The Appraisal of New Construction

The appraisal of new construction in a sense is the appraisal of a property in motion. What starts as raw land proceeds to land with approval to build a building, through construction drawings, to the start and finish of construction, and to stabilized occupancy. At each step of the process, the property increases in value. Part of the job of the appraiser is to make the property hold still for long enough so that it may be valued.

An appraiser taking on an assignment for a lender in the valuation of a proposed building needs to know the "rules of the road" for the client. Most appraisals for new construction are engaged by lenders. The rules under which federally regulated lending institutions operate require that, for construction lending, the property be valued both "as is" and at completion of construction. At completion, an additional value, the value at stabilized occupancy, when tenants have moved in, may be required as well.

At the start, a property is raw land or is land with a building that is to be demolished so that the new building can be built. The cost of demolition needs to be deducted from the value of the site as if vacant (without the building) to value the property with the old building still in place. If this isn't true - if the value with the old building in place is greater than the value of the site as if vacant - then, the old building is still contributing to value, and the highest and best use is to leave it standing. This is often the case. Demolition wipes out the marginal contribution of the old building. But, once they have approvals for new development, developers proceed anyway, because they know they have a bigger payoff on the other end.

Raw land value is typically established by comparison of the subject property with other properties that have sold. Another method is to value the property at completion of construction and to deduct the costs in all the stages involved in completion. But the simplest and most generally accepted method is raw land sales comparison.

Gaining approvals can add considerable value. The maximum increase is achieved when the approval is for a use not originally allowed under the zoning or when approval is gained in a high-value community that has a reputation for denying proposals. In one near-Boston suburb, a developer assembled numerous quarter- and half-acre industrial sites, most with old buildings, at prevailing industrial land values of $25 to $35 per square foot. Multi-family was not an approved use in the zone, but the developer succeeded in achieving multi-family approval and sold the eight-acre assemblage for $115 per foot of land. Because of the high profit potential and the ability to lock up a site through a purchase option, without actually taking title, some developers specialize in this part of the process, sell the approved site, and never actually build any buildings.

But they do face a downside. All those costs - in securing the option, in legal and engineering fees in the approval process, and in the value of their own time - are lost if the project is rejected.

In other cases, approvals may add little or no value. A single-family lot that has no development impediments has about the same value with and without the building permit. The same goes for the proposed retail strip with approvals in a retail zone. The benefit is small in either case.

An appraiser using raw land sales as comparisons needs to be aware of whether the raw land is truly raw or has approvals. The difference can be small. But sometimes, it is like night and day.

Completion of plans and specifications adds value. Construction drawings are typically developed in parallel with the approvals, so that government agencies can know what they are approving. Once approvals are granted, the developer's architect can complete the full construction drawings. Often, the appraiser is engaged at this stage of the process. Sometimes the engagement comes at an earlier stage. On occasion, the appraiser arrives to find that the borrower has little more than an idea of the facility to be built. If the borrower can't be specific about what the building will be, the appraiser can't make the appraisal. It is not necessary that complete plans and specifications be provided. It is only necessary that the design be sufficiently complete for the appraiser to make a reliable appraisal. It matters how the building is configured and how the interior is laid out. It matters whether the siding is vinyl or painted wood. It matters whether the kitchen counters are laminate or granite. If the borrower can't make up his or her mind, then the appraisal needs to wait. More than in the valuation of an existing building, it is important that the description of a proposed building be complete. For an existing building, if someone wants to know what the appraiser was appraising, not only is the appraisal available, but so also is the thing that's being appraised. Anyone with a key can go inspect it. For new construction, all that is available is the appraisal and whatever plans and specifications are available. If those aren't specific as to whether the counters are laminate or granite, who knows what the appraiser was valuing?

Next comes construction. Construction is the most straightforward part of the process. Everyone can see what is happening during construction and how value is being added. Construction is probably the most expensive part of the process. The costs are the easiest to identify. Probably there is a hard cost contract involving the builder. Other costs are soft costs, most of which have actually been incurred before a shovel goes into the ground. The way a deed is the fulfillment of a purchase and sale agreement, which is really the controlling document, construction is the fulfillment of the plans and specifications that came before.

For some property types, completion of construction is the end of the process. A house that's completed has reached its maximum value. It doesn't achieve more value when someone moves in. But for other property types that require tenants, there is a final stage.

A completed store block still needs rent-up to various tenants, which involves brokerage costs, the "cost" of lost rent during rent-up, and, often, the cost of build-out of the units. A finished but empty apartment requires rent-up. Value is added during the rent-up process.

The standard method of valuation at this stage is to value the property at some future date when stabilized occupancy after rent-up is likely to be achieved. Costs of lost rent, build-out, and brokerage are deducted to find the value at completion of construction (but before rent-up). These and the value "as is," before construction was started, are typically the values that a lender requires. The process of going backward with deduction of costs in theory can be followed to its earliest stage by deducting construction costs and the costs of drawings and approvals to get to the value of the raw land.

A final word concerns pitfalls in the valuation of a group of components like condominium units or subdivision lots. If the developer has built ten condominium units and each is worth $500,000, then the gross sellout is $5,000,000. The developer may wish for the gross sellout to be the value at completion. But it is probably not. If no one would pay $5,000,000 for the group of units, it is definitely less. A buyer of the ten units would incur holding costs and brokerage costs and would need to make a profit in the process of selling the units out. If these add up to 20% of the sellout, then the ten units as a group are only worth $4,000,000. The appraiser needs to know that, and the lender needs to know that, or the lender is at risk of making too large a loan.

The appraisal of new construction in large part is a matter of recognizing all the costs.