Wednesday, November 16, 2011

Highest & Best Use Analysis and SCIG

Highest & Best Use Analysis

There is a lot of emotion inherent in the objections being voiced over the Port of Los Angeles / BNSF Southern California Intermodal Gateway Project (SCIG).  In an effort to reduce or eliminate some of that emotion so that emphasis can be placed on facts, I am providing definitions and basic procedures followed in highest and best use analysis of land.   Whether you support or oppose this project already, these are the considerations that Port and Railroad planners had to look at when trying to search for the best place to put this project.  That the project is necessary someplace appears to be beyond dispute.   Proponents of the project cite the need for expansion of port capabilities to remain competitive with the rest of the country’s ports.  Even the inventor(s) of the so called zero emissions technology touted by project opponents acknowledge the need for port expansion of capability.

The only real argument appears to be the how and where aspects of the needed expansion.  I’ve addressed the ‘how’ portion elsewhere, demonstrating that while highly desirable, zero emissions technology in the form of MagLev™, LIM or LSM is simply not commercially available or viable for heavy freight movement in the Ports of Los Angeles and Long Beach.  It is my intent that the following addresses the reasons behind the ‘where’ question, ad helps readers to understand why the selected location really is the only viable location.

The following article, beyond the introductory comments, consists of a near verbatim quote from Chapter 12 of The Appraisal of Real Estate, 13th Edition, published by The Appraisal Institute. There are this authors comments interspersed (and identified) throughout.  The value of noted publication cannot be understated.  It is this publication that is often referred to in the industry as the Appraiser’s Bible.  In any event, it is generally acknowledged among appraisal professionals as the final authority or guide, on appraisal issues and concepts.  For these reasons, it was considered more appropriate to quote this authoritative and primarily educational work, than to paraphrase the concepts and procedures  described within it.

Where the terms property ‘to be appraised’ or ‘subject property’ appear in the quoted text, it is often easier to follow if you simply mentally translate it as ‘the property’ (any property).  Where “appraiser” is used, think of any person performing or critiquing highest and best use analyses.

Many years ago (early 1970’s) when I first entered the real estate field, the concept of highest and best use of real estate included a consideration of socio-economic benefits.  Over the years that aspect or consideration was eliminated from virtually all recognized definitions of highest and best use.  As currently accepted, highest and best use is considered to be that (those) use(s) that are:

 Legally Permissible

 Physically Possible

  Financially Feasible

Maximally Productive

Most communities are bound either by regulation (including local ordinances; state and or federal laws), or custom, to insure that the highest and best use is achieved in the development or use of publicly owned real property.  Where it is not a statutory requirement, it is usually a customary political reality.  What public official; elected, appointed, or salaried, wants to explain to their citizens why property owned by that jurisdiction is not be put to its highest and best use?   In some instances, use or uses that are less than highest and best use, could be perceived as potential malfeasance, or at best, incompetence, in the stewardship of public assets.  Optimal use of ALL real estate and real property interests assumes responsible management.

Highest & Best Use Analysis

“The analysis of relevant data to develop a market value opinion requires two important steps in the valuation process before the applicable approaches to value are applied. Market / marketability analysis begins the process of narrowing the focus from a broader macro view to data that is especially pertinent to the appraised property.  Highest and best use relies on that analysis to then identify the most profitable, competitive use to which the subject property can be put.  The highest and best use is shaped by the competitive forces within the market where the property is located and provides the foundation for a thorough investigation of the competitive position of the property in the minds of market participants. 

An understanding of market behavior developed through market analysis is essential to the concept of highest as best use.  Market forces create market value, so the interaction of market forces that identifies the highest and best use is of crucial importance.

Fundamentals of Highest and Best Use

Highest and best use may be defined as The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value

The theoretical focus of highest and best use analysis is on the potential uses of the land as though vacant.  In practice, however, the contributory value of the existing improvements and any possible alteration of those improvements are also important in determining highest and best use and, by extension, in developing and opinion of the market value of the property.  In the analysis of highest and best use of land as though vacant, the appraiser seeks the answers to several questions:

·        Should the land be developed or left vacant?

·        If left vacant, when would future development be financially feasible?

·        If developed, what kind of improvement should be built?

In the analysis of highest and best use of the property as improved, additional questions must be answered:

·        Should the existing improvements on the property be maintained in their current state, should they be altered in some manner to make them more valuable, or should they be demolished to create a vacant site for a different use?

·        If renovation or redevelopment is warranted, when should the new improvements be built?

In general, if the value of a property as improved is greater than the value of the land as though vacant, the highest and best use is the use of the property as improved.  However, a property’s existing use may represent an interim use, which begins with the land value for the new highest and best use and adds the contributory value of the current improvements until the new highest and best use can be achieved.  In practice, a property owner who is redeveloping a parcel of land may remove an improvement even when the value of the property as improved exceeds the value of the vacant land.  The costs of demolition and any remaining improvement value are taken into consideration in the test of financial feasibility for redevelopment of the land.  Likewise, if an improved property has value but may have greater value if modified in some way, the cost of modifying the improvements and the value gained in that modification are accounted for in the determination highest and best use.

The Four Tests

As market / marketability analysis progresses to highest and best use analysis, appraisers first consider the reasonably probable uses of a site that can be legally undertaken.  In the analysis of pertinent data, four steps are implicit and are applied in the following order to develop adequate support for the appraiser’s highest and best use opinion:

1.   Legally permissible

2.   Physically possible

3.   Financially feasible

4.   Maximally productive

These criteria are usually considered sequentially.  The tests of physical possibility and legal permissibility can be applied in either order, but they must both be applied before the tests of financial feasibility and maximum productivity.  A use may be financially feasible, but this is irrelevant if it is legally prohibited or physically impossible.”

M. Ford’s Comment: This is the area where most abuse takes place; either by applicants seeking to ‘enhance’ a specific property’s ‘highest & best use’, or by opponents to specific developments.  In each case the existing land use regulations are either exceeded by the applicant, or claimed to be illegally (or unreasonably) excessive by the opponents.  On the one hand an applicant seeks to gain market advantage by acquiring land for one (lower) purpose, and then through ‘special consideration’ (legal or otherwise) getting the allowable zoning or density increased (raised to a more intensive use).  Conversely, an opponent may claim that although a proposed project use is perfectly legal under an approved General or Specific Land Use Plan, and zoning, that it is somehow now uniquely necessary for the governing jurisdiction to ignore its own voter-approved land use regulations for a limited special interest constituency.  This could be a group of homeowners adjacent to the property that never liked the general or specific plan in the first place, but lost in the elections to approve it, so they now use every means to oppose legal, conforming uses of the property; or it could be environmental groups opposed to either the specific project, or seeking to ‘force’ extra conditions that are not already statutorily required under the existing lad use regulations, and lastly it could be a political interest group seeking to promote themselves by either  creating, or riding the wave of emotional fears associated by a project.  Each of these scenarios can be costly to the governing agency and citizens who invariably get sued by one side or the other.

The whole point of having an approved general plan, or specific land use plan; zoning, and development standards, is to avoid this type of scenario by having categorically approved uses that are permitted in each zone or district.  It is truly unfortunate that taxpayer dollars are wasted by self interest groups that do not want to play by the rules established by the community at large.  On the ‘positive’ side, it does provide more employment opportunities for attorneys.

(Quotes from the 13th edition resume below)

“The six step market analysis process…provides the data required for the four test criteria…. The initial analysis of the market and land use regulations (i.e., property productivity) usually limits the number of property uses to a few reasonably probable choices.  For example, market analysis may suggest that there is demand for a large office building in a community.  If the subject sites is surrounded  by modern, single unit residential developments, however, a large multistory office building would probably not be a reasonably probable use, even if it were legally permitted. Similarly, a housing development for the elderly might be a permissible use for a site, but, if most residents of the area are under 40  years old, this us is most likely not  reasonably probable and would not be tested for financial feasibility.  Consideration of whether a use is  reasonably probable should continue throughout the analysis of the highest and best use as more is learned about the potential use of the property.  Reasonable probability is both a tentative starting point a conclusion for the use or uses that are ultimately deemed probable.  Appraisers constantly evaluate and reconcile what develops through competent application of the steps in the valuation process.  Many of the considerations and discoveries that are made through their analyses become important points not only for the development of their own value conclusions, but also for inclusion in their reports to clients.

There may be a significant demand for a use in the market area of the subject property and the subject may be suited for this use, but a number of other sites may be equally or more appropriate.  The appraiser must test the highest and best use conclusion to ensure that existing and potential competition from other sites has been fully recognized.

An appraiser must also consider the competition among the various uses for a specific site.  For example, competition for available sites along a commercials trip development may be intense.  Developers of community retail uses, garden office uses, and fast food franchises may bid against one another for these sites, and the prices they pay for these sites will reflect this competition.  Market demand is not infinite. Even though the subject may be physically and locationally suited for that use, better-located sites may satisfy the market demand completely before the subject property can realize its development potential.

The same observation may be applied to central business districts (CBDs).  The market may define the highest and best use of land in the CBD simply as high-rise development, which often includes a mix of uses such as office, retail, hotel, and residential apartment or condominium use.  At times the highest and best use conclusion for a CBD does not indicate a specific highest and best use, but rather a class of uses that is supported by market area trends and reflects a consistent density of development.

Application of Highest and Best Use

Highest and best use analysis builds on the conclusions of market / marketability analysis.  The analysis of land as if vacant focuses on alternative uses, with the appraiser testing each reasonably probable use for legal permissibility, physical possibility, financial feasibility, and maximum productivity.  In contrast, the appraiser applies the four tests in the analysis of the property as improved, but the focus is not on alternative uses but on three possibilities: continuation of the existing use, modification of the existing use, or demolition and redevelopment of the land.

Highest and Best Use of Land as though Vacant

Land is generally valued as if vacant.  When land is already vacant, the appraiser values the land as it exists.  When land is not vacant, however, its contribution to the value of property as improved depends on how it can be put to use.  Therefore, the highest and best use of land as though vacant must be considered in relation to its existing use and all potential uses.  A conclusion of highest and best use of the land as though vacant is required in nearly all appraisal assignments.  However, the level of study will be significantly greater when a larger proportion of the total property value is in the land. The level of study will be significantly less when only a small proportion of the total property value is in the land.  Appraisers explain in the appraisal report why a lower level of study may have been applied so that others can understand the justifications and the data on which they are based.

Testing the Legal Permissibility of Land as though Vacant

Private restrictions, zoning, building codes, historic district controls, and environmental regulations may preclude many potential uses.  The appraiser must also consider whether there is a reasonable probability that the zoning or other restrictions could be changed in order for the highest and best use of the property to be realized.

          In applying the test of legal permissibility, the appraiser determines which uses are permitted by current zoning, which uses could be permitted if a zoning change were granted, and which uses are restricted by private restrictions on the site.  Private restrictions, deed restrictions, and long term leases may prohibit certain uses or specify building setbacks, heights, and types of materials.  If deed restrictions conflict with zoning laws or building codes, the more restrictive guidelines usually prevail, but this may pose a legal question that the appraiser cannot answer without assistance with the appropriate legal expertise.  A long term lease may affect the highest and best use because lease provisions may limit use over the remaining term of the lease.  For example, if a property is subject to a land lease that has 12 years to run, it may not be economically feasible for the tenant to construct and move to a new building with a longer remaining economic life.  In such a case the appraisal report should state that the determination of highest and best use as leased is influenced by the lease’s impact on utility over the remaining lease term.

          In addition to analyzing zoning and private restrictions, testing the legal permissibility of a land use also requires the appraisers to investigate other applicable codes and ordinances, and environmental regulations.

          Building codes can prevent the land from being developed to what would otherwise be its highest and best use by imposing burdensome restrictions that increase the cost of construction.  For example, the additional cost of a water retention pond with excess capacity that is required by local ordinance could impact the size of a proposed community shopping center.  Less restrictive codes typically result in lower development costs, which attract developers.  More restrictive codes tend to discourage development.  In some areas, more restrictive building codes are used to slow new construction and limit growth.  Historical ordinances, such as historic facade easements, and overlay districts may be so restrictive that they preclude development.

          Concern over the long range effects of certain land uses sometimes result in increased environmental regulation and stricter development controls.  Appraisers must be familiar with environmental regulations pertaining to clean air, clean water, and wetlands, and they should be sensitive to the public’s reaction to proposed development projects.  When resistance from local residents and the general public occurs, it can pressure public officials to stop or limit certain real estate developments or change the density or character of a specific plan.

          As with zoning ordinances, if there are other limitations inherent in other applicable codes, ordinances, and regulations, the appraiser should investigate whether there is a reasonably probability of a change relative to the subject property. “

 M. Ford’s Comment:   In smaller communities (towns, villages or small cities), where the impact of a few citizens can influence political careers, it is much easier, and frequent to stall, or stop undesired projects, regardless of their merit and conformity to applicable codes.  In larger urban cities, this is less common.  Partly because the influence of relatively smaller voting blocks is reduced, but also because the impact of individual politicians influence, is watered down.  There is the cost of probable lawsuits to consider as well.  Major projects tend to be very costly and well researched prior to application submissions.  Thorough research into underlying general or specific plans is completed.  Zoning and conformity is considered.  Suitability of a project to the proposed site is considered. Alternate sites (when available) are considered. Surrounding uses are considered. Environmental considerations are addressed. Unless the applicant is proposing a use, or uses that have never been considered for the site (up-zoning), or there are numerous equally desirable opposing uses from a community standpoint for the land in question, the applicants usually are proposing reasonable highest and best uses.  When Environmental Impact Reports are required, the door is opened for abuse from either side.

            If compliance costs are deemed excessive or overly burdensome, applicants may downplay or even misrepresent them or alternatively, overstate the benefits and efficacy of their proposed mitigation measures.  From the opponents perspective, challenges to specific aspects of an Environmental Impact Report (EIR) may be made t the governing jurisdiction, or even through the courts.  This gives rise to a potential for abuse by those completely opposed to projects for no other reason than “just because.”  It (EIR) also presents opportunities for litigators to chase high fee payoffs under the guise of ‘public interest’ lawsuits, or via representation of ‘community interest’ groups.  Sometimes these ‘community interest’ groups are created for the sole purpose of intended litigation.  When proposed project costs can run to hundreds of millions of dollars, even a 1% settlement cost is far cheaper and more cost effective for applicants than protracted litigation, coupled with the possibility that a friendly judge, or sympathetic jury could find partial favor with a complaint, resulting in judgment and ‘compliance costs’ far greater than 1%.  A 5% settlement would be a windfall!  (a $5 million settlement on a half billion dollar project is quite a windfall for the attorney that takes such a case on contingency.).

          “Environmental extortion” is a fact of life.  Legitimate, as well as pseudo-environmental groups have sprung up all over the country and have demonstrated their collective willingness to become involved in diverse causes and projects.  In best case scenarios, they promote preservation of the environment that might otherwise be lost. In worse case scenarios, the pseudo environmentalists can actually cause more environmental damage, by forcing abandonment of projects that could otherwise have resulted in more modern, cleaner use developments than currently exist.  There are negative indirect consequences as well.  Some states are perceived in the business community as being too difficult to get things done.  In their opinion, it is more cost effective to move entire operations to more business friendly states.  This phenomenon is not limited to states.  Oil pipelines across multiple states or countries have almost always been challenged, though such projects present their own unique challenges from the standpoint of highest and best use of the land under their intended path.

(Quotes from the 13th edition resume below)

“Testing the Physical Possibility of Land as though Vacant

The test of physical possibility addresses the physical characteristics associated with the site that might affect its highest and best use.  The size, shape, terrain, and accessibility of land and the risk of natural disasters such as floods or earthquakes affect the uses to which land can be put.  The utility of a parcel may also depend on its frontage and depth.  Irregularly shaped parcels can cost more to develop and, after development, may have less utility than regularly shaped parcels of the same size.

          Ease of access enhances the utility of a site.  For certain property types, visibility is an important feature.  For other property types, the privacy provided by the lack of a view is a benefit.  The capacity and availability of public utilities are also important considerations.  If a sewer main located in front of a property cannot be tapped because of a lack of capacity at the sewage disposal plant, the property’s use might be limited.  When topography or subsoil conditions make development difficult or costly, the lands utility may be adversely affected.  If the cost of grading or constructing a foundation on the subject site is higher than is typical for sites in the area competing for the same use, the subject site may be economically infeasible for the highest and best use that would otherwise be indicated.”

          I have chosen to end the educational text quotations here.  The next steps in the process are testing the financial feasibility of land as though vacant; testing the maximum productivity of land as though vacant, and a repeat of the same essential four steps for improved property.  Financial feasibility considerations are numerous.  The bottom line is that if the intended use does not provide either a market required rate of return, or particular investor’s required return rate (or alternatively, required utility for owner users), then that use would not be built.  Maximum productivity relates to being the use that produces the most return, or highest profit.  This concept is less cut and dry than the other steps.  It often involves a category of use rather than a specific use.  The defined concepts noted above are further discussed in The Appraisal of Real Estate, 13th Edition, published by The Appraisal Institute, in Chapter 12, from pages 277~296.  I concluded the above at page 283.  The current cost of the book is $89.00 plus shipping.  It may also be available in your local library.

Southern California Intermodal Gateway (SCIG), Port of Los Angeles, California

The above information was provided to assist readers in better understanding of a specific project, proposed for land under the jurisdictional control of the Port of Los Angeles, adjacent to land under the control of the City of Long Beach, California. 

A railroad (BNSF) has proposed broadening a section of existing track, for the purpose of building an off dock intermodal container transshipping terminal. The land is bordered to the North by Sepulveda Blvd., (a regional East-West connector street).  There is an existing ICTF facility located to the North side of Sepulveda. A freeway runs immediately adjacent to the East side.  There is a large refinery to the West and a variety of shipping and drayage services to the South (across Pacific Coast Highway).

The project requirements make it desirable to have a comparatively long and narrow parcel adjacent to existing railroad tracks for on and offloading containers directly on to parallel stationed trucks by overhead cranes.  This type of project is a heavy industrial use due to the railroad trains being stationed and used on site.  It makes use of already existing railway lines and infrastructure for North and South freight movement.  There are no viable alternative locations within the Port of Los Angeles itself.  It is located in an area zoned for heavy industrial use.  It is buffered from non-compatible uses on three sides by similar heavy industrial uses.  The fourth side boundary is a freeway, with housing and schools to the East of that.  Existing uses on the site are similar in character, though older, and more prone to generate pollution than the proposed project due to the lack of most-modern equipment in use there.

I have lived in, and around the immediate area of this project for approximately 20 years.  I presently live in the potentially affected Long Beach neighborhood to the East of the proposed project.  For fifteen years I lived on a boat inside the Port of Long Beach, near the border of Los Angeles and Long Beach Harbors.  I am familiar with each harbor-both on the land side and waterfront.  Satellite imagery, as well as past flights above this area, and the use of existing aerial photographs give a good sense of what exists throughout the harbor, and what sites are potentially available for alternative development sites.

When I consider the highest and best use criterion noted in the foregoing, I can only opine that there is no other site that provides similar utility; with as effective use of existing infrastructure, and similar or lower cost projections.  There is also the consideration that much of the harbor area is built on fill soil, and is more susceptible to liquefaction in earthquakes.  Numerous other issues with respect to inadequate rail linkage and access exist.

Looking at the proposed site itself, it appears that the proposed use is one of those rare land use development occurrences in which the ‘perfect’ highest and best use is being proposed.  The site is long and narrow.  Its access for commercial development is too limited to be viable for most uses.   Its access for industrial purposes is adequate, though again limited.  There are rail lines on the site.  A grain shipping operation and trucking (drayage) company are located there now.  Either use is legally permissible, and physically possible.  Though expansion of either use has not been postulated, such expansion could be financially feasible, though neither seems remotely capable of providing maximum productivity of the site (profit, to the People of Los Angeles), or benefit to the People of the United States through use intensity similar or superior to that which is proposed.  The proposed use of this site, along with a competitor site to the North (Union Pacific / ICTF) are reported to enable an increase of over two million TEUs in port handling and shipping of containers per year.  Facility cost projections of $400 to $500 million dollars are far beyond the reasonable ability of the existing trucking company, or grain shipping company to compete with.   There are comparatively few industrial uses that are potentially alternative candidates for this site. 

Refinery expansion would appear to be physically possible, but would encounter more legal hurdles than the proposed SCIG project.  It is unknown if it could pass state regulations, let alone broader AQMD, local harbor and adjacent jurisdiction regulations.  The location, configuration, and demand are inadequate to support distribution warehousing on the site. It could potentially be used to store and ship spent nuclear fuel to other countries for reprocessing, but that seems less likely than refinery expansion.  It is too small a site for a major manufacturing facility, even if demand for such a facility existed in this area.

A railroad container trans-shipment center seems to be the ideal and optimal  use given the shape, location, and existing infrastructure, including existing rail lines on site.

I can think of NO OTHER USE that would be a higher and better use than the proposed project on this site.  If any readers think they have one, please feel free to describe it in the comments section- but remember it has to pass the tests noted above; be financially feasible and result in the greatest profit / use to the citizens of Los Angeles, as well as surrounding areas.

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