McFarland PLLC

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Valuing Property in Development

by | Apr 8, 2022 | Eminent Domain |

Valuing Property in Development

Over the last 20 years, I have presented many times at the Eminent Domain SuperConference in Austin, Texas at the invitation of my colleagues at Barron & Adler (now Barron, Adler, Clough & Oddo). This year I addressed “sticky wickets,” those difficult compensation questions where, because of atypical facts, compensability issues, or the lack of reliable data, the ball simply does not bounce the way that one might expect. I thought I’d drop a note here to share some of my thoughts on atypical facts.

In many instances, the issue is not so much atypical facts as facts that we think are typical that aren’t. This can particularly be challenging for those practicing on the condemning authority side for the simple reason that they appraise many more properties than those of us on the landowner side. The fact is that most properties and most impacts are typical. That’s why it’s called typical. In a very real sense, the disputes between landowners and condemning entities on compensation issues can be understood as the argument as to whether the property at issue or the impact to the property is typical or atypical.

The first category of atypical facts involves special use properties, such as churches, schools, and industrial properties, where site functionality is paramount and the traditional approaches to market value may not apply. Special use properties have special needs. Churches need a lot of parking on one day a week, and they need to be able to get people in and out of the property essentially at the same time. Schools have a similar access challenges, while industrial properties may need to be accessible by larger (or heavier) vehicles or need to be able to stage larger vehicles without interfering with the other functions of the site. Additionally, storage or laydown areas on an industrial site cannot be construed as excess land. For these properties, marketability and functionality are essentially equivalent.

The second category of atypical facts we addressed was property in development. Anyone can understand raw, vacant land. The challenge in those cases is often convincing the factfinder to rely on experts as opposed to figuring it out themselves. Further, most of us understand improved property and application of the three traditional approaches to value to reach an indicated market value. But horizontal development, sometimes thought of as paper improvements, is not always obvious and, consequently, is easy to miss.

One particularly effective tool for unlocking the challenge of property in development is to consider, in the willing buyer/willing seller test of market value, the identity of the willing buyer. Is it another landowner, an investor, a developer, or an end user? What’s the difference? A landowner could be a legacy user (think farmer) or an investor. The common element: they are not going to take steps towards development, towards increasing the value of the property, or for making the property saleable to an end user (at its highest and best use). Depending on the market, the landowner sells to another legacy user, an investor, or to a developer.

In contrast, a developer is willing to take on the risk and effort to make the property marketable to an end user (for sale or lease). Pricing factors differ on who the willing buyer is. A legacy user cares most about being able to continue the existing use for a profit. An investor is literally trying to buy low and sell high. The investor is not so much interested in obtaining maximum value; their focus is the spread. The developer is not trying to buy low and sell high. They are trying to capture an opportunity that requires a physical footprint on property.

The development process begins with the developer’s identification of the opportunity. Land acquisition follows, and it is not uncommon that this will require an assemblage of tracts necessary to achieve the vision. After land acquisition and/or assemblage, the developer engages in planning his project. Additionally, they will secure any necessary utilities and entitlements for the development before proceeding with the permitting and, if needed, platting to allow for construction. Once vertical construction begins, the project as improved begins to take shape, and it is easier to see the opportunity presented by the development, which is the sale or lease of the property to an end user, one who will pay for the property based on what it can do with the property, as opposed to what other properties have sold for.

The tendency in valuing property in development is to rely on a cost approach, which builds value based on expenses incurred and application of a factor for entrepreneurial profit. But vision and opportunity are low cost, high value items that skew this factor from what we’d expect to see as applied over the total project cost. As a result, the cost approach is not reliable. Instead, we really need to figure out what the end goal is and back out costs to the stage of development as of the acquisition. Of course, you still have to include an entrepreneurial profit factor as part of the deduction from the as-completed value with the cost to complete development. From a push and pull perspective, the questions is, when do you move from a build value approach to a back out value approach? Understanding the development process is critical to answering this question. Obviously, the developer isn’t going to be compensated for identifying the opportunity if this precedes acquisition or assemblage of the property, even though condemnation of the property at this stage impacts the developer.
Purchasing the property alone may not be enough, but once the developer begins planning its development and securing the utilities, entitlements, and permitting necessary to move forward with the development, a cost or build approach to value inherently undervalues the opportunity and, therefore, undercompensates the developer for an acquisition while property is in development.

As always, it was a great conference with some really useful content, and I highly recommend attending if you have an interest in Texas eminent domain issues.