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# What's Financial Feasibility Got To Do With It?

abstract

Proper highest and best use analysis should not fail to take into consideration the impact of timing on financial feasibility. Acknowledgment acknowledgment, in law, formal declaration or admission by a person who executed an instrument (e.g., a will or a deed) that the instrument is his. The acknowledgment is made before a court, a notary public, or any other authorized person.  of timing as a factor recognizes the possibility that the maximally max·i·mal
1. Of, relating to, or consisting of a maximum.

2. Being the greatest or highest possible.

n. Mathematics
An element in an ordered set that is followed by no other.
productive use of a property may not be currently financially feasible and until such time, an interim use of the property is appropriate. Once the timing has been determined, the present value of the various alternatives can be compared. A use must only be eventually financially feasible to be a candidate for the test of maximum productivity. Eventual financial feasibility can be forecast using Residual Demand Analysis, which focuses on the fundamental forces of demand.

Any highest and best use determination requires a use to pass four tests. A highest and best use must be: 1) legally permissible per·mis·si·ble
Permitted; allowable: permissible tax deductions; permissible behavior in school.

per·mis
; 2) physically possible; 3) financially feasible; and 4) maximally productive. There is no particular order for the first two tests, but the last two tests are sequential One after the other in some consecutive order such as by name or number. . The implication implication

In logic, a relation that holds between two propositions when they are linked as antecedent and consequent of a true conditional proposition. Logicians distinguish two main types of implication, material and strict.
is that in order to be considered for the maximally productive test, a use first must pass the test of financial feasibility.

Financial feasibility is defined as "any physically possible and legal use of vacant land or land as though vacant that produces a positive return to the land after considering risk and all costs to create and maintain the use; any use that results in a positive land value." [1] This definition is often misunderstood mis·un·der·stood
v.
Past tense and past participle of misunderstand.

1. Incorrectly understood or interpreted.

2.
to mean that a use must provide an immediate positive cash flow in order to pass the test of financial feasibility. If carried to its extreme, this misunderstanding precludes the possibility of arriving at a use conclusion (such as for a contaminated contaminated,
3. an infective surface or object.
property to remain vacant) that has no potential of ever producing a positive cash flow. What, then, is the appropriate way to determine financial feasibility?

Although the importance of highest and best use in the appraisal process is well established, the concept is evolving and ripe for fresh insights and applications. As recently as the seventh edition of The Appraisal of Real Estate, [2] a non-economic highest and best use conclusion was included as a viable option. The eighth edition [3] corrected this mistake, while introducing the modern definition and the four-pronged Adj. 1. four-pronged - having four prongs
divided - separated into parts or pieces; "opinions are divided"
test used to determine the highest and best use. But, the modern definition fails to specify that timing is a consideration equal in importance to "use." Both the requirement to specify the timing of the use as well as to identify the typical user/buyer of the property have become attached to the definition through course and seminar material. [4] The timing issue has always been implicit in Adj. 1. implicit in - in the nature of something though not readily apparent; "shortcomings inherent in our approach"; "an underlying meaning"
underlying, inherent
a highest and best use analysis; it should now become explicit in the conclusion.

Acknowledgment of timing as a factor recognizes the possibility that the maximally productive use of a property may not be currently financially fea sible; until it is, an interim use of the property is appropriate. The 12th edition of The Appraisal of Real Estate defines "interim use" as:

The use to which a site or improved property is put until it is ready for its future highest and best use is called an interim use. Thus, interim uses are current highest and best uses that are likely to change in a relatively short time... [5]

An interim use may or may not be financially feasible. If the property is vacant land, any passive use is by definition not financially feasible. But, implicit is the understanding that in a "relatively short time," a more productive use of the property will become financially feasible. The term "relatively short time" is a qualified term that is open to interpretation. Many contaminated properties lie idle today with the hopes that a more efficient (economically feasible) remediation method will be discovered. It follows then that not even improved property is required to meet the test of immediate financial feasibility. Speculative Speculative

Securities that involve a high level of risk.

speculative

Of or relating to an asset or a group of assets with uncertain returns. The greater the degree of uncertainty the more speculative the asset.
holding due to contamination could be the conclusion and not meet the test, while still maximizing property value (which theoretically may be a negative).

The Tools of Financial Feasibility--Feasibility Rent & Residual Demand Analysis

It is clear that in order for a use to qualify for consideration under the maximally productive criteria, it need not be currently financially feasible. In fact, excluding special situations such as contaminated property, the true test is eventual financial feasibility, which is indicated by a positive net return to the land. Hence, the timing of a use is of paramount concern: value is the present worth of future benefits. The question is, when does the future begin?

It seems only logical that when financial feasibility is considered, the first inquiry should be about a project's status. That is, if a project is currently financially feasible, it automatically qualifies as a candidate for the maximally productive test. The tool for testing current financial feasibility is known as "feasibility rent."

Feasibility rent is the minimum rent necessary to justify new construction. If market rent is at or above feasibility rent, construction is justified. Conversely con·verse 1
intr.v. con·versed, con·vers·ing, con·vers·es
1. To engage in a spoken exchange of thoughts, ideas, or feelings; talk. See Synonyms at speak.

2.
, if market rent is less than feasibility rent, the project currently is not financially feasible. Eventual financial feasibility can only be achieved by market rent growing faster than feasibility rent until it equals or surpasses feasibility rent. The tool for forecasting the growth of market rent relative to feasibility rent is known as "residual demand analysis."

Residual demand analysis relies upon an interpretation of the forces of supply and demand acting on a particular market. Specifically, the fundamental forces of demand are examined. "Fundamental forces of demand" refers to the underlying factors that drive the need for a particular class of real estate. By interpreting the fundamental forces of demand relative to supply, and forecasting the future change, the timing of eventual financial feasibility can be determined. These forces are summarized in Table 1.

Generally, the engine of the equation is employment. Any change in employment in an area leads to a change in population, which leads to a change in income in that area. Generally, then, a change in the need for office and industrial space precedes the need for housing units, which in turn precedes the need for retail space.

Therefore, it stands to reason that if a large increase in office employment is forecast for a particular area, a corresponding increase in demand for office space will be registered. If the development of office space is not currently financially feasible, it may eventually become so, since the forces of demand may outstrip out·strip
tr.v. out·stripped, out·strip·ping, out·strips
1. To leave behind; outrun.

2. To exceed or surpass: "Material development outstripped human development"
the market supply, thus driving up prices (specifically rental rates). Thus, the eventual financial feasibility of a use becomes predictable and the timing of that use becomes a quantifiable Quantifiable
Can be expressed as a number. The results of quantifiable psychological tests can be translated into numerical values, or scores.

Mentioned in: Psychological Tests
factor in the test of maximum productivity. Even if the use is currently financially feasible, the future benefits of ownership are better understood by understanding the underlying forces of demand for the product.

Method of Analysis

The calculation of feasibility rent is based upon the relationship of development costs to the income required to attract new construction. Since any highest and best use conclusion is premised on the recognition that the cost to assemble the property is equal to the value of the property (i.e., no depreciation/obsolescence exists), the following formula holds true:

[V.sub.o] = [I.sub.o]/[R.sub.o] = [V.sub.L] + [V.sub.B(new)]

[therefore] [I.sub.o] = ([V.sub.L] + [V.sub.B(new)]) X [R.sub.o]

where:

[V.sub.o] = Property value

[I.sub.o] = Net operating income Operating Income

The profit realized from a business' own operations.

Notes:
This would not include income from things such as investments in other firms. Also referred to as operating profit or recurring profit.
necessary to justify new construction,

[R.sub.o] = Overall capitalization rate Capitalization Rate

According to the Appraisal Institute, it is a method used to convert an estimate of a single year's income expectancy into an indication of value in one direct step, by dividing the income estimate by an appropriate rate.
,

[V.sub.L] = Value of land, and

[V.sub.B(new)] = Value of improvements new.

To compute To perform mathematical operations or general computer processing. For an explanation of "The 3 C's," or how the computer processes data, see computer.  the current feasibility rent, begin with the cost of development (land and improvements), including profit/entrepreneurial incentive. Multiply mul·ti·ply
v.
1. To increase the amount, number, or degree of.

2. To breed or propagate.
the cost of development by the appropriate overall rate ([R.sub.o]) to arrive at the minimum net operating income ([I.sub.o]) necessary to justify new construction. Add all appropriate operating expenses Operating expenses

The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted.
to arrive at the effective gross income. Adjust for vacancy VACANCY. A place which is empty. The term is principally applied to cases where an office is not filled.
2. By the constitution of the United States, the president has the power to fill up vacancies that may happen during the recess of the senate.
and credit loss to arrive at the required gross income. Divide the gross income by the net rent-able area of the property to arrive at an estimate of current feasibility rent.

For example, assume that the assignment is to appraise appraise v. to professionally evaluate the value of property including real estate, jewelry, antique furniture, securities, or in certain cases the loss of value (or cost of replacement) due to damage.  a vacant site and that one of the alternative uses that is legally permissible and physically possible is a 10,000-square-foot office building that will have an 85% efficiency factor. Vacancy and collection losses are forecast to be 5% and expenses will be one-third of effective gross income. Your investigation reveals that a capitalization rate of 10% is appropriate and that market rent for the property, if it existed today, would be \$15.00 per square foot. Currently, there is a surplus of office space in the community, as indicated by a 20% vacancy rate, and no new space is planned. Additionally, assume there are no recent office land sales and that the most recent user [6] purchase of similar land for development of an office building occurred two years ago at a price of \$5.00 per square foot. The user price, supported by comparable sales, is evidence that at some time in the past (in this case two years ago) market rent was adequate to justify constr uction. The current problem is to determine if the proper balance between the user price of land and market rent exists, and, if not, when this balance will re-appear. The feasibility rent for this example is calculated as shown in Table 2.

Since market rent is only \$15.00 per square foot, the interpretation of the results is that the office building of the example is not financially feasible to construct at this time. That alone, however, does not disqualify To deprive of eligibility or render unfit; to disable or incapacitate.

To be disqualified is to be stripped of legal capacity. A wife would be disqualified as a juror in her husband's trial for murder due to the nature of their relationship.
the office building from consideration as the maximally productive use of the site. The office building alternative may be the ultimate highest and best use of the site, just not at this time.

The difference between feasibility rent and market rent is one factor that impacts the timing of the use; the other factor is the rate of growth of market rent relative to feasibility rent. The rate of growth of feasibility rent tends to be influenced most by general inflationary in·fla·tion·ar·y
Of, associated with, or tending to cause inflation: inflationary prices; inflationary policies.

pressures. That is, the costs to construct the building and the property's operating expenses are impacted by general inflation. Market forces primarily influence market rent.

In the example, the only factor that will drive up market rent will be an increase in office related jobs. By doing market analysis that focuses on office job growth (the fundamental factor of demand), the future demand for office space in the market can be determined.

Continuing the example, assume that fundamental market analysis indicates that there is currently negative residual demand; that is, there is an excess of supply over demand, in the current market (inferred from the 20% vacancy rate). However, suppose a governmental agency has recently announced relocation RELOCATION, Scotch law, contracts. To let again to renew a lease, is called a relocation.
2. When a tenant holds over after the expiration of his lease, with the consent of his landlord, this will amount to a relocation.
to the area to be completed in the next two years. It is known that the agency generates a certain amount of private sector spin-off The situation that arises when a parent corporation organizes a subsidiary corporation, to which it transfers a portion of its assets in exchange for all of the subsidiary's capital stock, which is subsequently transferred to the parent corporation's shareholders.  employment housed in freestanding free·stand·ing
Standing or operating independently of anything else: a freestanding bell tower; a freestanding maternity clinic.
office space. Fundamental analysis reveals that at the end of two years, the Years, The

the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109]

See : Time
vacancy rate is expected to decline to approximate the frictional frictional

pertaining to or emanating from friction.

frictional acanthosis
see acanthosis nigricans.
vacancy rate [7] (supply and demand in balance) and that for the following three years, there is expected to be increasing positive residual demand.

One interpretation of this data is that there will be upward pressure on market rent so that it could reach the feasibility rent level within three to five years. Thus, an investor would forecast a three-year holding period before either selling the ground to a user or actually developing the site personally. The timing issue has been resolved and the information can be utilized to determine the land's highest and best use.

Application of Results

In the example, the \$5.00 per square foot user price for land should remain stable until market forces act on it. Market forces indicate a three-year holding period before market rent will climb to meet feasibility rent, thereby justifying construction. Incidentally, this does not require that feasibility rent remain stable; in fact, this is likely not to happen since feasibility rent is subject to the forces of inflation. What is important in the highest and best use analysis is not the actual numbers, but the timing extracted from the numbers. Once the timing has been determined, the present value of the various alternatives can be compared. Normally, the highest value wins.

All values are ultimately driven by the user price, the price at which productive use of the property makes sense. Therefore, the investor price will be based on the user price net of expenses discounted to present value. If we conclude that the most likely purchaser of the vacant land in our example is an office developer who will act as an investor for three years, that expenses are limited to real estate taxes at \$0.10 per square foot per year, that a discount rate of 15% is appropriate for vacant office land, and that there is no interim use that could generate income, then the investor price for the subject land can be determined as illustrated in Table 3.

This analysis indicates that an investor would be justified in purchasing the land for \$3.06 per square foot with the expectation of it being worth \$5.00 per square foot at the beginning of year four.

Why is this significant? The use of the land for office building development is presumably pre·sum·a·ble
That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster.
one of several use alternatives under consideration. Suppose that retail development is the only other alternative use for the land, and that there is an active market in similar retail land; there appears to be positive residual demand for this use as evidenced by a 95% occupancy rate Noun 1. occupancy rate - the percentage of all rental units (as in hotels) are occupied or rented at a given time
pct, per centum, percent, percentage - a proportion in relation to a whole (which is usually the amount per hundred)
. Recent land sales to retail users indicate a market price of about \$2.50 per square foot for the subject. Is a current value of \$2.50 per square foot worth more than a future value of \$5.00 per square foot? Our analysis indicates the answer is no. The \$5.00 per square foot future value actually is worth \$3.06 per square foot now. The use that is currently financially feasible is secondary to the use that is not currently financially feasible.

Conclusions

So, what does financial feasibility have to do with it? Timing. To ignore timing is to ignore the root of value, the present worth of future benefits. Paradoxically par·a·dox
n.
1. A seemingly contradictory statement that may nonetheless be true: the paradox that standing is more tiring than walking.

2.
, a use that is not currently financially feasible can nonetheless be the property's highest and best use.

Using feasibility rent analysis with residual demand analysis facilitates the determination of current and future forces of supply and demand acting on a particular market. In the example presented in this article, it was shown that current financial feasibility can be determined by comparing feasibility rent to market rent. If market rent is below feasibility rent, the use is not currently financially feasible. The concept of interim highest and best use is a direct result of this relationship. Something has to be done with the property between the current financial infeasibility and the future financial feasibility--and that something is the interim highest and best use.

A use must only be eventually financially feasible to be a candidate for the test of maximum productivity. Eventual financial feasibility can be forecast using residual demand analysis, which focuses on the fundamental forces of demand. This requires consideration of timing in determination of highest and best use.

A highest and best use conclusion that states a use without mentioning the timing of that use is tantamount tan·ta·mount
Equivalent in effect or value: a request tantamount to a demand.

[From obsolete tantamount, an equivalent, from Anglo-Norman
to concluding a value without identifying the effective valuation date. For the value conclusion to have meaning, the date of value also must be identified. Similarly, for a use to have meaning, the timing of the use must also be identified.

Richard Ri·chard   , Joseph Henri Maurice Known as "Rocket." 1921-2000.

Canadian hockey player. A right wing for the Montreal Canadiens (1942-1960), he led his team to eight Stanley Cup championships and was the first player to score 50 goals in a
L. Parli Parli is short for Parliament. Parli may also mean:
• Parli, India, a town in Maharashtra, India
• Parliamentary Debate
• Parliament (Cigarette)
, MAI MAI Mail (File Name Extension)
MAI Multilateral Agreement on Investment
MAI Maius (Latin: May)
MAI Ministerul Administratiei si Internelor (Romanian)
, is president of Parli Appraisal, Inc., a full service real estate appraisal Real estate appraisal

An estimate of the value of property using various methods.
firm in Fairfax, Virginia Fairfax is an independent city forming an enclave within the confines of Fairfax County, in the Commonwealth of Virginia. Although politically independent of the surrounding county, the City of Fairfax is nevertheless its county seatGR6. . He has an MBA MBA
abbr.

Noun 1. MBA - a master's degree in business
from the Pennsylvania State University Pennsylvania State University, main campus at University Park, State College; land-grant and state supported; coeducational; chartered 1855, opened 1859 as Farmers' High School.  and is the current chief reviewer re·view·er
n.
One who reviews, especially one who writes critical reviews, as for a newspaper or magazine.

reviewer
Noun

a person who writes reviews of books, films, etc.

Noun 1.
for Appraisal Institute The Appraisal Institute (Institute), headquartered in Chicago, Illinois, is an international association of professional real estate appraisers.[1] It was founded in January 1991 when the American Institute of Real Estate Appraisers (AIREA) and the  Course 520 (Highest & Best Use and Market Analysis), serves on the Appraisal Institute's Curriculum Subcommittee sub·com·mit·tee
n.
A subordinate committee composed of members appointed from a main committee.

subcommittee
Noun
, and is a member of the review panel for The Appraisal Journal. Contact: (703) 273-6677; email: parliapp(r)erols.com.

(1.) Appraisal Institute, Course 520, "Highest & Best Use and Market Analysis."

(2.) Appraisal Institute, The Appraisal of Real Estate, 7th ed. (Chicago Chicago, city, United States
Chicago (shĭkä`gō, shĭkô`gō), city (1990 pop. 2,783,726), seat of Cook co., NE Ill., on Lake Michigan; inc. 1837.
: Appraisal Institute, 1978).

(3.) Appraisal Institute, The Appraisal of Real Estate, 8th ed. (Chicago: Appraisal Institute, 1983).

(4.) For example: Appraisal Institute, Course 520, "Highest & Best Use and Market Analysis" and Appraisal Institute Seminars, "Case Studies in Commercial Highest & Best Use" and "Highest & Best Use Applications."

(5.) Appraisal Institute, The Appraisal of Real Estate, 12th ed. (Chicago: Appraisal Institute, 2001).

(6.) A "user" is defined as a buyer who intends to put the property to its ultimate highest and best use immediately, regardless of whether they intend to actually occupy the property. Conversely, an "investor" is a buyer who recognizes that the property must be held for some time before it can be developed. An investor bases value on the user price adjusted downward to account for the holding period.

(7.) Frictional vacancy is defined as "a vacancy unrelated to disequilibrium disequilibrium /dis·equi·lib·ri·um/ (dis-e?kwi-lib´re-um) dysequilibrium.

in supply and demand, but rather due to tenant relocations as leases roll over and expire expire /ex·pire/ (ek-spi´er)
1. to exhale.

2. to die.

ex·pire
v.
1. To breathe one's last breath; die.

2. To exhale.
...the normal vacancy rate in any given market." Appraisal Institute, The Dictionary of Real Estate Appraisal, 3rd ed. (Chicago: Appraisal Institute, 1993): 153.

References

Appraisal Institute. The Appraisal of Real Estate. 7th ed. (Chicago: Appraisal Institute, 1978).

Appraisal Institute. The Appraisal of Real Estate. 12th ed. (Chicago: Appraisal Institute, 2001).

Appraisal Institute. The Dictionary of Real Estate Appraisal. 3rd ed. (Chicago: Appraisal Institute, 1993).
```Table 1 Fundamental Forces of Demand

Employment   [right arrow]  Office jobs             [right arrow]
Employment   [right arrow]  Industrial jobs         [right arrow]
Population   [right arrow]  Households              [right arrow]
Income       [right arrow]  Effective buying power  [right arrow]

A Change In  A Change In Demand For

Employment        Office space
Employment        Industrial space
Population        Housing units
Income            Retail space
Table 2 Calculation of Feasibility Rent

Cost to construct
Building                          10,000 sf x \$75.00    = \$750,000
Land                              40,000 sf x  \$5.00    = \$200,000
Appropriate capitalization rate                            \$950,000
([R.sub.o])
Required NOI ([I.sub.o])                               = x     0.10
Add expenses at 33% of EGI                             =    \$95,000
Effective gross income                                 =    \$47,500
Add vacancy and credit loss at 5%                      =   \$142,500
Gross income required to justify                       =     \$7,500
construction                                          =   \$150,000
Feasibility rent - GI + net
rentable area (at 85% of gross
area)                                                 =  \$17.65/sf
Table 3 Determination of Investor Price Per Square Foot

Year                           1         2        3

Income
User price                \$0        \$0       \$5.00
Expenses
R.E. taxes                \$0.10     \$0.10    \$0.10
Net income                  (\$0.10)   (\$0.10)   \$4.90
Present value @ 15%         (\$0.087)  (\$0.076)  \$3.222
Investor price per sq. ft.   \$3.06
```
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Author: Printer friendly Cite/link Email Feedback Parli, Richard Appraisal Journal Oct 1, 2001 3172 The Effects of an Oil Pipeline Rupture on Single-Family House Prices. Using Multiple Regression Analysis in Real Estate Appraisal. Financial analysis Real estate appraisals Real property