20,000 SF retail strip shopping center along a major traffic route. Based upon his research, the developer concludes that, at a market rent of $14/SF plus tenant paid Common Area Maintenance (CAM), tenant paid proportional property taxes over the base year, and tenant paid utilities, the proposed building will achieve a stabilized occupancy of 90% at completion of construction into the foreseeable future, and the developer estimates landlord operating expenses at $3.35/SF. Using the income capitalization valuation methodology, the developer estimates the value of this proposed strip center, when completed and in place with stabilized occupancy, will be $1,540,000. The developer estimates that all of the costs and expenses, including his entrepreneurial profit, to create this proposed building and attain stabilized occupancy will total $1,153,000, excluding the cost of the land. To determine the maximum amount that the developer can afford to pay for the land, being the amount of its productive contribution to the value of the whole entity, the following process is undertaken: Estimated Value of Completed Entity: $1,540,000. Less: Hard & Soft Costs (Labor): ‹1,000,000› Interest on Construction Mortgage (Capital): ‹53,000› Entrepreneurial Profit (Coordination): ‹100,000› Land (Excess Productivity): $387,000. Assuming the proposed improvement and necessary site improvements require a 2 acre site, the developer will research the market for offerings of land in the immediate area which will support the needs of this proposed project. He'll soon know the asking/offering prices of sites suitable for his project and, depending upon those asking/offering prices may find a bargain among them, which frequently indicates an inadequately informed seller, upon which the developer will seize, or he may alternatively find that the asking prices are far above the economic capacity of his project, again, perhaps, indicating uninformed sellers, or the possibility of an infeasible project proposal, and will forego its creation. VALUE INFLUENCE FROM UNDERLYING ECONOMICS: The contributing value of a given parcel of vacant land is its Market Value when the improvements upon it create an overall entity that produces the highest possible value of the land. However, as seen in this example, the value of the land, which is totally dependent upon the income generated by the greater entity, is substantially influenced from the income which can vary widely depending upon such things as: 1. use, 2. quality of construction in terms of materials, design & finish of the improvement(s), 3. quality of tenancy, 4. general supply & demand conditions for the type of improvement proposed, as well as 5. general economic conditions that impact the businesses that would typically occupy the proposed improvement(s). Evidence in the market of the contributory value of land to the total value of the whole entity is all around us. Take, for a common example, the substantially higher prices for land typically paid by major fast food chains as opposed to other potential users of the exact same site; it's not uncommon to see these major chains pay double or even triple the prices that would otherwise be considered reasonable by other potential users. If you've ever asked yourself, "Why?", you now have the answer. These major fast food chains see the land for what it is, a necessary agent in the production and sale of its product. Since major fast food chain stores frequently generate income dollars many times more than other potential users, frequently into the multi-million dollar range from a single location, the value of the land component is determined as the residual of all costs of doing business and reflected as a percentage of the potential gross income from the site based upon a predetermined formula; a text book example of the economic principle of contribution. It should be evident that there is more than 1 way to estimate the Market Value of a parcel of vacant land. It should also be clearly evident that applying an inappropriate valuation methodology is likely to result in an inaccurate value estimate, as well as an incorrect conclusion of highest and best use, which results in the following ways: 1. Applying the sales comparison methodology instead of measuring the value of the economic contribution of a parcel of land whose highest and best use is for its immediate development with improvements of the same use as those created on the sold sites, although with differing economic potential. eg: A 2 acre site was sold for $645,000 and subsequently developed with a 20,000 SF retail improvement which was functionally super-adequate for its market. Instead of generating the $15/SF absolutely net with a 90% stabilized occupancy rate, the forecast upon which the developer based his purchase price of the site, the building is actually generating only $14.50/SF with only partial tenant expense contributions netting $9.80/SF at 87% occupancy which appears stabilized. If we assume that the subject of our appraisal is the 2 acre parcel in our earlier example, and if we relied upon this and other recent sales of sites with no other apparent differences, all of which were put into immediate production (productive land), we would rapidly find ourselves in the common dilemma of trying to determine why their was such a variance in the overall and unit prices among these sales. Further, unless we had knowledge of all of the underlying economic factors upon which each sites sales price was determined prior to the purchase, and all of the actual subsequent economic performance of the subsequently created entities, we could have no idea of the reasonableness, and perhaps the competence of the developer, nor would we have a clue that the developer of our so-called "comparable" sale both over-built the improvements and under estimated the NOI resulting in his substantial over-payment of the site. 2. Applying the sales comparison methodology instead of measuring the value of the economic contribution of a parcel of land whose highest and best use is for its immediate development with improvements of a different use as those created on the sold sites. The best example is the common error of comparing the sale of a parcel of productive land whose sale price/value was determined by a its contributing economic value to a whole entity which produces either a substantially greater or lesser value than that to be created upon the subject parcel. eg 1: Comparing the sale of a 1 acre parcel of vacant land sold at $500,000 with no other value influencing difference than the fact that it was put into immediate production by a major fast food chain as a retail outlet, then viewing this sale as being "comparable" to your subject, which is a 1 acre parcel that's going to be developed with an single unit owner occupied retail carpet outlet. eg 2: Comparing the sale of a 1 acre parcel of land sold at $120,000 with no other value influencing difference than the fact that it was put into immediate production by a local entrepreneur for use as a used car lot, then viewing this sale as being "comparable" to your subject, which is a 1 acre parcel that's going to be developed with a multi-unit, 2-story structure housing 2 retails on the 1st floor and 2 professional offices on the 2nd floor. In these 2 examples we can see that the land is likely to have a very different contributing value to each of these 4 users, all of which represent the highest and best use of each site. In turn, the contributing value of the land is reflected in the sales price of each site being reflective of the value of the land component as an agent in the production of the overall income. 3. Applying the sales comparison methodology using non-productive land "comparable" sales when the parcel being appraised has a highest and best use as productive land; a highest and best use for its immediate development with improvements. This error will undoubtedly result in a substantially lower value than would reasonably be arrived at by the typical market participant who would recognize the higher value of the subject parcel in its contribution to the productive use of the site. While it's relatively common to find this occurrence in the appraisal of vacant land, it's a very dangerous position in which an appraiser finds him/herself having arrived at a value estimate based upon inappropriate data and methodology that could substantially alter the benefit or liability position of their client. Such an occurrence calls into serious question the competence and, perhaps, the ethics of the appraiser who could reasonably be perceived as either being incompetent or an advocate for his/her client, neither of which is a lesser evil. 4. Attempting to apply the principle of contributing value in the appraisal of a parcel of non-productive land whose highest and best use is for it to remain vacant for an indeterminate period of time until such an indeterminate time in the future when the market demonstrates sufficient demand for its development with improvements that would represent its future highest and best use that are currently unknown. This error will undoubtedly result in a substantially higher value than would reasonably be arrived at by the typical market participant who would recognize the lower value of the subject parcel based upon the lack of economic evidence necessary to support the development of the site as put forth by the appraiser. Unlike the example in number 3, it's relatively difficult to sustain this type of an occurrence in the appraisal of non-productive vacant land, since, in order to reasonably support a highest and best use conclusion that it be developed with improvements, it's absolutely essential for the appraiser to provide reasonable market evidence to demonstrate both the demand for that improved use, as well as the underlying economic feasibility which would support its creation. Given the remote possibility that an appraiser would attempt to fabricate or substantially distort factual market evidence, it would be an even more dangerous position in which an appraiser would find him/herself than in the case of number 3; having arrived at a value estimate based upon either inappropriate or non-existent data, then using a methodology that could substantially alter the benefit or liability position of their client. Such an occurrence would necessarily call into serious question the ethics of the appraiser, although lack of competency should not be ruled out. So, when someone asks, "What's the value of the land?", you now know there's much more involved in coming to that answer than most people are generally aware. Remember, if you ask the 1st basic question that must be answered, "Is this land productive or nonproductive?", you'll probably have little problem in determining the appropriate valuation methodology. From there, it's a matter of becoming educated on the valuation methodology and putting it into practice. | 
