Conditional and Grandfathered Uses Complicate the Appraisal Process By: Timothy A. Rye
Conditional and Grandfathered Uses Complicate the Appraisal Process
Timothy A. Rye
Introduction
From time to time, appraisers are engaged to value properties impacted by conditional use permits (C.U.P.s) or grandfathered use designations. For properties of this nature, it is a challenge for the appraiser to appropriately identify and assess the effects of the C.U.P. or grandfathered use on market value.
Conditional use permits allow city planners to regulate specific uses that are not generally desirable in certain districts and do not conform to current zoning ordinances. Planning commissions may approve a specialty use in a specific location if it complies with the majority of the conditions and standards of the area and fits into the scope of the city's master plan. Prior to granting a conditional use permit, city planners review development plans and assess possible impacts on existing and future businesses. The zoning committee may also require that additional restrictions are met before issuing a C.U.P.
If, for example, a business owner desired to establish an auto repair facility (commercial use) in an area zoned for warehouses (light industrial use), he or she would apply for a conditional use permit. While an auto repair shop does not meet the city's zoning criteria for business parks, it is not a completely incompatible use. Because the potential for large open areas of parked cars and auto parts exists with this use, but is not allowed under current zoning ordinances, the business owner and the city planners will lay out the conditions under which a C.U.P. will be granted.
While C.U.P.s regulate and control new property uses which do not conform to current zoning standards, grandfathered uses allow businesses already in place to continue operating. Consider what happens when the city takes land from a property owner for road expansion. A building on the affected property, previously in conformance with zoning laws, may now be located too close to the property boundary. It violates new setback restrictions and no longer meets the zoning requirements. Cities often employ the grandfathered use provision of the zoning code to authorize continued operation of a non-conforming property.
Communities rely on standards of development and special permits to facilitate their long term development plans. A grandfathered use designation could prevent/encourage redevelopment; it may mitigate the impact of an eminent domain taking. A grandfathered use permit may also define the terms under which the business can continue to operate before it must come into compliance with current zoning requirements. The city's vision does not always mirror the vision of a property owner, developer or the market itself. A property operating with a conditional use permit or a grandfathered use permit may be viewed as an asset or a liability in the market. Quantifying this premium or discount presents a unique challenge for owners, managers, attorneys and appraisers. The following discussion illustrates how an appraiser identifies and measures the impact of a special use permit or a grandfathered use designation on a property's value.
Valuing Property Impacted by a Conditional Use Permit
The appraiser must have a thorough understanding of all the facts in order to quantify any enhancement or discount to the property value that is a result of a conditional use permit. In order to measure the impact of the C.U.P., it is necessary to determine exactly what the permit allows or restricts. Following discussions with city officials and a general review of the zoning codes, the appraiser focuses on the conditional use permit section of the city's code. He/she must now determine whether the conditional use permit is restrictive or permissive. A restrictive conditional use permit allows the non-conforming use but places physical restrictions such as size, height, parking, screening, noise, etc., on the business - an inward focus on the property. A permissive conditional use permit also allows the non-conforming use within the zoning class but, in addition to restricting physical characteristics, it also places conditions on where, within the zone, the business may be located - an outward focus on the property. For example, the non-conforming business may be subject to distance requirements between it and other businesses: as in the restriction that a pawn shop be at least one mile from a public school. Once the city agrees to issue a conditional use permit, the owner must prove that all restrictions have been met and that neighborhood approvals have been obtained. These challenges may limit the number of permits actually issued.
The ease or difficulty of obtaining a C.U. P. reflects on the economic potential of the permit itself. The appraiser must understand the basic supply/demand equation for a particular use: how often are requests made for a given C.U.P. and how often are they granted?
Consider an industrial property with an open yard storage conditional use permit. Does the city limit the number of such permits in a given area? Is there a demand for additional such permits? Is there neighborhood opposition to additional open yard storage permits? If supply does not equal demand, the conditional use may truly be unique. If no other property can function in the same capacity in the area, the C.U.P. may provide a measurable premium or benefit to the property owner.
It would seem that if the market supports the non-conforming use, it is an indication that the C.U.P. has a positive economic effect on the subject property. However, the relationship is not so easily defined. To illustrate the complexity of zoning variations, let's compare two properties which are identical except that one has a C.U.P. and the other does not. Assume the following facts:
* The property is zoned commercial; casino use is prohibited within the commercial zone, but is allowed with a conditional use permit;
* Video lottery casino conditional use regulations require connection to a commercial zoning district as well as an attached on-sale liquor license;
* Additional requirements do not allow casino use within 2,000 feet of schools, churches, other casinos, bars or day care facilities;
* The C.U.P. relates to the land and cannot be moved;
* Market is made up of 200 video lottery casinos in the town many of which are non-conforming uses (operating under grandfathered use status due to zoning code changes).
When supply meets demand, market values are stable creating economic equilibrium. If supply is high and demand is low, equilibrium is not achieved and prices will fall until supply equals demand. Based on the location restrictions in our assumption, only a handful of sites legally permitting a new casino remain in the city and those locations have already been eliminated as a result of neighborhood opposition. Thus, supply is limited or fixed and, as demand increases, we would expect prices to increase as well. Such a price increase may be considered a premium resulting from the C.U.P. restrictions. This hypothesis can be tested by comparing the general market rent levels in the area which are not supported by video casino sales to market rent levels in the same area which are supported by sales activity in video casino sales. Following, are two scenarios for valuing a commercial property. Using the assumptions outlined above, Scenario I is based on a typical commercial building without a conditional use permit for a video casino and Scenario II is based on an identical commercial building with a conditional use permit allowing a video lottery casino use.
Scenario I:
Assume a general purpose 1,000 square foot commercial property with no conditional use permits. It is located in an average retail area with no deficiencies or superiorities. We will use the income capitalization approach to determine market value. The standard income approach for this type of property is derived by capitalizing a net operating income which is based on market rents.
If retail comparables in the area indicate a market rent of $10.00 per square foot net of expenses, the gross income for the subject property is $10,000. We assume a 10% loss for non-reimbursable expenses, resulting in a net operating income of $9,000. Applying a capitalization rate of 8%, the calculation of market value, using the income capitalization approach, is as follows:
$9,000 ÷ 8% = $112,500
This estimate represents a typical market where supply and demand are at equilibrium. It serves as the baseline value for estimating the economic impact a conditional use permit has on market value.
Scenario II
In Scenario II, we consider the same 1,000 square foot commercial building, in the same retail market but with a video lottery casino conditional use permit. It is one of 200 locations allowed to operate as a video casino lottery. In order to apply the standard income approach to the subject property with its C.U.P., we must look for comparable market rents which reflect the change in use. There are few sales of video casino lotteries indicating that they do not often change hands. While the building itself may still function at the rents used in Scenario I, the property now has a different use which results in a significant change in market rent.
For illustrative purposes, let us assume a market rent for casino properties of $30 per square foot net; the gross income for the subject property is $30,000. Based on a 10% non-reimbursable expense rate, we calculate a net operating income of $27,000. Applying a capitalization rate of 8%, the income capitalization approach produces the following value:
$27,000 ÷ 8% = $337,500
The above estimated value clearly indicates that a premium over the typical market exists. It is important to figure out why the premium exists and how accurate our assessment of the premium is. Because video casinos function like other retail properties, we know there is a relationship between sales revenue and rent. One way to quantify that relationship is through a percentage of sales analysis.
A percentage of sales analysis allows us to determine rent; from the rent, we can determine the value. Rent is derived from a percentage of gross revenues of the business in the space. The appraiser may use industry recognized percentages, for example fast food stores use percentages between 4% and 6% with the lower percentage applying to stores with higher per square foot sales and the higher rate to stores with lower sales per square foot. Percentages can also be determined through open negotiations when an industry standard is not available. This is effective for unique uses that cannot rely on industry standards.
In Scenario I, our typical market retail property had $10,000 in annual gross income. If we work backwards, we can use a percentage of sales to determine the level of revenues represented in the typical retail market. Using 6% of sales ($10,000 ÷ 6%), we calculate $166,667 in gross sales revenues. In Scenario II, the video lottery casino showed $30,000 in annual gross income. Using a 6% of sales ($30,000 ÷ 6%), we calculate $500,000 in gross sales revenues. Annual sales in our two scenarios are strikingly different, with the general retail property generating roughly $166.67 per square foot in sales and the video lottery casino generating $500 per square foot in sales.
Investors and property owners recognize that a specific property location or use may benefit the operative business on the site. When this is the case, an effectively crafted lease will reflect this premium. Some of the revenue premium returns to the property owner in the form of higher rent. An in-depth analysis of actual financial statements for businesses similar to our Scenario II video lottery casino reveals the extent of the premium generated by the conditional use permit. Recently, we encountered a casino (featuring the above assumptions) with annual revenues of $600,000. Even if we consider $500,000 in annual revenues (Scenario II), as average and $600,000 (actual revenues), as above average, we still see a significant premium over revenues from the basic retail facility in Scenario I with its $166,667 in annual revenues. The only difference between the two types of facilities is the existence of the video lottery casino permit.
In our hypothetical situation, the value difference between a typical retail property ($166,667) and the casino property ($500,000) is $333,333. In this case, the premium due to the conditional use premium is $333,333. If we ignore the fact that there is a C.U.P. associated with this location, we severely underestimate the market value of the property. While most conditional use permits reflect simple variances from common uses and performance requirements, sophisticated investors recognize that a C.U.P. may significantly affect market value. Regardless of whether one is buying or selling, it is essential to have the property appraised. Industry standards and general due diligence requirements mandate that the appraiser base the final value estimate on the property's highest and best use. Appraisers, attorneys, brokers and owners who recognize that a conditional use permit impacts the highest and best use of a property will make the most of the premium or discount it generates.
Valuing Properties Impacted by a Grandfathered Use Designation
Grandfathered uses are created to accommodate current uses which no longer comply with new zoning restrictions or to assist property owners when eminent domain takings result in the current use becoming a non-conforming use. Either situation can significantly affect the property's revenue generating capacity or the economic life expectancy of its improvements and may result in redevelopment of the site to a higher and better use. Whether the impact is positive or negative depends on the nature of the non-conformity. Once again, we look to the supply/demand model to understand the market's reaction to non-conformity. Consider an existing industrial property with outside storage which fits nicely in the area. Due to zoning changes, that type of use no longer conforms to the standard. If the site in question is one of only a few locations allowing that use, demand may drive up the price a willing buyer would pay. In this case, the zoning change created a premium. Conversely, if a road expansion project reduces the existing on-site parking of a business to the extent that it is no longer sufficient to support the improvement, potential buyers may avoid the property resulting in a loss of value.
If a property is physically altered by eminent domain takings which make the improvements non-conforming, municipalities will often allow the use to continue. However, it is common to impose limitations on the length of the use by restricting or eliminating the potential to make modifications to the property, such as expanding or renovating. Many municipalities require that a property be brought back into compliance with zoning codes if renovation, repair (including storm-related repair), additions or other changes to the property equal more than 60% of the value of the improvement. Consider a 20 year old office warehouse building valued at $200,000 with a life expectancy of 50 years. Assume the owner is considering significant renovations in order to accommodate a growing business. Renovations will be in excess of $120,000 (greater than 60% of existing improvement value when land value is considered.) Further, assume the property does not have sufficient parking to meet zoning regulations. The property owner must bring the property into compliance with current zoning standards. Because site characteristics do not provide sufficient space to meet parking requirements, attempts to renovate the property will be abandoned. As a result of noncompliance limitations, the property owner suffers a loss of value. In this case, restrictions on the grandfathered use resulted in a discount to the property's value.
Sometimes, the opposite is true and the owner realizes a benefit from the grandfathered use designation. Recently, we valued a small meat locker/slaughter house enterprise that served local farmers and businesses. Zoning regulations have changed and this type of use is no longer allowed in the city. The property was allowed to continue operation as a grandfathered use. As a result, the subject business is the only location within the city limits permitted to conduct that business. The grandfathered use designation created a strong premium for the property due to significantly increased revenues over those in the typical retail market.
Conclusion
While conditional use permits and grandfathered uses offer the potential for significant premiums, they also create the potential for higher risk and/or reduced opportunity. When these issues present themselves, it is crucial that appraisers investigate all of the details that may influence the value. Extensive research of guide plans, redevelopment plans, comprehensive zoning plans, comparable property sales, etc. are part of the due diligence process. In addition, the appraiser must focus on the actual use and conformity as of the date of valuation. If the restrictions and permissions of C.U.Ps or grandfathered uses are overlooked or inadequately analyzed, the analysis is flawed. Basic economic principles suggest that property owners seek to reduce risk and maximize value. Buyers and sellers alike engage appraisers to assess the risks and benefits associated with potential transactions. Identifying the impact of a conditional use permit or a grandfathered use designation on market value is one part of the process of valuing a property; quantifying that impact is yet another. The appraiser is ethically required to thoroughly investigate and reveal, in his or her analyses, how the value conclusion was reached and why it is justified.
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