External depreciation

[bradellis]

Mike,

You made a leap of faith that is not there. Read the derfinitions from Professor Fischer again. He said nothing about the loss being allocated.

He was my income instructor in the 80's.

Koert asked for an example. Now, I do not know want his wife's dog- got two barkers of my own, but here goes:

Take the Harrison statement of building a house in an industrial area:

You build the house- new and functional so neither physical nor functional exists. Yet is sells for less than other homes in the area, so there must be a loss. It is external-locational. Build an industrial property and there is no loss of any kind; ergo it is the use to which the land is put that determines the loss or lack thereof. Ergo, it is attributable to the improvements and not the land.

That said, the land value can CHANGE depending upon the use. It is just NOT called depreciation.

Brad

 

[Austin]

Bradellis wrote: “You build the house- new and functional so neither physical nor functional exists. Yet it sells for less than other homes in the area, so there must be a loss. It is external-locational. Build an industrial property and there is no loss of any kind; ergo it is the use to which the land is put that determines the loss or lack thereof. Ergo, it is attributable to the improvements and not the land.”
Reply: In my view, you can build a house new with functional obsolescence. The reason is if you did so, you made the wrong highest and best use determination when you built the house. The chief cause of functional obsolescence in my view is the H & B use being wrong. Known as a lack of external balance. This can change over time. The property sells for less than other homes in the area not because of external/location but because the land to value ratio is out of balance due to wrong H & B use determination or evolution, thus rendering the value lower. Location only comes into play in two instances: When you are comparing areas with different demand components for similar improvements, and when forces are causing a future change in H & B use between neighborhoods or areas. The benchmark or standard of measure is the land to value ratio that results in the highest profit in a given style/design/quality of construction dwelling. The dwelling cost is constant so the variable, profit, is achieved at the land to value ratio that maximizes profit. That ratio is a market determination. I think of land to value ratios as correlating to highest and best use. When the ratio changes, externalities are changing H & B use which causes the contribution of the improvements to change. Or so it would seem. Wouldn't you agree?

 

[bradellis]

Austin,

I agree ONLY with the statement that you can build a brand new home that does have functional obsolescence, and I have seen many of them. But that was not part of the example. The example said that the dwelling was free of functional obsolescence.

Land to building ratios are fine but do not always answer the question. Even when a site is substantially underdeveloped, the H&B use can still be the current use- IF the improvements add anything at all to value.

Let's say you have a subdivision of 20,000 SF lots that sell for $100,000. Code allows dwellings up to 4000 SF and the typical home built there is between 3-4000 SF. There is a lot at the front of the subdivision of similar size, BUT this lot would allow for retail stores or a home- per zoning.

Someone buys it and builds an 800 SF home and sells it for $180,000. Heavy land component in value- exceeds the improvement value, but this is still highest and best use because the improvements are worth $80,000 and it would make no economic sense at all to tear them down.

But, you notice that there are other subdivisions with the same sort of entry lot where strip malls have been built (again, the zoning allows it). The strip malls have 8,000 SF of retail space built at a cost of $500,000. Then you see a few sales of these at $650,000.

What does that mean to the appraiser? It means that the land value under the higher use is $150,000 vs. $100,000 for the residential use. But would you tear down that new 800 SF home? NO- because it cost $180,000 all in and you would have to spend $500,000 plus demolition cost to replace it with a strip mall, thereby losing $30,000.

Consistent Use Theory. But let's go further. Let's say that the 800 SF home is fully functional (2BR, 1 bath) and because it is new, no physical exists. But, it sells for $170,000 instead because the location at the front of the subdivision is less desireable than lots further in. The $10,000 is external-locational, but it is attributable to the use. Under retail development the land is simply worth more.

That is why external is attributable to the improvements and not to the land which cannot depreciate.

It is a hard concept, and I have no problem with the "powers that be" changing this concept to allow for land to depreciate. But for now, that is how we must approach it. Most real life examples are much less clear cut.

Brad

 

[KD247]

Brad,

Well-written example. Let me reiterate it with my thinking and see if we can figure out where our approaches would differ.

For The Typical Lot in the Subdivision:
Highest and Best Use - Single Family Residential
Highest and Best Use as Improved - Single Family Residential
Site Value $100,000
Improvement Costs $80,000
Functional Obsolescence -0-
Estimated Value $180,000

For the Front Lot
Highest and Best Use - Commercial
Highest and Best Use as Improved - Single Family Residential
Site Value $150,000
Improvement Costs $80,000
Functional Obsolescence $60,000
Estimated Value $170,000

In the Cost Approach, from my perspective, the Site Value of the front lot would be its value as if it were vacant (the cost to replace it with a similar lot).

Correct me if I've misinterpreted what you're saying, but it sounds like, because the subject is improved with a residence, you would use the site value of a similar R-1 lot even though the subject site is C-2.

In terms of what we're communicating to the reader, I can see problems with both approaches. In your approach, you are minimizing the possibility of future conversion to commercial use, which could be viewed as either a strong positive attribute or a strong negative attribute.

The problem with my approach is that the huge amount of Functional Obsolescence might suggest that the subject has severe "usability" problems, when in fact the problems are more philisophical in nature.

Just to make myself clear, here's the same front-lot situation but without the commercial zoning:

For an R-1 Front Lot
Highest and Best Use - Single Family Residential
Highest and Best Use as Improved - Single Family Residential
Site Value $140,000
Improvement Costs $80,000
Functional Obsolescence -0-
Estimated Value $170,000

In this case, the total value is $10,000 less because the site is less desirable to the tune of $10,000. It doesn't matter if the developer paid the same amount for each site when bought in bulk. When approached individually, each site has unique characteristics that affect the value of that specific site.

After all this head scratching, I wish I could start this thread over with this proposition: Depreciation of the improvements through External Obsolescence is only necessary when a significant external factor exists, but it not considered, when developing the site value.

Hope those don't sound like "fighting words" because I don't really feel "that" strongly about the topic. But, I have appreciated the education that this thread has offered.

Koert
The wind is howling here today - you'd think it was winter or something!

 

[Austin]

Koert & bradellis: Let me clarify one point. When I was discussing in my above post that different land to building ratios change highest and best use, I did not mean from residential to commercial. It is much more subtle than that. I was referring to a change of highest and best use in the dwelling from larger to smaller, higher to lower quality of construction, etc. For example, the highest and best use of a site may be a 1000 sq rancher with an average quality of construction. If something external affects impacts value negatively, the highest and best use may change to smaller houses with lower quality. In my mind, the cost of the dwelling is a constant. If the average lot sells for $15,000 and the average dwelling price is $100,00 with a $10,000 builders profit included, then the land to value ratio is 15%. If an externality diminishes value by $10,000 in the subject dwelling, to build this house is no longer feasible. A dwelling of lower quality and size may be feasible. This is a highest and best use change. Remember that one of the test of highest and best use is not just feasibility but is maximally feasible. The house with the highest profit is the highest and best use.
I have found from my experience and research with regression analysis that the most prevalent form of functional obsolescence is an over improvement in the form of quality of construction and GLA. You can’t even see this without regression methods. Every neighborhood has a trend line that shows a correlation between GLA and price, which shows quality of construction if you compare similar subdivisions with different quality of construction. If you over build the trend line, you made a mistake in gauging the highest and best use of the dwelling that would maximize profit (maximally feasible.) That is why I say that any time the land to value ratio is different from the norm, the highest and best use has changed or was mistakenly determined. If the average land to building ratio is 15% for new dwellings, and an identical dwelling has a ratio of 20%, then that is another indication that the highest and best use is wrong because if the dwellings are competitive they can’t all be maximally feasible if the ratios are different but dwelling cost is the same. It cost the same thing to build the dwelling on the site regardless of the price of the site.

 

[bradellis]

Austin and Koert,

I understand where you are going and have no problem with the land to building ratios.

In Koert's post the land (if we were valuing the VACANT LAND) would be worth $150,000. Improved with the house, it is worth $100,000. That is what the market says.

Austin mentioned the phrase "maximally feasible". I believe he means, "maximally productive". Both scenarios are completely feasible.

However, it would not matter to Highest and Best USE if the guy builds an 800 SF home or 4000 SF home- the land, under residential use, would still be worth $100,000. You just spend more and get more for the larger improvements.

Brad

 

[KD247]

Brad,

I think we are getting to the heart of the matter and there may not be a right or wrong perspective.

In your post, you say that the commercial site, "Improved with the house ... is worth $100,000. That is what the market says."

I respectfully disagree. In my experience, on commercial sites, a residential use is often viewed as an interim use and buyers will typically pay a premium for a site with future commercial potential. True, some of this premium may be offset by the negative effect of traffic on the interim residential use, but the net effect on value will vary from property to property.

From www.fhalibrary.com : "The concept behind this approach is that a knowledgeable buyer will not pay more for a house than the cost of reconstructing a substitute house on a similar lot in a similar condition. "

When I think "similar lot", I think similar location, similar external factors, similar zoning. You seem to be taking this one step further and require a lot with "similar current use".

If the subject property was a small cottage on a busy street in a prime retail district, would you still compare the site to those found in a nearby residential area? I think that would lead to an inappropriate value and mislead the reader of the report.

From http://www.erassoc.com/a-costapproach.htm :
"If the Cost Approach is discredited, it is largely because its textbook application asks the appraiser to make measures for obsolescence that the appraiser knows are at least partially arbitrary and that, to an extent, may be viewed as false. Little wonder that appraisers back off from application of cost analysis when they know that it may amount to little more than an academic exercise."

Austin, I've always understood Highest-and-Best Use in terms of the difference between e.g. residential, commercial, or industrial use. Within a particular use, the design can either be maximally (financially) productive or not.

Only entirely uniform neighborhoods have the optimal land/value ratio that you mention. In some neighborhoods, every site has a different personality (size, views, topography, setting, privacy, etc.) and the optimal improvements for each site do not necessarily yield the same land/value ratio.

In terms of regression analysis, one of the first things I learned in applied statistics was that you need about 27 data samples to significantly analyze one variable. For each additional variable, the data requirements mushroom dramatically. I have never seen 27 home sales that are exactly the same except for one variable, so I'm very reluctant to rely on any statistical measure except as secondary support for a value estimate. (Sorry if my statistical theory needs some freshening - that was 20 years ago!)

Koert

 

[bradellis]

Koert,

Frankly, I think your view is skewed toward the commercial potential. If, as you say, the value under a residential use is still higher than the other strictly residential lots, it may or may not be material.

The "interim" use is an assumption that may be unsupportable. What if residential properties rise faster than (or fall slower than) commercial uses? To cite that an interim use yields a higher value than current use (which, by the way IS the highest and best use via the consistent use theory) requires an extraordinary assumption. We do not know what will happen. Our value estimate is as of the effective date of the appraisal.

The web site you offered is interesting, but appears to be a private site by an individual MAI who concludes that the cost approach is mostly effective for special use properties that can be hard to value under other approaches. He specifically mentions schools and churches.

Out hypothetical example does not meet those tests; it is far more simplistic.

Thanks, but I'll respectfully stick to my guns here. This thread began with a discussion over externalities. My point is and was that the external depreciation is attributable to the improvements, and is fully in accord with "prevailing wisdom" as proferred in the various texts used in all our training. It was offered as an explanation to the logical question over whether land can depreciate under current theory.

Brad

 

[Austin]

This is an interesting thread that many may save for future reference, so I am addressing myself to the record on a few points mentioned in the above post:
1. Koert mentioned that when using regression you had to have at least 27 examples of each independent variables thus with 4 independent (value influencing variables) would require 108 sales. Not true. You are talking about the law of numbers I believe that says you have to have 30 sales when estimating the standard deviation. The process relies on what is called degrees of freedom, meaning number of sales minus number of variables. Typically with 30 sales and five variables you have 25 degrees of freedom. M-N. It is like doing matched pairs, five at the time, using five sales instead of two for each match. There is another force than comes into play called multicollinearity of variables which means two or more variables are correlated, which they are, for example, bigger houses typically are bigger, have more and better quality variables etc., I don’t want to go off on that, I just didn’t want anybody going off thinking they had to have a 1,000 sales to do regression.
2. Theory of consistent use: This has caused me more problems and loss of money than you can imagine. I can’t tell you how many times I have been called up and lambasted because of this rule. The typical appraiser around here when appraising a dwelling on a commercial lot will value the lot at say $100,000 and add the contributory value of the dwelling as if it was on a normal lot, and come up with a big number. Then I come along and appraise the lot at $100,000 because the lot is under contract of purchase for commercial development. As usual, the appraiser with the lower number is always wrong, at least to the client.
3. Maximally feasible: By that I mean the maximum profit. Ten different style dwellings on a given lot can be feasible, but under highest and best use analysis, the use that yields the highest profit is the maximally feasible or highest and best use. I think this is where the “fuzz” factor enters the picture and in my mind is the key to this discussion. If you stick to this highest and best use principle, lets use a simple 1000 square foot rancher, is worth zzz$’s in comparison to comparable dwellings. The land value is a given and reflects the market balance or trend. Under the principle of change, land values change and the change reflect a change of market balance, thus a change of highest and best use. Again, not to some other category, but to a different size, quality of construction, etc., that maximizes profit. That in my mind is why external obsolescence is in the building and not the land, because the land’s highest and best use as though vacant is a function of the market trend. The highest and best use is what the market says it is, and if your building says otherwise, that building pays the price for being out of kilter with the market. There is always some land to value ratio, assuming the highest and best use is in line with the market trend, that will maximize profit as improved, and any other building on that site will suffer. Another source of “fuzz” seems to be buildings, houses, in areas of transition. When you get into interim uses, that is a completely different ball of wax and each case has to be judged on its own merits. If you build a dwelling in a transition area and the land to value ratio is higher, how can that property, using the theory of substitution, compete with the same house on a cheaper lot and in conformity. The numbers will not work. If the average price of that type dwelling is $100,000 in the market, the building cost is the same but the lot prices are vastly different, the lower lot price in conformity with that type property will win out and be maximumally profitable or feasible.
4. Koert wrote: “Within a particular use, the design can either be maximally (financially) productive or not. Only entirely uniform neighborhoods have the optimal land/value ratio that you mention. In some neighborhoods, every site has a different personality (size, views, topography, setting, privacy, etc.) and the optimal improvements for each site do not necessarily yield the same land/value ratio.” Reply: I have a different view of highest and best use of existing properties. In my mind, every existing property has a highest and best use. It may be as is; it may be with the addition of a bath; it may be as remodeled; it may be conversion to rental versus single-family ownership occupancy. Again the determining factor is value under each potential highest and best use as just outlined minus value as is. The use that results in the highest profit is the highest and best use. When you say: “Only houses in uniform neighborhoods have the optimal land/value ratio” in my view that is the standard by which we measure. Why would the same house is a less desirable location (lack of conformity) be worth more than a dwelling in a neighborhood that is in conformity? The answer is that is inconsistent with appraisal theory and economic laws. You say that size, views, topography, etc., result in different land to value ratios. True. But, it is because the site has a different highest and best use. Remember I mentioned multicollinearity in my first paragraph. This means that houses with these amenities are typically bigger, on better lots, of better quality of construction, more amenities of better quality etc. This means a different highest and best use of those sites with advantages.

 

[KD247]

Brad,

My viewpoint is definitely skewed towards the commercial aspects. Prior to working as a residential appraiser, I sold commercial properties and spent a lot of time doing informal highest-and-best use analyses, all done under my terms and rarely under much scrutiny.

So, I bring a lot of baggage to the table with me - and that's why I'm using this opportunity to sort out my thoughts. My viewpoint - that external depreciation is seldom attributable to the improvements - goes against the prevailing wisdom and standard methodology, but seems more logical (to me).

As for interim uses affecting land value, just last month I had a buyer tell me that they were offering "above market" for a commercially zoned residential property because they were anticipating a shortage of office space. But it doesn't matter what happens in the future, because I'm concerned with market reaction to the property on the day it's being appraised.

However, we do agree that external factors must be fully considered and we differ only in where the adjustment gets plugged into the Cost Approach. We probably would generally agree on the fundamental approach to value.

As to whether land can depreciate, I believe that the word depreciation refers to any loss in value. And land does lose value due to negative factors. But, typically an appraisal is done as a "snapshot in time" so the site value would already include any previous depreciation or appreciation. This question probably has commonalities with the external obsolescence question.

Regards,
Koert