HIGHEST & BEST USE CHALLENGES AND SUPPORTING ADJUSTMENTS 6/11/2018 KEN MROZEK, MAI, SRA, ASA HIGHEST AND BEST USE CHALLENGES AND

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1 HIGHEST & BEST USE CHALLENGES AND SUPPORTING ADJUSTMENTS KEN MROZEK, MAI, SRA, ASA KEN MROZEK, MAI, SRA, ASA Appraiser for 15 years Commercial and Residential Appraisals Partner and President of ARC Appraisals 11 total Appraisers Agricultural, Residential and Commercial Appraisals Primarily Cover Northwestern Illinois and Eastern Iowa Most Appraisals we do are Rural Communities (under 15,000 people) HIGHEST AND BEST USE CHALLENGES AND SUPPORTING ADJUSTMENTS The Valuation Process Market Value and Highest & Best Use Examples of H&BU Challenges Residential Commercial Disclaimers How I Approached the Problem Part of My Goal Encourage you to Challenge Yourself 1

2 THE VALUATION PROCESS The Appraisal Institute The Appraisal of Real Estate (4 th edition), page 37 How Does Identification of the Problem relate to H&BU? Purpose Property Characteristics Assignment Conditions Why is Scope of Work before to Data Collection? 2

3 Highest and Best Use Analysis Why Land As Though Vacant What is Ideal Improvement Ideal Improvement The improvement that takes maximum advantage of the site s potential given market demand, conforms to current market standards and the character of the market area, and contains the most suitably priced components; the improvement that represents the highest and best use of the land as though vacant. REVIEW OF REAL ESTATE APPRAISAL DEFINITIONS Market Value is defined by federal regulatory agencies pursuant to Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA): Most probable price Buyer and seller are typically motivated Both parties are well informed or well advised Acting in their own best interests Note: Definition has been shortened for purpose of presentation REVIEW OF REAL ESTATE APPRAISAL DEFINITIONS Highest and Best Use the reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible and results in the highest value. The four criteria the highest and best use must meet are: Legally Permissible Physically Possible Financially Feasible 3

4 RESIDENTIAL H&BU CHALLENGE 2-UNIT RESIDENTIAL PROPERTY One heir wanted to Purchase Property from Estate (date of death December 2015) Two Sides - Two Attorney s hired Two Appraisals Complete Appraisal 1 for Estate Purposes: $100,000 (date of value December 2015) Appraisal 2 for Financing Purposes: $48,000 (date of value May 2016) Why so different? Which one was correct? Third Appraisal Ordered NOTE: What form did I use? 2-UNIT RESIDENTIAL PROPERTY 1 st Floor Unit 5 rooms/2 bedroom/1.1 baths Enclosed Porch 2-Car Attached Garage 4

5 2-UNIT RESIDENTIAL PROPERTY 2 nd Floor Unit 3 rooms/1 bedroom/1.0 baths Enclosed Porch 2-UNIT RESIDENTIAL PROPERTY Seemed like a Typical 2-Unit Residential Property Hidden Stairwell between Floors Minimal Work to Open Stairwell Access and Photographs were not available Description and Provided by Attorney s Client Extraordinary Assumption Required Assumed Minimal Work to Convert Back to a 1-unit Property 2-UNIT RESIDENTIAL PROPERTY Legally Permissible Both 1-Unit and 2-Unit are Legal Uses Physically Possible Continued 2-Unit is Possible Could be Converted to a 1-Unit with Little Effort Financially Feasible Continued 2-Unit Use is Financially Feasible Cost to Convert to a 1-Unit was estimated to be $5,000 5

6 2-UNIT RESIDENTIAL PROPERTY 1-Unit: $95,000 (after adjusting for cost to convert) 2-Unit: $50,000 What is the subject s Market Value? Knowledgeable Buyer/Seller Acting on there Own Best Interest 2-UNIT RESIDENTIAL PROPERTY Supporting Adjustments Based on H&BU Analysis Are there any adjustments that could be supported? In Theory - Yes In Practice - Probably Not What about the difference between a 1-Unit and 2-Unit Property ~$45,000 Conversion costs must also be considered I agree the size of the adjustment is a bit uncomfortable, but is supported by market. 2-UNIT RESIDENTIAL PROPERTY Other Considerations Was the Appraisal for $48,000 wrong? Since My Appraisal was for Testimony, I included analysis for 1-Unit and 2-Unit CONSIDER DOING EXPERT WITNESS TESTIMONY! 6

7 RESIDENTIAL H&BU CHALLENGE 4-UNIT MIXED USE PROPERTY 4 Roughly Identical 1-Bedroom Units ~1,200 sf each Roughly 1,200 sf of Common Hallway Zoned B-1 Limited Neighborhood Business Multi-Unit Residential is a Permitted Use 1 Unit used as Owner s Architect Office 4-UNIT MIXED USE PROPERTY Office Unit Configuration was Identical to Residential Units How Do you Appraise this 4-Unit Residential Mixed Use Commercial 7

8 4-UNIT MIXED USE PROPERTY Legally Permissible Both 4-Unit Residential and Mixed-Use are Legal Uses Physically Possible Continued Mixed Use is Possible Although Office Configuration is not Usual Could be used as 4-Unit Residential with No Changes Financially Feasible Both Uses are Financially Feasible Although, Rental to an Office Tenant other than Owner is not Likely 4-UNIT MIXED USE PROPERTY Similar Mixed Use Sales Not Available How to Conclude what is Maximally Productive 1-Bedroom Apartment Rent: $400 to $650 (subject at high end) Concluded $650 per month per unit Office Rent: $5 to $9 per sf (subject office space at low end) Concluded $6 per sf for office unit, at best $6/sf x 1,200 sf = $7,200 annually or $600 per month Who is Most Probable Buyer Residential Investors tend to use GIM = Maximum Rent 4-UNIT MIXED USE PROPERTY Supporting Adjustments Based on H&BU Analysis What if Office Unit didn t have a Full Kitchen or Shower? Best Method is Paired Sales Analysis But No Similar Sales Market Rent would be $50 Less per Month GIM 3.30 to 9.88 and averaged around 7.60 Concluded 8.5 $50/month x 12 months x 8.5 = $5,100 How does this line up with Cost? Contributory Value Of Unit with Full Kitchen & Shower: $5,000 8

9 4-UNIT MIXED USE PROPERTY Other Considerations Form Report or Narrative How Did I Complete Report One Tenant offered to Purchase for $220,000 Owner Thought it was Worth over $300,00 Owner wanted My Opinion, but Lower Fee I offered a Restricted Appraisal Report with a Value Range Appraised Value: $225,000 to $255,000 For Sale By Owner at $325,000 Still Not Sold After 12 months Exposure and Marketing Time was 3 to 9 months CONSIDER NARRATIVE REPORTS! Industrial Park [NOTE: THIS IS NOT THE PROBLEM I WAS ASKED TO SOLVE, SO NUMBERS ARE NOT ACTUAL AND FOR DISCUSSION ONLY. 9

10 Legally Permissible (RD Rural Development) Physically Possible Continued Residential Use Redevelopment for Industrial Use Sites in Park Ranged from ~7 acres to ~40 acres Developable sites ranged: acres to acres Combined Subject Sites Totaled 3.18 acres was acres Assembled Acreage Total is 18.8 acres Increases Utility of Larger Parcel Financially Feasible Continued Residential Use Redevelopment for Industrial Use Say: Value of the Residential Property is $200,000 (probably high) What is the Land Value for the 3.18 acres No Sales of 3.18 acre sites in the Industrial Park 10

11 Consider a Regression Analysis $70,000 Lot Size versus Price/Acre y = 8668x R² = R 2 is low $60,000 Only ~52% of variation in price paid per acre is related to differences in lot size If use correlation analysis: Price per Acre $50,000 $40,000 $30,000 $20,000 $10, acres is ~$58,000 8,668 x (3.18) = $18,202/acre $ Lot Size (Acre) $18,202/acre x 3.18 acres = ~$58,000 But is that the value? Say: Value of acre site is $400,000 (~$25,600/acre) Say: Value of 18.8 acre site is $950,000 (~$50,500/acre) What might a developer be willing to pay for the 3.18 acres if they own the acre site? Maybe as much as $550,000 less demolition costs Is It Worth More Than the $200,00 as a Residence? Why the difference: $58,000 and $550,000 Informed buyer and seller Who is the most likely buyer What if you were hired by the owner to assist in decisions related to listing property for sale? What is the Maximally Productive Use? Assemblage for Redevelopment for Industrial Use 11

12 Supporting Adjustments Based on H&BU Analysis If Appraising the 3.18 Acre Property What Comparable Sales Should be Used? Similar H&BU Very Unique Situation H&BU would be the basis for many adjustments. Other Considerations Clearly a Residential Use Can a Certified Residential Appraiser Appraise this Property? What about a Residence Used as an Office BUILD RELATIONSHIPS WITH OTHER APPRAISERS! 12

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14 EXCESS LAND Legally Permissible C-1 Limited Office District Same for Before and After Taking EXCESS LAND Physically Possible Level, Not in Flood Hazard Zone, No Adverse Easements or Restrictions Excess Land Size Before Taking acres Slightly Below Average in Size After Taking 0.4 acres Well Below Average 14

15 EXCESS LAND Physically Possible Corner Location Before Taking Development is closer to Corner EXCESS LAND Physically Possible Land to Building Ratio Generally Around 7 to 9 Excess Land Before Taking (Office Development 5,300 sf to 6,800 sf) Excess Land After Taking (Office Development 1,900 to 2,600 sf) EXCESS LAND Physically Possible Opposing Counsel Argued 6,136 square foot office Parking in One Long Drive (Medical Building) 15

16 EXCESS LAND Financially Feasible 13 th Busiest Intersection In City Only 7 Vacant Corner Lots Although at end of the Recession, Office Development of Excess Land is likely within 5 years EXCESS LAND Significant Difference Between Uses of Before and After Typical Lot Size (Before) and Small Lot Size (After) No Longer a Corner Location Using Market L/B Ratios to Indicate Differences in Ideal Improvements Successful Argument Other Considerations Condemnation Appraisals are Very Specialized Seek out Challenging Assignments Make you a Better Appraiser Take Classes (ICAP Sponsoring Organizations) AI, ASA (NAIFA), ASFMRA Find Other Appraisers to Assist INVEST IN YOURSELF! MORE EDUCATION! 16

17 H&BU Analysis Drives the Process Type of Appraisal Residential or Commercial Approaches Developed Comparable Selection Land Sales Lease/Rates Reconciliation Strength of Each Approach HIGHEST AND BEST USE CHALLENGES AND SUPPORTING ADJUSTMENTS QUESTIONS? 17