May 20, 2013 Article

A Cross-Examiner's Primer: The Real Estate Appraiser and Highest and Best Use

The second in a series of articles on practical skills for new and experienced real estate litigators

by Kevin H. Brogan

Trial attorneys handling real estate valuation issues are often confronted with widely divergent opinions of value proffered by appraisal witnesses. In many cases, the reason the appraisers’ opinions differ is because their opinions of highest and best use of the subject property vary. Cross-examining the appraiser on highest and best use requires that the attorney understand not only the concept but also the foundation of the appraiser’s reasons for his or her opinion. Armed with both, one can undermine the basis of the appraiser’s opinion through careful, pointed, and killer cross.

What Is Highest and Best Use?

Highest and best use means the most profitable use that can be made of real property. This determination drives the selection of comparable sales, if the market approach is used to value property, and comparable rentals and the capitalization rate, if the income approach is used. For improved property, the appraiser must determine the highest and best use not only based on the existing improvements but also assuming those improvements do not exist. In a condemnation action involving the taking of only a portion of a larger parcel (a “part taking”), the appraiser must look at the highest and best use of the property before the condemnation (the “before” condition) and the highest and best use of the property after the part has been taken (the “after” condition).

 

For example, assume that the subject property is improved with a gasoline service station at a heavily traveled intersection in the downtown area of a city. The property has a commercial zone with a conditional use permit for a service station use. The appraiser must determine the highest and best use of the property “as improved” with the gasoline service station improvements and then also assuming it is vacant.  In analyzing the market for properties with comparable improvements, the appraiser may conclude that the fair market value of the property as improved is $30 per square foot. In analyzing the market for vacant properties at corner locations in the downtown area, the appraiser may conclude that the fair market value for vacant commercial properties is $40 per square foot. In comparing the two ranges of value and taking into consideration the demolition costs to remove the improvements, the appraiser could well conclude that the highest and best use is for commercial development purposes, rather than continuation of the service station use.

 

As we discussed in the first installment of this occasional series (“A Cross-Examiner’s Primer: The Real Estate Appraisal Expert,” Real Estate Litigation (Fall 2012)), a highest and best use of property must satisfy these requirements:

  • The use must be a legal use.

  • The property must be physically adaptable to the use.

  • The use must be economically feasible.

  • The use must be the maximally productive use of the land.

The appraiser should analyze each element to determine whether a proposed use can qualify as the highest and best use.


A Legal Use?

As a first step, the appraiser must determine what uses may be legally placed on the subject property. The appraiser should review the existing and proposed use by reviewing the zoning and planning designations for the property, as well as any permits that apply to it. If the use is allowed under existing zoning, this element is satisfied. If the use requires a conditional use permit (CUP) or a variance, the appraiser should determine whether it is reasonably probable that the applicable zoning authority would issue the CUP or variance.  This is typically done by reviewing the city’s planning documents and preferred development for the area, as well as other applications for CUPs or variances in the neighborhood or similar areas. The appraiser then considers the city’s preferences for development of the site and the similarities and differences of the other zoning applications to other parcels to determine whether, in his or her opinion, it would be reasonably probable that the zoning relief, if needed, could be obtained.

The appraiser must also use reasonable probability to consider a property that may need a zone change for a proposed use. For example, if a property was long ago zoned “Agriculture” (which presumably would not allow commercial uses) but is now within the suburban area of a city and otherwise capable of a residential or retail use, is it reasonably probable that the local zoning authority would allow the change of zone? What conditions or exactions would the local authority require for the change of use? How long will it take? The appraiser needs to investigate these issues so that a proper foundation can be laid for the admission of his or her opinion on this change in use. Of course, the extent of this investigation is fertile ground for cross-examination and impeachment. Introducing evidence on cross that the city recently turned down a similar request a block away can be devastating to the appraiser’s opinion that such a change would be reasonably probable.

And don’t forget the other potential impediments to a legal use determination. The appraiser should also have investigated whether there are deed restrictions or long-term leases that could be an impediment to development. Building codes may also preclude a highest and best use based on requirements such as setbacks, drainage facilities, or water retention basins. If the matter is a condemnation or inverse condemnation case, the appraiser should have considered whether the current or anticipated future zoning is project-related and determine whether the project-related zoning should be considered. Showing these impediments on cross proves that the appraiser didn’t do his or her homework.


Is the Property Physically Adaptable to the Use?

Assuming that the appraiser is satisfied that the proposed highest and best use is a legal use, the next step is to determine whether the property is physically adaptable for that use.  Is the property itself of sufficient size and shape to support the use?  Are public utilities readily available, or if not, could they be made available at a reasonable price?  Is there, or could there be, adequate access?  Is there adequate visibility for a commercial development? Sometimes the answers to these questions are not readily apparent, and the appraiser needs to consult a civil engineer or an architect to determine whether the property is physically adaptable to a proposed use.

Again, this is prime area for potential cross-examination. Do not be afraid to dig into the nitty-gritty of the appraiser’s assumptions on this point. How many miles away is the closest water service?  How much would it cost to extend water service to the subject property? Given the sandy soil on the property, how much would it cost to sink footings on the property? The appraiser must be able to conclude that, in his or her opinion, the subject property is physically adaptable to the proposed highest and best use. To do that, the appraiser must have the factual data to back up the conclusion. If you can dominate the facts—show you know the important components of the property better—you can undermine the expert’s opinion on this point.


Is the Use Economically Feasible?

Some appraisers refer to the highest and best use analysis as a funnel. Only the uses that would be both legal (or reasonably probable of becoming legal) and physically feasible make it through the funnel and are analyzed for financial feasibility. A giant theme park may be legally permissible and physically possible, but if no one would attend it, would it be economically feasible? No. As with any economic issue, half of the question is whether revenue will be generated—in essence, if you build it, will they come? As in Field of Dreams, converting a cornfield into a ballpark may not be economically feasible. More down to earth, an office building may be a great use, but without tenants paying the right amount of rent, an office use may not be economically feasible.

The other half of the question is cost. How much will it cost to construct the hypothetical use? This dovetails into the adaptability of the property. The farther the property is from infrastructure, the more it will cost to build. The appraiser must estimate the cost to build and anticipated net operating income. All things being equal, the rents may need to be higher at this location to justify the increased construction cost. And, of course, there must be enough money to pay for the land to justify acquisition of the property for this hypothetical use.

An additional factor for feasibility is timing. How long will it take for the hypothetical development to generate returns? How much will it cost to hold the property pending development? These aspects are often ignored in the summary financial feasibility calculations and also provide grist for effective cross.

Many appraisers do not have the expertise to evaluate these issues, or others simply ignore them. Those who do not ignore them may have detailed feasibility studies. These studies, however, can provide great fodder for cross. Change one number or assumption and the project is a financial ruin or a blockbuster. The key in this type of cross-examination is to strike quick and hard, without boring the jury.

Although economic feasibility studies are the type of analysis real estate developers use every day, whether looking at residential subdivisions, retail malls, or office construction (called the “residual land value” or “developer’s approach” to value), such studies are often not admissible on fair market value and are only admissible to show the financial feasibility of a proposed use. The cross-examiner should consider whether cross-examination on such a study will “open the door” to its admissibility and should consider the pros and cons of such a study coming into evidence.

With so many numbers and variables, the foundation for an opinion on economic feasibility offers additional fertile ground for cross-examination. Disprove a few assumptions and the hypothetical use becomes a pipe dream.


Will the Use Create the Highest Return?

The last step in the appraiser’s highest and best use analysis is essentially a comparison of various potential uses—which one would generate the greatest return for the owner? The highest and best use is the one that results in the highest value consistent with rates of return tied to the risk. Therefore, the cross-examining attorney’s job in figuring out whether and how to attack this step of the analysis is to see if the appraiser actually picked the wrong use. This generally relates to the comparable sales market. If vacant properties available for office use are selling for higher prices than vacant residential properties, all things being equal, the office use would be a higher and better use. Similarly, if improved properties sell for more than vacant properties (the improvements add value), then the highest and best use may be the improved property.

If the subject property is improved, the appraiser must analyze whether market participants would demolish the improvements and change the use, continue the use, or change the existing use. The appraiser needs to determine the nature, quality, and market acceptance of the existing improvements and analyze physical deterioration and functional obsolescence. Perhaps a redesign, or historic reuse, of the existing improvements will generate greater returns than simply demolishing it and considering the property as vacant property available for development.  On the other hand, the cost of bringing the property into compliance with current building codes may prove prohibitive.

The cross-examiner will want to carefully evaluate the foundation for the appraiser’s opinion on which use generates the highest return. As with other issues, changing one or two assumptions may devastate the appraiser’s opinion. And if you destroy that opinion on one issue, you may get the magical moment when the jurors put down their pencils, giving up on the witness.


Preparing for Trial

Ideally, the cross-examiner will have the opportunity to take the appraiser’s deposition and determine the foundation for opinions on highest and best use. As with any other expert, you will want a complete copy of the appraiser’s file and you will want to determine exactly what information the appraiser relied on in determining highest and best use. Find out who the appraiser spoke with and what he or she relied on in evaluating highest and best use. Make sure the appraiser performed the necessary steps, and if he or she didn’t, find out why. Look for weaknesses or holes in the investigation or lines of questioning that might support your appraiser’s opinions. Most of all, you’ll want to simplify your examination to make sure the trier of fact, judge or jury, follows your questions and understands your view of why the opposing appraiser’s opinion on this important issue is just plain poppycock.

Keywords: real estate litigation, cross-examination, valuation, legal use, jury trial, economic feasibility, property use

Kevin H. Brogan is a partner at Hill Farrer & Burrill LLP in Los Angeles, California, and a cochair of the Condemnation Subcommittee of the ABA Real Estate Litigation Committee.


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