I've included this article since it discusses some real life situations you will encounter in real estate and the appraisal business. This article is reprinted with permission from Ken Jones.
What's the Value of the Land?
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 and 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?
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.
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.
Hard and 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.