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The basis validity of modern appraisal techniques is called Into question when two professionally qualified practitioners honestly arrive at conclusions that differ by more than 100 percent. Under such circumstances, the role of the expert is redefined from "appraiser" to "advocate." Such sharply divergent valuations are most likely to occur when professionals attempt to value land considered as if "vacant and unencumbered" in the central business district.

The traditional long-term ground lease usually provides for periodic reviews with new rental to be based on the "value of the land as vacant and unimproved." It is accepted that the best criteria for determining such value are current sales of comparable undeveloped land. Unfortunately, these leased fees are generally located within the developed core of the central business district. There is not likely to be an adequate data base of vacant land transactions within this area. The appraiser is, therefore, forced also to consider sales of improved property and to make complex and subjective adjustments to the data supplied by those transactions. The recorded sales data must be analyzed to account not only for difference in desirability between the subject location and the comparable location, but also for the value of site improvements, the impact of continuing leases, and the availability of the comparable property for improvement. He may be forced by the scarcity of comparables to compare data from different time frames although the market has changed dramatically from one period to another.

THE COMPLEX ASSUMPTIONS REQUIRED BY RESIDUAL LAND ANALYSES

The dearth of relevant sales information about unimproved land compels appraisers to rely on residual land analysis. It is widely recognized that this technique may lead to dramatically different value judgments that result from relatively minor differences in assumptions. The appraiser's freedom to indulge in hypotheses, which may run the gamut from unbridled optimism to utter despair, can distort the analytic process. However, even if the appraiser conscientiously attempts to use the most reasonable assumptions, he is faced with serious technical problems that are inherent in residual land analysis.

Residual analysis requires that the appraiser undertake at least six major computations, each of which contains assumptions and judgments that are difficult and subjective.


Highest and Best Use
Unless he is otherwise limited by provisions of the lease, he must determine the "highest and best use" for the land. It does not necessarily follow that the most intensive development permitted by zoning will prove to be the most profitable. Frequently, the appraiser must test several different hypotheses.


Valuing the Cost of Improvements
Having determined the preferred economic development, the appraiser must establish the cost of that hypothetical improvement. This calculation includes both "hard costs" for actual construction and "soft costs" for such items as interest and taxes during construction, operating loss during a "rent-up" period, brokerage commissions, rent concession, mortgage closing, and other legal and professional fees to name only a few such expenses. Actual costs are any builder's cherished secret, so the facts are always hard to ascertain.


Fixing a Probable Income Stream
The next and relatively the easiest step in the process is to fix a probable income stream for the hypothetical improvement. The critical question is whether the appraiser looks at the rental market as it exists on the valuation date or whether he elects to project the rates to a future completion date. In an inherently cyclical industry, it would seem more prudent to focus on the present rather than attempt to guess the future.


Operating Costs
The appraiser must now deduct estimated operating costs and real estate taxes from the hypothetical income. In this step, the basis for a reasonable projection presents no problem so long as the computation is based on current experience and not on forecasts of an uncertain future.


Selecting a Cap Rate
Now the appraiser has established the hypothetical project's net income free and clear. He must convert this income stream to a capital value by selecting an appropriate interest factor. Probably no other step in the process presents so many difficulties. The appraiser must make major assumptions about the following four areas. Each presents its own problems:

• The effect of debt service requirements.
• The effect of locational advantage.
• The role of inflationary expectations.
• The role of entrepreneurial profit.

Cap rate for the improvement "as if free and clear." It is customary in residual land analysis to adjust for capital requirements as if the property were "free and clear." In fact, virtually every major building is mortgaged. In the real world, the price that a developer will pay for a buildable site is likely to include a premium for its preferred location, which may confer upon him more advantageous borrowing terms, both loan ratio and applicable debt service. Construction tends to be concentrated where the highest rental rate is obtainable. The conclusion that development is most profitable in the best available location is evidenced by the action of the marketplace. Marginal sites are not likely to be developed so long as more desirable land is available.

Until recently the investment builder considered a successful venture to be one in which he could "mortgage out." Under ideal conditions, he could even end up with money in his pocket. In any case, it is clear that ordinarily no development will take place unless at least the cost of construction can be financed. It therefore follows that in the residual land analysis, the capitalization rate applicable to the improvement should take into account prevailing debt service requirements.

Locational advantage. It is axiomatic that a building costs the same number of dollars to construct in a premium location as it costs in a secondary location. With minor variations, the cost to operate a property and its real estate taxes are the same in both types of locations. Borrowing costs tend to be inversely related to building income (i.e., the lowest interest rate and the most favorable repayment schedule can be obtained for the building located in the area where rental demand is strongest). On balance, however, the landlord's overall cost including financing is likely to be approximately the same (or to vary only slightly) in any central business district location. The significant difference between two similar projects is therefore in the anticipated income stream because the higher rental rate of the better-located project will flow directly to the bottom line. It is this locational advantage which determines land value.

The landlord/developer is solely a conduit for most of the rental income. There is no economic benefit in collecting the dollars required to provide for utilities, wages, real estate taxes, debt service, and the myriad other items which go into the maintenance of investment real estate. Unless anticipated income exceeds all projected costs with a reasonable expectation of profit, the project will not be built. The developer's profit opportunity can be defined as the available excess of rental income over and above related expenses. The land value is consequently the highly volatile component in the capitalization equation reflecting the capitalized worth of the marginal differences in the income stream due to location.

Inflationary expectations. The investment builder will not undertake the risks of construction and renting or the deferred return on his capital during the development period unless there is adequate incentive in the form of entrepreneurial profit. More simply stated, he would not be willing to build in order to create an investment at a cost equivalent to its full economic value. Whatever the property may be worth on completion, the developer must foresee his ability to produce it at a cost substantially below market value for the finished product. The capitalization rate must, therefore, include an adequate allowance for entrepreneurial risk and reward (i.e., a markup over and above the estimated improvement cost).

Role of entrepreneurial profit. There is a widespread misconception about the rate of return required to attract investment capital to office building development. The prevalent myth is that office buildings can be sold at nominal returns because foreign investors and institutions alike are eager to protect capital against the erosion of inflation. It is perfectly true that low cash-flow deals have been made (and can be made) for existing buildings. The investment value of such buildings,* however, includes not only their present cash flow but their potential for substantially increased cash flow that will be produced on the expiration of existing "below market" leases. Some appraisers analyze such projects by projecting future rentals, operating costs, and taxes based on compounding an annual inflation factor. Traditional appraisal wisdom asserts that given the recurrent cyclical character of real estate, the conservative approach is to use current market levels for both income and expense projections, but most recent transactions have been based on projected inflationary increases in income and expense streams.

The purchase and sale of these existing buildings are based on finding an "internal rate of return" from an analysis in which both building expenses and expiring leases are brought up to future market with the increased revenue and the consequent enhanced capital value at the end of the holding period discounted back to present worth. Every arm's-length market transaction with which we are familiar has been based on assumptions which forecast an internal rate of return of approximately 14 percent, including the profit on eventual sale.

The new building starts with its potential fully realized and the required rate of return should, therefore, be consistent with other investment opportunities.


Establishing Present Land Value
One way or another, the appraiser must thread his way through the perils of setting a capitalization rate. He may establish either an overall rate for the investment package or a split rate, setting one rate for the improvement cost and a lower rate for the land. From the value of the completed total investment package that he establishes by applying his cap rates, the appraiser subtracts the improvement cost that he has previously determined. The balance represents land value. We noted that this allocation is valid only if the appraiser has previously factored into the process due and proper allowance for entrepreneurial risk and profit.

The benefits of the hypothetical improvement will not be enjoyed until the improvement is constructed and rented. Consequently, the land value that the appraiser has computed may have to be discounted to its present worth.


Merely an Upper-Limit Calculation
It is evident that the complex procedure above is so delicately balanced as to be error prone. Even a minor miscalculation in any of the projections may result in a major difference in the final valuation.

Given the difficulties, it might be hoped that the calculations could lead to a dependable conclusion. Unfortunately, that is not the case. Even at best, the residual land analysis cannot determine what a builder would pay for a site. It can only indicate what he might be justified in paying assuming that his evaluation of risk and reward corresponds with that of the appraiser. It follows that, in a sense, the valuation determined by residual land analysis is similar to the value determined by the summation approach: It sets a theoretical upper limit of value which may or may not be consonant with the actual market.

DIFFERENTIAL ANALYSIS

Clearly, comparable sales afford more dependable guidance than residual land analysts. However, we have already noted that a scanty data base requires that the appraiser make adjustments, usually subjective, that the subject property is some percentage factor better or worse than the comparable. Thus both the comparable sales technique and the residual land analysis present problems as approaches to valuation. It may, however, be possible to quantify on a factual basis the subjective adjustments required for locational differences in comparable sales and, at the same time, to simplify the residual land analytic process so as to avoid many of the pitfalls. Furthermore, the two methods may be used in tandem rather than as parallel independent investigations, so that they can support one another. The approach that accomplishes these ends is "differential analysis."

The concept of differential analysis can be summarized by a simple analogy. Suppose a shopper in a supermarket with a basketful of groceries which has already been "rung up" at the checkout counter decides to add a pack of cigarettes and to discard a can of beans. Neither the customer nor the cashier would deem it necessary to recount and recompute the entire purchase. The sensible and practical method of determining the value of the altered market basket is simply to add or subtract the differences. Similarly, in a single time frame, any two buildable plots differ in only two significant respects - the rentable building area which may be placed on each and the quality of location. Each of these differences can be quantitatively measured.


Underlying Assumptions
In applying the suggested line of reasoning to land valuation, we make the following underlying assumptions:

• The appraiser should mirror the marketplace.
  
• The appraiser will find some record of recent sales intended for like-kind improvement even though the desirability of location may differ considerably.
  
• Absent any unusual factors (such as owner-occupancy or "build to order" for a major tenant), any sale will, in substance, finesse the appraiser's concern with (1) improvement costs, (2) determination of operating expense, (3) financing and capitalization, (4) required rate of return, (5) builder's profit, and (6) discount to present worth.

Focusing on the Differential
The recorded comparable sale transaction is the best possible evidence that the market believes the contemplated development to be economically feasible. If, as previously postulated, the costs of building the comparable and the subject improvement are about the same, operating expenses the same, and capital costs and developers' profit expectations the same, then the only economic difference between subject and comparable sites lies in the anticipated income stream. The appraiser may focus narrowly between reasonable rental expectations at the subject site and at the recorded comparable site.

It is the income stream differential and only that differential that accounts for significant bottom-line differences between projects. Whether increase or decrease, any change hi rental rates will be directly incorporated in the net income stream attributable to the land. The appraiser who is looking to establish land value need not concentrate on highly controversial issues like improvement cost or discount for futurity. And most significantly, the selection of an appropriate capitalization rate can be derived from the record of comparable sales. When the appraiser concludes that he has only one judgment to make (i.e., whether the rentals in the subject property will be higher or lower than those in the comparable), he has not only simplified the valuation process, he has reduced the likelihood of error by substituting the recorded transaction for his own complex projections. He is deriving his conclusion directly from the reality of the marketplace.

If the subject property enjoys a superior location, the measure of its advantages is the additional rent that it will command. The additional income expected in the superior location is all profit, and the impact on the earnings can be readily quantified by multiplying the differential in rental rate by the number of square feet of rentable area in the respective sites.

This anticipated difference in profit (positive or negative) can easily be expressed as a separate income stream and can be independently capitalized. The value so calculated affords an objectively determined adjustment to the comparable sale. Rather than the customary subjective percentage adjustment to the record transaction, the appraiser can justify a direct dollar "add-on" or subtraction. If the subject property is in a marginal location, the contemplated income deduction may be so large that it cancels out (or unreasonably diminishes) the price paid for the comparable. This does not invalidate the procedure. It simply demonstrates that the hypothetical improvement for the subject site is not economically competitive and probably not justified.

It was suggested previously that gross income does not necessarily determine economic value. The rental dollars which are required to meet expenses do not create value. The key test is profitability. It therefore follows that a relatively modest change in gross income has a disproportionate impact on earnings and consequently on market value of the site. If all other factors are equal, land emerges as the major volatile component in the development process. It is easy to conceive that a 10 percent increase in rental could be equivalent with a 100 percent increment in land valuation.


An Example
The concept may be clarified by an example. Assume that a comparable plot of 10,000 square feet was recently sold for $1.5 million ($150 per square foot). Zoning regulations permit a building with 120,000 square feet of net rentable area on this land. The land cost can thus also be expressed as $12.50 per square foot of buildable area.

The appraiser's best judgment is that the subject property will produce a rental rate $1 per square foot higher than the rental in the comparable. The total additional profit arising from the difference in location is $1 multiplied by the rentable square footage in the subject property. When this sum is divided by the number of square feet of plot area, it yields the additional price per square foot of the subject land above the price recorded for the comparable.

Specifically, if the two buildings were the same size, then the subject property would enjoy additional earnings of $120,000 per year. If this sum is capitalized at, let us say, 12 percent, it yields additional land value of $1 million above the $1.5 million comparable sale. We have established a land value of $2.5 million ($250 per square foot) for the subject property.


Relevant Time Frames
The one obvious deficiency with the differential analysis technique is that comparables cannot be selected from earlier time periods because the approach requires that certain elements of the comparable and the subject properties be assumed to be identical (cost of construction, operating, financing terms, and availability). Obviously, these are precisely the elements that vary with different economic conditions over time. However, the absence of any comparable sales within a relevant time frame may demonstrate certain things about whether development would produce economic value to the subject land. Assuming the availability of sites for improvement, the lack of market activity would demonstrate a collective judgment by potential purchasers that profit margins are inadequate or that the risk is too great to stimulate development.


Analogy to Single-Family Appraisals
The concept of differential analysis is so novel and relatively so simple that some appraisers may dismiss it as tricky and, therefore, unreliable. These reservations are not justified. The proposed methodology is nothing more or less than a relatively sophisticated version of the old and well-established technique that is regularly used for single-family house appraisals.

The experienced appraiser knows what prices a typical house in his community commands in the marketplace. When he looks at a particular property, he adds on so much for a swimming pool or tennis court, so much for an extra room or bath, and subtracts for any of the amenities that are not present in the subject property but that are generally available in the community.

This is exactly what it is suggested the appraiser should do when he determines the value of land beneath commercial improvements. He should simply focus on the potential income differentials and add or subtract from the established value evidenced by the market for other properties.

SUMMARY

The technique that we have described is designed to deal specifically with a particular problem which is not easily resolved by conventional methods. It may be limited in its applicability. The appraiser who attempts to value land "as if vacant and unencumbered" within a heavily developed area is unlikely to find an adequate data base of comparable sales. He may attempt to use conventional residual land analysis, but that approach allows too much latitude for subjective variables. Perhaps the most important contribution of the proposed differential analysis methodology is that it is likely to reduce opposing opinions to a "range of reason" and thus to eliminate the professional embarrassment which results from widely divergent conclusions.