Appraising Development Projects During Challenging Economic Times
Robert Strachota and Christopher J. Stockness (Shenehon Company) teamed up with Tom Gump (Neighborhood Development Partners) to produce this article for the Minnesota Real Estate Journal. The authors address the difficulty of valuing and marketing a development project in an economic downturn. Economic forecasters are guardedly optimistic as we enter the 4th Quarter 2008, but most housing studies indicate that we will see only a modest increase in demand for the next few years. Launching a successful development project in this environment calls for the use of strategic planning techniques. It is more important than ever that the planning team include an experienced appraiser to analyze and value the proposal to increase the chances of arriving at a unique, viable development project.
One only has to read the newspaper or watch the news to see how a troubled housing market and the general economic downturn have affected development projects.
Evidence of the weak economy is everywhere. Mortgage interest rates are rising foreclosures are up and the jobless rate is climbing. The housing market is grim and likely to get worse before it gets better.
During these uncertain times, it’s difficult to remain optimistic. There is a large inventory of available housing and new housing starts are at historic lows; investors, developers and lenders are reluctant to break ground on new projects. Those whose projects are already in the pipeline must decide whether to move forward as planned, put everything on hold or attempt to revise their plans. It’s safe to say that we are in the midst of an economic downturn — largely initiated by the troubled housing market — and no one knows when it will end.
For investors interested in launching a large development project, it is easy to buy into the doom and gloom of the current market and assume the worst. Money is tight, carrying costs are high and there are no guarantees that roads and utilities will be in place on schedule. Although not every development plan is feasible, strategic intervention at the onset of a project may increase its chance of success. Hiring an experienced appraiser to analyze a proposed development and offer valuation guidance makes good business sense.
This article focuses on how strategic planning techniques can affect not only a development project’s value, but its success in today’s uncertain market.
Part I – Analyzing a Development Project
Typically, as a part of a potential investor’s due diligence, an appraiser is hired to analyze the proposed development and the land associated with the project. Often considered the simplest of appraisal assignments, appraising land for development purposes is actually quite complex. When large parcels of raw land are involved, the highest and best use (HBU) of the land may be in transition from rural or agricultural use to a more urban use. Anytime there is a change in the HBU, value is affected.
In addition to relying on the traditional valuation methods to arrive at a value (cost, market and income approaches), the experienced appraiser relies on a subdivision analysis of the development to further confirm the value. A subdivision analysis forecasts the overall performance of the proposed project based on market evidence. The appraiser may suggest valuing several scenarios in order to clearly define the relationship between current costs and future benefits. When appropriately and correctly executed, the subdivision analysis provides one of the most accurate looks at the behavior of typical market participants.
Before hiring an appraiser, inquire about the firm’s experience in the area of subdivision appraisal. A qualified appraiser not only has the knowledge and experience to complete the assignment, he or she has a wealth of relevant information from previous assignments. The appraiser is familiar with the many stages of a project, recognizes typical subdivision infrastructure costs and has monitored the success or failure of previous developments.
The Appraiser’s Role
The appraiser’s role in development analysis can vary – from that of consultant to that of appraiser. As a consultant, the appraiser may be asked to analyze market data, make recommendations, suggest strategies for moving the project forward and/or offer an opinion of value. Determining housing absorption rates, quantifying market supply and demand, performing highest and best use analyses, and providing a feasibility analysis for the proposed development are all examples of appraisal consulting.
If the investor decides to move forward, the appraiser may be asked to render a formal opinion of value. In this capacity, the appraiser does not advocate for or against the project, but remains independent in his or her analysis, valuing the project as of a certain date, based on current market information and appropriate assumptions. When the market is less optimistic, the success or failure of the project may depend upon the depth of analysis leading to the appraisal report. Both the land development proposal itself and the appraisal supporting its value are subject to greater scrutiny in a weak economy. Whereas a verbal opinion or a summary report may have been sufficient in the past, a more detailed, inclusive self-contained report may be necessary to adequately address investor concerns at this point in time.
It is often a good idea to tackle development assignments in phases. This is particularly true during times of economic uncertainty. A Phase I appraisal analysis ranges in scope from consultation on the feasibility of a development to providing a verbal opinion of a likely value range. Let’s say that as a result of the feasibility study, the appraiser determines that the infrastructure costs are much higher than those of similar development projects. He or she may suggest that the developer pay less for the raw land to offset these anticipated costs.
During a Phase I analysis, the appraiser has the opportunity to provide feedback on the subject’s value and make recommendations without writing a complete appraisal. The client and the appraiser will discuss the Phase I findings and determine if or when to proceed with a Phase II analysis. Phase II typically involves the completion of a full summary or self-contained report which meets the criteria (scope and methodology) outlined in the client’s engagement letter.
When appraising a proposed development, the appraiser usually starts by meeting with the developer to hear, firsthand, the details of a project. The more sophisticated the developer the more analysis will have been completed and the further along in the planning stages a project will be by the time an appraiser is engaged. After meeting with the developer and armed with an understanding of the vision, marketing plans and scope of the project, the appraiser begins an independent study of the market and the proposed development. It is important for the appraiser to keep the client in the loop throughout the process. When the appraiser and the stakeholders work together, the client is more likely to make an informed decision. The following discussion focuses on the more complex issues of a subdivision appraisal and describes several strategies common to successful development plans.
Telling the Story – Extraordinary Assumptions
To determine the highest and best use of raw agricultural land, the appraiser may rely on the use of extraordinary assumptions to accurately depict the value of land. In-depth research allows him or her to identify the appropriate use(s) of the land and come up with a time-table of development – ultimately affecting the appraised value of the land.
Consider, for example, agricultural land which may be considered for a mixed-use development in the near future. Its appraised value will be greater than what it is as agricultural land, but less than its value if it were already fully entitled for development. Because the land is raw and the developer’s vision not yet a reality, value is based on defining the relationship between current costs for the developer and future benefits. The appraiser often includes extraordinary assumptions in the report to show how various anticipated conditions change overall value.
According to the Uniform Standards of Professional Appraisal Practice (USPAP), an extraordinary assumption is an assumption, directly related to a specific assignment, which could alter the appraiser’s opinions or conclusions if it were untrue. Development projects, by their nature, are dependent on events which may or may not happen in a timely fashion. For example, if a project is delayed six to 12 months due to construction problems or the inability to obtain city approvals, the value conclusion may no longer be valid. When the most likely scenario is based on extraordinary assumptions, those assumptions must be prominently mentioned in the transmittal letter and supported by the research and analysis in the report.
From evidence presented in the appraisal, the reader should be able to judge the validity of the extraordinary assumptions. Some types of assumptions involve more risk than others. If a development plan has received preliminary plat approval and is expected to receive final plat approval within six months, it is considered valid to assume that final approval will be forthcoming. Typically, facts of this nature can be verified by contacting the appropriate city officials. In comparison, if value is dependent upon municipal utilities, originally scheduled to be extended to a site by 2009, but now not likely to be in place until 2015, the appraiser is dealing with a different level of risk. The delay may create a less feasible scenario and that should be reflected in the conclusion of value. Extraordinary assumptions serve a purpose, but in order for the appraisal to be credible, they must be clearly stated and supported by strong, reliable evidence.
Part II – Development Strategies
When the market is weak, it’s essential that the investors consider not only the type of real estate currently in demand, but also the mix of uses most likely to enhance feasibility and accommodate the ever-changing market. Having a complementary zoning designation, such as a Planned Unit Development (PUD) or Mixed-Use zoning designation, gives the project flexibility by allowing a variety of land uses.
In contrast, a development project zoned primarily for single-family units may saturate the market with a specific type of housing. It does not attract a diverse pool of potential buyers which results in a longer absorption period than for comparable mixed use developments. By offering a variety of housing types and a commercial component, the developer appeals to a broader sub-market than is possible with a project exclusively marketing single-family homes. Additionally, when the developer has the flexibility to adjust the ratio of residential units to multi-family rental units and/or commercial uses based on demand, the community benefits as well.
The housing boom of the earlier part of the decade is not likely to recur in the near future. Recent housing studies indicate only a modest increase in housing demand over the next few years. In an effort to avoid costly vacancies due to overbuilding, developers may reduce the overall size of the project, accommodate a range of uses and schedule construction in manageable phases.
Well-designed projects attract a good mix of residential and commercial buyers, promote economic stability and reduce the chances of obsolescence during future market swings. Five or 10 years ago, it was more common than it is now for investors and developers to focus exclusively on projects exceeding 100 acres in size. They anticipated sustainable growth in the single family market over several years. As the market trended downward, the economics of development projects have changed. As the absorption rate of housing units drops off, purchasing large tracts of land in the early stages of development becomes less economically feasible. In a strong market, developers purchased available land outright, building as needed. Now, large upfront investment costs can hinder the success of a development and increase the capital recovery time.
One way for developers to minimize the initial costs of a project is to pay less for the land. By purchasing smaller tracts of land and using first rights of refusal or purchase option agreements to lock in adjacent land parcels for the future, additional land is available if needed. This strategy creates an advantage not only for the developer, but also for the property owner. The owner receives some money upfront for the right of refusal or option while waiting for a turnaround in the market to create additional demand for the land. The potential seller might not be able to sell the property in today’s market for what he/she could have sold it for in 2005, but banking on the success of the adjacent development and a market turnaround, he/she hopes to sell it at a comparable price in the near future.
Global warming, rising energy costs, and environmental consciousness have created a huge market throughout the United States for environmentally conscious products. The opportunity to create energy-efficient green housing is not only a responsible approach to development it is also a great way to tap into a new market of potential buyers. In commercial real estate, green building — especially Leadership in Energy and Environmental Design (LEED) certified development — has seen strong growth from coast to coast throughout the United States. Developers, building owners and occupants enjoy the energy savings while creating a good public image. Although green residential development has not been as widely visible as it is in commercial developments, it represents an area of demand in the housing market. As such, it has the potential to set a new development apart from existing housing and development projects.
Part III – Stone’s Throw Development
Shenehon Company was hired to appraise the future Stone’s Throw development in spring 2006. The development consists of 600-plus acres of land where the developer intends to develop approximately 200 acres of commercial land and 400 acres of mixed residential land. The property, located in the southeast corner of Hassan Township, is considered to be one of the few prime development parcels remaining along the northwest metro’s Interstate 94 corridor — a fast-growing portion of the metropolitan area.
This assignment was complicated from the beginning – the property was still in a very raw agricultural state — it was zoned agricultural — and there was no finite plan in place for the extension of sewer and water to the site. Additionally, city planners and developers in neighboring municipalities (as well as nationally) knew there was potential interest in an interchange at Brockton Lane North and Interstate 94. If the interchange became a reality, it would further increase the commercial viability of the site.
Initially, the appraiser, developer and investors met to share information and determine the appropriate scope and methodology of the assignment. Considering the site’s raw nature and the multiple variables involved with potential development options it was determined that two valuations were needed. The first was a “Best Case Scenario,” assuming a mixed-use development with a strong commercial component. The second was a “Moderate Case Scenario,” which would conservatively analyze the development under a highest and best use of single-family development. We also engaged the services of a local law firm with land-planning experience to help make the appropriate assumptions regarding the regulatory, statutory and other legal constraints associated with the proposed development.
One of the most challenging aspects of this appraisal was that during the research and analysis phase, it became apparent that the residential boom of the past 10 years was about to end. Most of the evidence was based on hearsay: reports of builders and developers backing out of purchase agreements and options for land purchases. There were definite signs that the economy was trending down, but no one knew for sure how it would affect the market. We used two value scenarios in our analysis so that the investors could see the impact of choosing one over another. The lower end of our concluded value range for a mixed use development (Best Case Scenario) actually fell above the purchase agreements for the land, providing a strong indication that the project had a very good chance of being successful. We were, therefore, quite comfortable with our valuation of the development. In situations like this, where the development’s location, legal and infrastructure issues might result in a development vastly different from the one laid in our Best Case Scenario, the investors were wise to stipulate two valuations.
Each valuation scenario required extraordinary assumptions to arrive at a reasonable value range for the proposed development. The extraordinary assumptions were set forth based on extensive market research as well as regular meetings attended by the appraisers, the developer, investors, legal counsel, land planners and local municipal officials. In this appraisal assignment, the use of extraordinary assumptions allowed the land and proposed development to be appraised under a scenario that all parties involved were comfortable relying upon.
Despite its large size, the site and potential development have several unique characteristics: a development plan with significant green space, a strong potential for a diverse mix of housing and commercial uses and a great location. On the southeast corner of Hassan Township, the property is adjacent to the municipalities of Rogers, Dayton, Maple Grove and Corcoran. Rogers was deemed the most suitable development partner, but the surrounding cities expressed interest in being involved as well. Demand was also supported by several letters of intent from national development firms expressing strong interest in developing large tracts of land. The ideal location was further complemented by the types of uses being considered and the development flexibility the site offered.
Appraising development projects when the market is trending downward creates a new set of challengers for appraisers, developers, lenders and other real estate professionals. Creativity and the flexibility to adapt to a changing market are crucial to the success of a development. There is still a market for land development, even when the economy is weak, especially if the plan has unique features that set it apart from run-of-the-mill existing and potential projects.
In the case of Stone’s Throw, the purchase of land and start of development took place as the market weakened. Although the developer may make a few changes, having a unique and flexible development will keep the project on track toward the original expectations.
Appraising development land is complex during the best of times. To arrive at a credible value conclusion in a weak economic environment, it is more important than ever for the appraiser to complete the necessary due diligence and maintain open communication with all members of the development team.
Questions or Comments? Please email Chris Stockness at CStockness@Shenehon.com
Christopher J. Stockness, senior real estate appraiser, joined the real estate division of Minneapolis-based Shenehon Company six years ago. His experience in appraising special purpose property ranges from resorts, marinas and airplane hangars, to restaurants and development projects.
Robert J. Strachota is president of Shenehon Company. For more than 30 years, he has prepared real estate and business enterprise valuations. He regularly serves as an expert witness in Federal, State and District courts and spends some time each year teaching at the local universities.
Tom Gump is principal and managing broker of Neighborhood Development Partners, LLC. He invites comments and questions about this column. He can be reached at:
Neighborhood Development Partners, LLC
750 2nd St NE Ste 100
Hopkins, MN 55343