A Perspective on Subdivision Appraisal
By: Darrell V. Koehlinger and Stephen T. Hosch
Of all the real estate property types to appraise, one of the most challenging are subdivisions. Subdivisions are generally described as the division of land into two or more lots, parcels, or other divisions of land for sale or redevelopment. Although often associated with residential land development, subdivisions also occur on industrial, office, and retail property. Typically, developers submit subdivision plans to a municipal planning board for the purpose of reviewing and making recommendations on them. New subdivisions can be proposed for either land never previously developed or land under redevelopment. In conjunction with government officials, entrepreneurial developers propose and deliver new subdivisions to cities in accordance with the municipal vision for the land in question and overall civic land use policy.
Why Are Subdivisions Appraised?
The most basic question regarding subdivision appraisal is why is it done at all.
Because the most valuable asset of developers is their entrepreneurial energy, capital for most subdivisions comes from other sources. Typically, banks which have departments specializing in land development will loan money for subdivision development. The amount of financing extended to a developer is a function of (1) his own financial strength and (2) the value of the subdivision. Depending on the particular situation, the developer may have a minimum of his own money invested in the development. Because of the nature of the incremental subdivision value being created above raw land value and the preponderance of outside financing, the lender wants to collaterize his loan as accurately as possible. Thus, an objective appraisal may be required to determine how much money can be loaned with a high probability of being repaid.
A second reason subdivisions are appraised is to estimate market value of vacant land for potential sale or purchase. For example, a family farm in an outer ring suburb may be surrounded by new single-family residential subdivisions experiencing strong demand. The city's comprehensive plan has guided the land area encompassed by the farm for additional single-family residential development and the subject family farm is ripe for development. The farmer has been approached by local developers with numerous offers, and is not sure of what a fair price would be for his farm if he decides to sell next year upon retirement. The farmer may retain an appraisal company to aid him in potential negotiations with the local developers. A subdivision development analysis would most likely be utilized within an appraisal of this property in conjunction with recent vacant land sales that share similar highest and best uses.
A third reason subdivisions are appraised is usually more associated with redevelopment scenarios. Typically, when governments, in conjunction with developers, embark on a redevelopment plan for a formerly improved area, an enhanced tax base is one of the primary goals. A good subdivision plan informs municipal officials of the highest and best use of the land in question and guides overall planning policy, especially when tax increment financing (TIF) is involved. A solid and reasonable appraisal of a prospective redevelopment improves the overall decision making.
A fourth reason subdivisions are appraised is the scenario no one usually desires-litigation. Misunderstandings and unforeseen actions and events can easily derail otherwise reasonable expectations with sometimes catastrophic repercussions. When subdivision plans are altered or forestalled, it is common for one or many parties to claim damages. Lawsuits sometime follow and attorneys feel it necessary to hire objective experts to quantify their claims. An appraisal of a subdivision plan that was unfairly aborted, changed or delayed is often necessary. In difficult economic times, lenders sometimes repossess a subdivision that may have earlier offered great promise. A subsequent appraisal of a repossessed subdivision contains assumptions much different than were initially considered.
Basic Distinctions Between Subdivision Appraising and Other Types
Unlike most property types, a subdivision is sold off in small increments while it is under construction. In contrast, most other property types, such as office buildings or industrial facilities, must wait until final construction completion before a sale to an unrelated party is feasible and any profit can be realized. Most property types become more valuable as construction continues, while the values of subdivisions may rise and fall as more construction continues and the sales of completed lots progress. Subdivisions are front end loaded, in that substantial capital must be invested in infrastructure before any income can be generated from the sale of individual lots. In some ways, the appraisal of subdivisions is like the appraisal of any manufactured product, consisting of inventory (raw land), goods in construction (partial platted, graded, and utility installed land), and finished goods (completed lots). The appraisal of any subdivision reflects the value at any point in time of these three assets.
A primary difference between subdivision appraising and other types is the lack of comparable sales. If a subdivision sells off as predicted, the bulk value of the subdivision dissipates with time. It is extremely rare for a successful subdivision to sell in bulk unless its developer finds it necessary because of factors such as his lack of time to devote to the project and better opportunities elsewhere. Bulk subdivision sales (complete or partial) that do occur are often between related parties or developers and builders who have ongoing relationships. Banks may sell repossessed subdivisions, but these projects are not typically similar to proposed subdivisions having no negative track record and only optimistic expectations.
Another difference between subdivision appraising and other types of appraising is that while subdivisions are all about projected cash flow, one of the players involved, the developer, is typically notoriously oblivious to yield issues. Most subdivision developers in our experience simply do not think in terms of time value of money. While lenders are highly knowledgeable on these matters, most developers approach subdivisions in terms of simple payback and increasing their capital as the subdivision progresses without reflecting on discounting issues. A good appraisal of a subdivision must somehow combine the concept of investor's yield requirements with a developer's payback requirements.
Some Subdivision Appraisal Components
There are three basic components to subdivision values (1) raw land (2) development costs and (3) developer's profit and overhead. A traditional rule of thumb in residential subdivisions has been the "1/3-1/3-1/3" rule, whereby one third of subdivision value should be allocated to raw land costs, one third is allocated to development costs and the remaining one third goes to developer overhead and profit. Development costs are those involved with correcting soils, extending municipal utilities, making necessary road improvements, and obtaining permits and planning services. Developer's overhead and profit compensates the developer for out-of pocket costs during development, such as marketing, interim financing, office and personnel expenses, as well as a premium for the level of risk incurred during development. Our appraisal experience has been that this rule is becoming less universally true, with raw land and development costs increasing over their traditional percentages.
Of these three components, the most controversial in subdivision appraising has been the developer's profit after overhead has been estimated. There is little empirical evidence on what a reasonable level of developer's profit should be. Some appraisers argue that no developer's profit should be included in a subdivision cashflow. However, we believe that developer's profit is a valid component of subdivision appraising under the theory that any real estate investment should be appraised in a "hands-off" manner. Specifically, we believe that all real estate value includes an owner's or developer's profit or return on his investment, even if he is not one actually involved with most of the on-site activity.
Another issue with subdivision appraising is the selection of an overall yield rate to discount back the expected cashflows. There is no one right discount rate to select when appraising a subdivision. Discount rates or yields reflect the unique risk and return nature of the specific project and can change with time. The one truism about subdivision yields are that they should be at the high end of the real estate spectrum and reflect the greater risk of subdivisions as when opposed to office, industrial, and retail buildings, and at the most conservative end of the spectrum, high credit, triple-net corporate leases. Our office experience is that yields on subdivisions range from 10% to 30%. These yields should reflect the risk in inaccurately estimating important assumptions such as absorption time.
Subdivision Development Model
The following model demonstrates how one may value a proposed single-family residential lot subdivision, given a projected sell-off period of three years, lot prices starting at $30,000, developer's profit of 15%, a 14% discount rate and various other estimated expenses.
Conclusion
All subdivisions are unique, and must be approached independently by an appraiser in order to quantify the key components of value and the stage of completion. Depending on what component is being measured (raw land or developer's profit) and the stage of development (raw land, a partially improved subdivision, or a finished subdivision), different models may be implemented to provide the answer to a particular valuation problem.
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