UP Standards

4.4.5.1. Reasonable Probability of Development.Under federal law, the development method cannot be used unless the property was “‘needed or likely to be needed in the reasonably near future’ for residential subdivision.”638 And showing “that a few new homes had been built in the area around the time” of valuation is insufficient: There must be “evidence ‘of…current demand or potential for subdivisions in the neighborhood[.]’”639 To credibly establish demand for such lots, “there must be some evidence that others have developed and sold such lots, so as to establish a trend, at least, toward that type of development of [similar] property.”640  Use of the development method requires evidence that on the date of value, there was a reasonable probability that the…

4.4.5. Subdivision Valuation and the Development Method.When appropriate, aspects of the sales comparison, income capitalization, and cost approaches to valuation can be incorporated into a technique for appraising undeveloped acreage having a highest and best use for subdivision into lots. A federal court recently explained this development method634 as follows: [O]ne first determines or projects both how the land would be subdivided and the prices at which those lots would sell. The projected gross sale proceeds for all lots in the tract are then aggregated and a deduction is made for all projected direct and indirect costs of maintenance and sale, including development [i.e., the developer’s anticipated profit] and marketing. Finally, the net amount is discounted to present value to…

4.4.4.5. Further Guidance.The income capitalization approach to value in the appraisal of real estate generally—not only in the context of federal acquisitions—has evolved significantly in recent decades.627 The basic parameters for its use for just compensation purposes can be found in Supreme Court cases such as United States v. Toronto, Hamilton & Buffalo Navigation Co.,628 and several recent circuit court cases cited in this Section provide more concrete analysis.629 The district court rulings affirmed by or on remand from three recent circuit court opinions are also instructive—see the Gettysburg Tower litigation in the Third Circuit, the Amexx litigation in the Second Circuit, and the Piza-Blondet litigation in the First Circuit.630 The Parrish case, an older district court ruling from the…

4.4.4.4. Unit Rule Implications.The unit rule, discussed in Section 4.2.2, applies in valuations using the income capitalization approach as in all other approaches to value.621 “The subsidiary interests in a fee cannot add to its market value and compensation for these interests must be paid out of the amount awarded for the whole.”622 Accordingly, in federal acquisitions, if using the income capitalization approach to value, appraisers must value the property being acquired as if in single ownership—not by “computing separately the value of the various constituent legal interests” (such as lessor/lessee or operator/owner) in the property.623  For example, in United States v. 6.45 Acres of Land (Gettysburg Tower), the United States acquired two adjacent tracts in fee simple: Tract 4-203,…

4.4.4.3. Capitalization Rate or Discount Rate.Determination of the capitalization or discount rate in an income capitalization approach is critical. This rate “reflects the degree of risk in the undertaking involved. It is an extremely important figure in the computation because a change of even a fraction of one percent will produce a surprisingly material change in the result.”618 As a result, federal courts have rejected use of the income capitalization approach if the discount rate is not supported by appropriate market evidence.619 The capitalization or discount rate must be derived from actual market data, through comparison if possible:  [A] capitalization rate…should be ascertained by reference to the best evidence—the most similar property—as well as dissimilar investments if that proves necessary.…

4.4.4.2. Income to Be Considered.The Supreme Court has instructed that “separation…must be made, in any case, between the value of the property and the value of the claimant’s own business skill . . . .”613 As a result, in determining the market value of the property, only income generated by the real estate itself—typically rental or royalty income—can be considered and capitalized.614 In contrast, income generated by a business conducted on the property (such as a farming operation) is not considered.615 As the First Circuit stated: “It is the value of the real estate, not the business that we are concerned with in this case. To allow evidence of past and future business profits would only confuse the value of…

4.4.4.1. Applications.While federal courts recognize the income capitalization may be a valid and reliable approach to value in certain cases, they uniformly hold that it should be used only “when there are no comparable sales and market value must be estimated.”594 Accordingly, the fact that a property produces (or could potentially produce) income will not, on its own, justify use of the income capitalization approach. Rather, its relevance to what a willing buyer would pay to a willing seller must be demonstrated.595  The income capitalization approach may refer to either direct capitalization or yield capitalization techniques:  • Direct capitalization techniques are used to derive an indication of the market value of a stabilized income-producing property by applying an overall capitalization…

4.4.4. Income Capitalization Approach.The third recognized approach to value in federal acquisitions is the income capitalization approach, which involves capitalizing582 a property’s anticipated net income to derive an indication of its present market value.583 When properly applied, the income approach can indicate what a buyer would pay at the present time for the anticipated future benefits, discounted for risk and other variables, of owning a property.584 The income capitalization approach is relevant only in certain circumstances—namely, in the valuation of income-producing property with no available comparable sales.585 Even then, “[g]reat care must be taken, or such valuations can reach wonderland proportions.”586  For this reason, federal courts have often found iterations of the income capitalization approach to value “ill-suited to the…

4.4.3.6. Unit Rule and the Cost Approach.Valuations derived from the cost approach and any other approach to value must follow the unit rule, which requires property to be valued as a whole, as discussed in Section 4.2.2. Indeed, “it is firmly settled that one does not value the [ ] land as one factor and then value the improvements as another factor and then add the two values to determine market value.”579 In using the cost approach, it is therefore critical to distinguish between calculating the cost of improvements and estimating the market value of the property as a whole, considering the contributory value of improvements.580  As discussed in Section 4.2.2.3, some assignments may require separate allocation of the contributory…

4.4.3.5. Entrepreneurial Incentive and Entrepreneurial Profit. Current appraisal methodology recognizes entrepreneurial incentive—the amount an entrepreneur expects to receive from developing a real estate project—as an element of the cost approach to valuation.571 Similarly, entrepreneurial profit (also developer’s profit) is the amount actually received, reflecting the difference between the total cost of development and its market value after completion.572 Of course, not all developments live up to expectations: “It must be remembered that an entrepreneur is not guaranteed a profit.”573  The Supreme Court has yet to address the propriety of entrepreneurial incentive or entrepreneurial profit in the cost approach to valuation in federal acquisitions.574 Still, rulings from one of the only federal courts to consider this issue are instructive:  Because the…