Highest & Best Is Not Current Use

[G-man]

I have been assigned to appraise a two family property in a suburban area of Toledo. The duplex is a 2005 built one story side by side, both units being identical with two beds/one bath and 1,235 sq.ft. of living area. The market for duplexes has been very poor, with few sales in the past 3 - 5 years, many being for cash. I have no sales of duplexes over $135K. Where this property is located, there are several villas & condominiums of similar age, dwelling area and layout, which sell at the low end for $110K to upwards of $170K, so if each unit was sold separately, the property could be worth over $200K.
I called the local planning commission, to inquire as to whether it is legally possibly to split the duplex into two separate dwellings, either as attached villas or as condominiums, as zoning allows either use. Their response was it is possible, with minimal fees, with the one possible hang-up being the fire-wall between the two units in the attic not being up to current code for single family use. So, it appears that a conversion would be legally permissible, and physically possible (assuming the firewall can be upgraded), and the economic benefit would be greater if the property was split into to two separate units.
I have yet to inform the client of my research, as I'm trying to get my ducks in a row so I can lay out this highest & best use issue as plainly as possible. My main question is, if the client comes back and says they want the property appraised as a duplex, regardless of H & B use, can this be done? Would this be a "Value in Use" issue? It's the first time I've ever had to check the box "No" in regards to present use. I know I would have to explain why this is so, but other than that, is there any other info that would need to be presented?

 

[Mike Kennedy]

Client type, Intended Use and Intended Users?

 

[George Hatch]

The only reason you're even looking at HBU is because of the pricing for the comps?

The assignment is for the "as is" value of the property; i.e, the most probable price for it in its current configuration and condition. HBU analysis comes into play as a means of identifying the "typical buyers" who would pay the most for the property. Just because a property has the potential for conversion doesn't necessarily make that use marketable.

The buyers paying $110k/unit for condos are owner-users using conventional financing terms. The buyer for a conversion project will be an investor using construction lending terms. They won't engage in this project unless they can clear a profit that's commensurate with their perceived risk (of both the known and unknowable) and costs. If it costs $20k to perform this conversion and there's no track record in the market for such conversions being approved by the city then you can bet that the additional profit margin necessary to motivate an investor to take this project on will be a lot more than $20k.

If your other duplex sales were being purchased for conversion then their current pricing indicates to the "as is" value of them as conversion bait. If they're not being purchased for conversion then the burden of demonstrating the market demand for this property as conversion bait even though the other duplexes apparently aren't as valuable as your subject will be on you.



If there is no identifiable market demand for such conversion projects as evidenced by other such sales data then that would be something you would be compelled to note in your analysis. My guess is that once your readers see that they won't care what your number is. That conclusion certainly won't fit the underwriting criteria for whatever conventional lending program the lender is considering for this property.

 

[Michigan CG]

A short answer to what George is saying is the test of financial feasibility. Would it be financially feasible to convert the property?

 

[hastalavista]

It sounds like you have a different H&BU as-vacant vs. as-improved.
My advice: Develop and report the two opinions. It could impact (a) your comparable selection and (b) the cost approach (functional depreciation).

I agree with George on all else.

Good luck!

 

[G-man]

A short answer to what George is saying is the test of financial feasibility. Would it be financially feasible to convert the property?

I believe the cost of conversion would be fairly minimal. When speaking with the guy at the planning commission, his basic comments regarding costs would be about $300 in typical fees for approval of the request, plus the cost of upgrading the interior fire wall in the attic, which may or may not need to be done. Even if it cost a few $1,000 to upgrade the attic fire-wall, it is still well within the realm of feasibility. I inserted the exterior sketch to better represent what I'm appraising. The units are split down the middle, with each unit having a one car attached garage. Running the property line down the middle would give you two attached single family two bedroom villas that are ten years old. The other question is, if the client says to appraise it as a duplex, can this be done on an "As Is" basis, as I would state that the H & B use is not its current use? The appraisal is for a conventional refinance with a major lender.

 

[HF Mudd]

You state that there are villas and condos of similar age, GLA and layout to the subject, so my question would be WHY the subject was built as a duplex rather than as villas or condos to begin with. Was the subject a "white elephant" when built, or was it just the top of a crazy market and EVERYTHING sold no matter what?

Has the difference in the market for duplexes vs. the market villas and/or condos changed significantly in the last 10 years to make such a conversion economically feasible now vs. then?

 

[hastalavista]

The following is my opinion: others may disagree...

There are four (some say three) things that can be done to an improved property from the H&BU perspective:
1. Remodel (this is what you are analyzing)
2. Renovate (update/modernize0
3. Bulldoze
4. Retain as-is (repairing needed items, normal maintenance/replacing short-lived components as necessary)

While we use the term "remodel" and "renovate" interchangeably, from a technical perspective, "remodeling" means that one is going to change the use or functionality.
So, you are faced with a remodeling potential. If it is financially feasible to do so, and there is evidence in the market that it would be done, then H&BU as-improved is to remodel (change the use).

The remodeling decision-trigger just isn't the financial feasibility of the calculation. The appraisal must demonstrate that this is what would actually occur. In other words, while someone might purchase the subject in its as-is condition and use it in its as-is condition, the likely buyer is someone who would purchase, remodel (split into two units), and then sell each unit off individually (or, maybe, occupy one and sell/rent the other). And, they are willing to pay more for the subject for the remodel project than another would pay for its as-is configuration.

The costs to convert is one factor. EI is another. Holding and selling costs also have to be addressed.

Let's assume the 2-unit would sell for $135k. Let's assume that when remodeled, the two units would sell for $200k. That's a $65k spread. Costs and required EI have to be paid from that spread, so the residual (what is left over, which technically is allocated to the site value, right? The H&BU of the site, as-vacant, would clearly be to build 2 independent units that can be sold separately vs. the duplex) would have to be enough to motivate "in real life" someone to really go forward and do it.
I think you'll have to do some more-than-typical research to clearly demonstrate that then what a run-of-the-mill refinance appraisal requires.

But, for a fact, IMO, if that is the H&BU, as-improved conclusion (remodel), then for a market value appraisal, that is how it would be appraised.
(such a valuation does not require a hypothetical condition and may not require an extraordinary assumption; although there may be something in you find in your research which might warrant an EA).

The other question is, if the client says to appraise it as a duplex, can this be done on an "As Is" basis, as I would state that the H & B use is not its current use? The appraisal is for a conventional refinance with a major lender.

I think there is confusion (likely with your client) about what the improvement physically resembles and what the property rights would sell for.
Physically, the improvement is a duplex.
However, if the property would be purchased by someone who is going to change the use, they are not valuing the property based on its physical configuration; they are purchasing the property based on the rights that allow its remodeling into something that is more productive (profitable) than the current use.
The value (market value) is as-is (based on what exists). But as-is, the buyer isn't buying a duplex. The buyer is purchasing a remodeling project with the intention of changing it to a 2-unit property.

But regardless of what you and your client decide, if the H&BU of the property as-is is not "as improved",then it is not eligible for Fannie submission.



Good luck!

 

[George Hatch]

IMO the risk factors involved are as significant to the decision making as the potential for profit.

There is no risk involved in a decision to leave an existing use to continue on. There's no loss in utility, occupancy or rents to account for, and the purchase can still be financed under a conventional residential mortgage program.

Regardless how much potential profit may be involved, a property purchased for conversion is not being sold to an owner-user as such, and is not eligible for 1-4 residential financing with the nice long 30-yr amtz or the 4% mortgage interest rate. Non-residential loans are harder to qualify for, have lower LTVs, shorter amtz rates and higher origination and interest costs. So just the financing situation increases both the necessary equity percentage of the purchase as well as the holding costs.

The difference in available financing terms is one reason why in many markets (like mine) a 4-unit property is often worth quite a bit more than a 5-unit or 6-unit property with otherwise similar attributes. You guys should not underestimate the effects of financing terms on these values.

Then you add in the lost income or utility during the conversion and sell-off period, as well as the risks or rewards in projecting pricing increases through the end of your holding period.

So you really CANNOT just look at it like your average flip transaction. There are always unknown contingencies involved when you're talking about remodeling or adding structural elements or separate utility connections and such.

And besides all that, we're here to look at what the market's reaction is to these attributes, not to opine what would happen if all these buyers were smarter. That's why the case for conversion would have to be compelling. Depending on the market conditions an marginal ROI (after consideration of the risk factors) might not attract any investors.

 

[George Hatch]

One other thing to consider is that under ideal circumstances the comps for these units would come from other small projects of less than 10 units, not from large projects that create their own neighborhoods and have all the extra common elements. A spread of $65k/unit (duplex) vs $135k/unit (condo) is pretty big. In this case it means a buyer buys at $135k, does the conversion and sells off the 2nd unit to get their unit free and clear.

I wouldn't say it's impossible but I will say such a situation usually wouldn't escape the entire market's attention for very long.

How similar are these $135k duplex comparables? How do their rents stack up to your subject's rents?


Condo mapping costs or lot split costs in your state must be a lot cheaper than in my state.