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Appraising undeveloped land in Russian cities.

This article is a summary of appraisal work conducted in 1995 under a contract with the United States Agency for International Development as part of its housing reform technical assistance program in Russia. In 1995 the city governments of Tver and Nizhniy Novgorod prepared to sell through competitive tenders long-term property rights on several undeveloped land plots zoned for residential or mixed-use development. The author recommended starting (or reserve) land prices to ensure that no parcel would be sold below these minimum rates.

The most obvious characteristic of the rapid privatization of real estate and creation of a real estate market in Russian cities is the unevenness of this process across real estate subsectors.(1) By mid-1994 about 45% of the housing stock in urban Russia was already privately owned and actively involved in market turnover through secondary market sales. In 1993 the annual volume of sales of privately owned houses was 4.5%-9.3% in Moscow, St. Petersburg, and Nizhniy Novgorod. Documented data on the volume of privatization of commercial and industrial properties are not available. In St. Petersburg, 30%-75% of all commercial and industrial buildings were privatized by the fall of 1995, according to various city government sources. The secondary market of commercial and industrial properties, particularly rental properties, is remarkably active in large cities.

All these data refer only to buildings or units inside buildings. Under current Russian legislation, property rights in land and buildings are regulated separately. Not much urban land has been privatized to date. Only in 1995 were privatized enterprises allowed to purchase underlying land sites in full ownership. In St. Petersburg several dozen enterprises obtained titles on land by the end of 1995. Some urban land has been allocated to families for ownership of single-family homes and garages, or privatized by families living in existing single-family, homes. A percentage of these plots is being sold through private transactions. However, the volume of these sales is insufficient to create a land market for real estate developers because there isn't much land like this in the total inventory of urban land, especially in mid-size and large cities, and it is forbidden to change the planned use of these plots.

In the absence of a land market, it was necessary to develop some reasonable recommendations concerning starting prices - a task considered impossible by many industry professionals. The current Russian situation with land does not fit fundamental assumptions typical of the contemporary appraisal of real estate in market economies. Indeed, the essential notion of "market value" assumes that a market consists of multiple transactions and that there are many independent sellers and buyers.(2) The problem with translating this concept to Russia is that, in Russian cities, multiple sales of land planned for construction do not exist. Second, there are no multiple sellers. Although there is sufficient evidence that there are many potential land buyers, there is practically only one seller from whom a buyer may obtain a clean title and that seller is the city government. On the other hand, appraisers can apply the land residual technique to determine market value in situations devoid of transaction data.(3)

Developing an institutional infrastructure for real estate markets in former socialist countries strongly depends on the successful transference of experience from developed countries. The participation of American professionals in discussions related to appraisal problems in Russia is an important step, and the ideas that emerge from them could be applied in many developing countries.

APPRAISING MUNICIPAL LAND

Why was an appraisal required at all? Why was the alternative approach whereby buyers competitively bid on a site, which is sold to the highest bidder, not implemented? The city authorities wished to be informed of the price offers they could potentially solicit at land auctions or competitive tenders for several reasons. First, municipal officials are mentally unprepared to play such a passive role and to be replaced by market forces. Second, in one instance, when the site for commercial use in the downtown area went up for sale, it was reasonable to expect that unfair competition could result from the pressure that racketeers could apply to get this site, and thus keep offers artificially low. Third, when land sales were planned as part of the World Bank project, the World Bank required a preliminary land appraisal to confirm that anticipated price offers would cover the cost of offsite utilities that would be provided using World Bank loans to the various cities.

Starting prices for municipal land, especially now as the sales market is developing, are in large part determined by political, not economic, factors. If city authorities are trying to earn a reputation as strong supporters of market reforms or of creating a land market, they may set up low starting prices to attract more potential buyers and increase the likelihood that the land will be sold. If local authorities are not sympathetic to land privatization because they are ideologically opposed to the concept of private property or wish to retain control over land allocation, they may establish starting prices so high that the land never sells at all. But before allowing political concerns to set the starting price, city officials should have some guide by which to anticipate price offers.

Three interest groups are involved in any land sale transaction in Russia: the city government or seller, real estate developers or potential buyers, and the group of organizations providing utilities (water supply, heating, gas, electricity, and so on). The last group plays a very important role in determining the final cost of a land development project. These organizations first decide what kind of offsite utilities should be built on the site and then set up the needed payment to connect onsite utilities to the whole network. Legally these organizations are municipal or privatized enterprises but, in either case, they are financially independent of the city governments. They are monopolistic and powerful and, in fact, dictate their conditions to buyers and sellers.

At least two typical situations are possible: The government would sell raw land and real estate developers themselves would pay for offsite and onsite utilities, or the government would finance the offsite part but any costs would be included in the purchase price of the land. In either case the government should know what it could reasonably anticipate real estate developers will offer for undeveloped land, assuming that the marketing policy of the seller will encourage price competition among potential buyers. To predict these anticipated prices with useful reliability is the immediate task of the appraisal, although there are other problems tied directly to the pricing of municipal land. For example, there are questions about the ability of the local market to absorb land parcels offered for sale and about the reasonable size of parcels offered for sale.

RESIDUAL TECHNIQUE

The variation of land residual technique that applies in this case is based on the equation:

Proceeds from sale of completed project = Cost of a project + Profit from a project (1)

where,

Cost of a project = Price of land purchase + Direct construction cost + Indirect project cost (2)

The underlying concept is that a buyer is going to build up something that will be sold on the market, and a feasible land price is determined by the difference between the anticipated future proceeds from the sale and the cost of the project and required profit:

Price of land purchase = Proceeds from sale - Direct and indirect costs - Required profit (3)

In market economies, real estate developers use this equation to get a rough preliminary estimate of a reasonable land price for feasibility purposes. This equation is the foundation of site evaluation.

The necessity to use equation 3 in performing an appraisal creates several difficulties and raises some questions. (It should be noted that using the land residual technique automatically makes an appraisal process much more loaded by algebraic formulas than is typical for mature real estate markets.)

Market Value or Investment Value?

Can the anticipated price offers described above be interpreted in the same terms developed in contemporary appraisal practice and theory? This is not a question of merely choosing a familiar label to determine the appropriate value ("market value" or "investment value" or another) or "westernizing" the appraisal process. The real question is whether we can use contemporary concepts and techniques in practice for estimating anticipated price offers.

As mentioned earlier, the notion of market value cannot correctly be applied to the Russian context because there are no multiple transactions and there is only one seller. The concept of investment value defined as the value of an investment to particular investors based on their investment requirements is more appropriate in this case. Investment value is the price a particular investor would pay for a property in light of a perceived capacity to meet his or her needs, goals, and financial requirements.

Contradictions Between an Appraisal's Objectives and Contemporary Approaches to Analyzing Investment Projects

Because the land in question is undeveloped, valuation is done by evaluating an investment project. This approach presents several internal contradictions between the tasks and conditions of the appraisal on the one hand, and the approaches to performing an analysis of investment projects on the other (see Table 1).
TABLE 1 Contradictions: Needs Versus Means

Needs Means

A. Appraisal is conducted at a stage when Approaches to evaluating
nothing is known about the future buyer an investment project
(about his equity, access to financing, are oriented to a
or other investment options, etc.). concrete investor and
 usage information about
 him or her.

B. Single characteristic, an anticipated Analysis of investment
price (does not matter whether it is a projects cannot be
point or an interval estimate) is needed. reduced to a single
 characteristic.

C. For the same reason as A, nothing The main contemporary
is known about the timing of a project. instrument of analysis,
 discounted cash flow
 analysis, deals with the
 time disposition of
 a project, and the
 characteristics of an
 investment project
 strongly depend
 on timing.




This analysis assumes the simplest scheme of a project: The buyer or developer buys the land, builds housing, or mixed-use properties, and sells the improved lots. Housing starts for sale are the most typical projects in Russia today, both single-family and multifamily homes. The sale of commercial units in mixed-used buildings also exists but is not as common as housing sales. Therefore, income capitalization does not apply.

An evaluation of investment projects cannot be reduced to any combination of the three approaches to value. An evaluation of an investment project in the United States is not a standard valuation problem.(4) However, in New Zealand, the United Kingdom, and Australia, discounted cash flow analysis was not employed in appraisals until recently,(5) and the evaluation of investment projects is designated as a fourth approach to value.(6)

In the United States, the most comprehensive approach to evaluating development projects involves parallel considerations of two sets of discounted cash flows and their characteristics.(7) One set is related to the project as a whole, when cash flow is considered without any loan repayments (neither principal nor interest). The IRR for this cash flow, "economic internal rate of return," should exceed the cost of borrowing money. The second set considers cash flow only for equity; return on equity is characterized by the IRR for this cash flow. When return on equity is higher than "economic IRR," the leverage of a developer is positive and he has an incentive to take a risk on a project. Two corresponding net present values (NPVs), one for equity and the other one for a project considered free and clear of debt, are other measures used for estimating investment projects.

In another approach to evaluating a project, the cost of financing (interest on the loan and other charges related to borrowing money) is included in the estimated cost of a project. In this case, an estimated land value obtained by the residual technique from the evaluated development project should be interpreted as an investment value that reflects the value of a project to a concrete developer. This is interpreted as the investment value because the cost of financing depends on the amount of the developer's borrowed funds and the lending conditions. This approach can be used either for a cash flow variant or a one-time estimate.

Trying to use the first of these two approaches for land evaluation in Russia today faces a twofold problem. First, it is necessary to assume some average amount of equity since the investor is not known. This is difficult to do because of changes in financing construction starts - the result of an evolving construction industry. In addition, financing methods can vary considerably from city to city (see Table 2).

This data is drawn from a large survey of housing developers in seven Russian dries conducted during the preparation of the World [TABULAR DATA FOR TABLE 2 OMITTED] Bank housing development loan to these cities. The last column, "share participation," is a way that future homeowners can finance the construction. The mutual obligations of the developer and the "shareholder" are stated in a share participation contract, and the legal terms of any presales are determined by a purchase and a sale contract, which usually provide for successive payments during construction and for a potential increase in payments related to increases in construction costs.

The second part of the problem is that cash flow is needed for a project and equity, meaning that the appraiser must assume a schedule for construction and sales, and must assume the successful transaction between the developer and the lender. This appraiser is applying many assumptions to some abstract "average developer," and will inevitably produce an unreliable final conclusion.

Another fundamental difficulty with using discounted cash flow analysis is that Russian developers are not very familiar with this technique, and they usually estimate the profitability of a project in terms of total profit generated by the project (as a percentage of total cost). Bankers, on the other hand, estimate investment projects using discounted cash flow analysis and, consequently formulating their return requirements accordingly. Thus, using either discounted cash flow or one-time estimates presents an additional problem of how profitability is defined and formulated.

A Practical Solution

Estimating possible investment values in a onetime variant without discounted cash flow analysis seems most appropriate for this task. Potential buyers of urban land can be grouped according to their different investment alternatives. Calculations of residual land values can be made, at least for typical cases in each group, and the appraisal report will contain the range of these "typical land values." The next step is to estimate the probability of getting a purchaser from each of these groups.

The first group consists of ordinary developers whose only available and reasonably reliable investment alternative for cash equity is bank deposits. In the beginning of April 1995, at the time of the appraisal, the mean interest on hard currency deposits was 11%.(8) As a typical case for this group, assume that construction is at 100% equity financing. It should be noted that "typical" in this context does not mean the most probable. Extreme cases in which developers use pure financing strategies are considered in order to see the range of possible price offers. To simplify, take the example of a one-year project.

Equation 3 can be rewritten as:

Proceeds from sale - Direct and indirect cost - Price for land purchase = Required profit (4)

and the latter one can be specified for the first group as

S - C - [L.sub.1] = 0.11 (C + [L.sub.1]) + [p.sub.d] + [p.sub.1] (C + [L.sub.1]) (5)

where,

S = Proceeds from sale

C = All costs of a project other than the cost of financing and the cost of land

[L.sub.1] = Purchase price for land feasible for an investor with return requirement (determined by the right side of the equation)

[p.sub.d] = Fee to developer for his work

[p.sub.1] = Required premium to investor over the opportunity cost

In this case, there is no cost of financing. The annual return (see the right side of equation 5) is the sum of three items: opportunity cost to the investor (0.11(C + [L.sub.1])), fee to the developer for time spent managing the project ([p.sub.d]), and premium to the investor ([p.sub.1]). This premium should be large enough to cover the investor's risk and encourage him or her to pursue the project. In this case, when the developer makes an equity investment, the premium intended for the investor and the fee for the developer go to the same recipient.

The investment value of land obtained from equation 5 for this type of investor is

[L.sub.1] = S - (1.11 + [p.sub.1]) C - [p.sub.d]/1.11 + [p.sub.1] (6)

The second group of potential buyers consists of banks. Because of the absence of mortgage laws, high inflation, and the general instability of business activity in Russia, banks prefer to issue construction loans to companies over which they exercise some control. But the most common form of financing investment projects used by banks is to take an equity position in specially created joint ventures. At the time of the appraisal, the main alternative opportunity to get returns for banks was to issue short-term loans to less risky businesses, and the mean interest rate for such loans was 26.4%.(9) The assumed mean cost of funds for banks was 11%.(10) A project fully financed by a bank is one typical case. For this case, equation 4 takes the following form:

S - C - [L.sub.2] - 0.11 (C + [L.sub.2]) = 0.264 (C + [L.sub.2]) + [p.sub.d] + [p.sub.2] (C + [L.sub.2]) (7)

where,

[L.sub.2] = Purchase price for land acceptable for a bank investor with a return requirement determined by the right side of this equation

[p.sub.2] = Required premium to an investor over the opportunity cost, and the last item on the left side (0.11(C + [L.sub.2])) represents the cost of financing.

In equation 7, the first item on the right side 0.264 (C + [L.sub.2]) is the opportunity cost, as in equation 5. Item [p.sub.d] shows that a developer is compensated for the work with the same fee as in the previous case, but with no additional premium because essentially, the developer works for the investor as an employee. The developer's compensation ([p.sub.d]) is placed on the right side of the equation mainly to demonstrate that, more than the other entities in the deal, the benefits the developer receives in the project are closely tied to the investor's benefits.

The investment value of land in this case

[L.sub.2] = S - (1.374 + [p.sub.2]) C - [p.sub.d]/1.374 + [p.sub.2] (8)

An important assumption is that both investors' groups will anticipate the same proceeds S from a project and the same costs C. The sites considered in both cities indicated no likelihood of this assumption being problematic.

The opportunity costs for investor groups vary widely - substantially more than is typical for western countries - a result of lack of information. The informational infrastructure for servicing the market sectors of the Russian economy remains inadequately developed.

The significant difference between the mean interest rate on loans and the mean interest paid on deposits is explained by the reserve requirement imposed on commercial banks. The Central Bank of Russia requires 15%-22% of deposits to be held as reserves. For commercial banks, these reserves are noninterest bearing.

For further analysis, some assumptions regarding [p.sub.d], [p.sub.1] and [p.sub.2] are necessary. The developer fee ([p.sub.d]) should depend on the scale of the project and the general income scale of the country. In any case, it is a relatively small number and could be determined, for example, as some percentage of total costs C. The premiums to investors ([p.sub.1] and [p.sub.d]) are much more complicated. At this stage, only an empirical approach and some general speculations are possible. It seems reasonable to assume that if one investor has an opportunity cost higher than another investor, then the premium required by the first investor will be at least, and not less than, what is required by the second investor. In considering actual cases, this means that

[p.sub.1] [less than or equal to] [p.sub.2] (9)

Only rough numerical estimates of these parameters are possible. It seems that for bank investors, the average difference between required return for investment projects and interest rate for loans is 10%-15%. For this model it means that [p.sub.2] is in the range of 0.1-0.15. For developers, assume that the required premium ([p.sub.1]) is in the range of 0.09-0.14. These figures comport with available information. Indeed, developers interviewed in Tver and Nizhniy Novgorod during the appraisal said that they would not take any suggestion to buy municipal land seriously until the projected profit was at least 40% of total expenses. If it is higher than 50%, they would think about purchasing. If the life span of such a project is two years, then developers would require 20%-25% profit annually. The model assumes a 20%-24% required return (excluding the developer's fee).

In comparing equations 6 and 8, it is obvious that

[L.sub.2] [less than] [L.sub.1] (10)

for any [p.sub.1] and [p.sub.2] taken from the assumed ranges mentioned before, even if equation 9 is not valid.

This means that if the behavior of potential buyers is rational in the short term, then the city government should expect ordinary developers to offer better prices than bank investors.

Consider the numerical example. In Tver the site in question had 11.86 acres of salable land, with permission to build 308,300 square feet of total floor area for residential use. The estimated cost of the project (without the cost of financing, land, and offsite and onsite utilities) is $ 9,296,000 (or $30.20 per square foot), and the estimated sale proceeds are $12,046,000 (or a price of $39 per square foot). Assume that requirements concerning premiums to investors are modest and equal to the lowest values of the ranges mentioned above: [p.sub.1] = 0.09, [p.sub.2] = 0.1. Simplifying for illustration purposes, assume that [p.sub.d] = 0 because it is a relatively small number. In the result, equations 6 and 8 give, respectively, [L.sub.1] = $742,300 or $62,588 per acre of salable land and [L.sub.2] = -$1,123,700 or -$94,747 per acre. The negative land value means that an investor would yield a required return only if he or she gets the land free plus the subsidy equal to [absolute value of L].

The two typical cases already considered represent extreme variants of financing and give estimates of extreme price offers. In the case of mixed financing from equity and borrowed funds (developer as investor), the equation is as follows:

S - C - [L.sub.3] - [Alpha] (0.264 + [Gamma]) (C + [L.sub.3]) = (1 - [Alpha])

x 0.11 (C + [L.sub.3])

+ [p.sub.d] + (1 - [Alpha]) x [p.sub.1] (C + [L.sub.3]) (11)

where,

[Alpha] = The share of borrowed funds in the total amount of financing;

[Gamma] = The difference between the mean interest rate for construction loans and for other, more standard, types of loans; and the assumed percentage premium to investor ([p.sub.1]) is the same as in the first case

As in equation 7, the last item on the left side ([Alpha] (0.264 + [Gamma]) (C + [L.sub.3])) is the cost of funds, and the first item on the right side ((1 - [Alpha]) x 0.11 (C + [L.sub.3])) is the opportunity cost.

Thus, the investment value of land for this case is

[L.sub.3] = S - [1 + (0.264 + [Gamma]) [Alpha] + (0.11 + [p.sub.1])(1 - [Alpha])] C - [p.sub.d]/1 + (0.264 + [Gamma]) [Alpha] + (0.11 + [p.sub.1])(1 - [Alpha]) (12)

It is clear that in any case of mixed financing, investment land value ([L.sub.3]) will be between [L.sub.2] and [L.sub.1]. For example, if [Alpha] = 1, [Gamma] = 0.03, and all other parameters are the same as above, then [L.sub.3] = $13,100 or $1,104 per acre.

It should be noted that for the extreme parameter ([Alpha] = 1), equation 11 describes the same source of financing as equation 7 - 100% bank financing - which is interpreted differently and with a different perspective on required return. These two different considerations of the same situation result in two different investment land values [ILLUSTRATION FOR FIGURE 1 OMITTED]. Why should a bank distinguish between a project to which it has lent money and a project in which it has an equity investment? Thus, it may be possible in a mixed-financing case for a bank to apply criteria different from those in equation 11 before making a loan. If so, the final return requirement would be a compromise between the requirements of a developer and a bank lender.

Another peculiarity of the model in equation 11 is that the return on equity is less than the economic return, for any reasonable premiums ([p.sub.1]), in particular 0.09 - 0.14 as assumed before. This is negative leverage for developers. Thus, the model shows that Russian developers find construction loans too expensive and prefer not to use borrowed funds because of the negative leverage that exists. It is worth while to note that sometimes if developers cannot finance a project without a bank loan, they will work with negative leverage just to survive.

The last typical case that needs to be considered is one in which a developer uses 100% interest-free funds in the form of prepayments from future owners for housing or commercial units. Equation 4 for this case is

S - C - [L.sub.4] = [p.sub.d] + [p.sub.4] (C + [L.sub.4]) (13)

and the investment value of land is

[L.sub.4] = S - (1 + [p.sub.4]) C - [p.sub.d]/1 + [p.sub.4] (14)

In fact, following the logic of the model, one should assume that [p.sub.4] = 0 because if a developer does not invest equity, he or she should not get any investment premium. In this case, the situation could be interpreted as a purchase of land by future housing owners who hire a developer as manager. This interpretation comports with the well-known fact that buyers who are buying land for themselves are often prepared to pay more for land than developers who build structures on the land and then sell them. Indeed, [L.sub.1] is less than [L.sub.4] for any reasonable [p.sub.4] ("reasonable" here means that [p.sub.4] is less than [p.sub.1]). On the other hand, it is not obvious that equation 13 is completely accurate in the case of presales. The distinction turns on the issue of price: Are prices equal for the sales of the final product and for the presales? In other words, is it correct to assume that the proceeds generated in the case of presales is the same proceeds that have been assumed for previous cases? Until now the tendency in Russian cities was to set presale housing prices lower than prices on the final product. The explanation is probably that a developer makes a price reduction as compensation to the buyer for construction financing provided by presales proceeds. For buyers, lower presale prices award a premium for the risk of paying for uncompleted homes. In the United States, having lower presale prices is typical for many development projects, but the explanation is different: because of the reduced risk to the developer and the opportunity to move future cash flows closer, thus reducing marketing time after project completion. The results of studies of presale prices in parts of the world where construction financing through presale proceeds has been practiced longer than in Russia(11) cannot be transferred to Russia because of significant legal and organizational differences among the various countries.

In any case, using [L.sub.4] as the most optimistic case is helpful in a practical evaluation of anticipated price offers for municipal land. In this numerical example, using the parameters already given and [p.sub.4] = 0.04, equation 14 gives [L.sub.4] = $2,286,000 or $192,749 per acre.

Figure 1 shows the possible variations of [L.sub.1] - [L.sub.4] for this example. This figure shows that if one uses any combination of financing (equity, bank loan, and interest-free presales) and if investment value is estimated from a developer's point of view, the investment value of land would lie somewhere between [L.sub.3] ([Alpha] = 1) and [L.sub.4].

In addition to the possibility of negative land value, this picture also presents a problem with the cost of utilities. The cost of onsite and offsite utilities is estimated as $63,162 per acre of salable land, and the seller, the city government, would wish to have the buyers pay for this infrastructure through the purchase price of the land. But as can be seen from this scenario, the purchase prices offered by investors and the wide variety of financing arrangements for a project would not cover partly or fully the cost of the infrastructure.

Of course, for an actual appraisal, the model should be built more accurately. For example, the cost of financing for construction would be less than the cost shown for a lump-sum loan in the equations used in this model.

Predicting offering prices (L) is not realistic before an advertising campaign is launched and feedback from potential buyers have been received. Rather, the city should make a special effort to attract the buyers willing to purchase the land at higher prices. In the example, the only hope that these cities have to sell the land at a price that would cover the cost of utilities is by attracting developers who can successfully combine equity and presales financing. In this case, the city could offer, for example, some tax benefits for investors and special guarantees to holders of presales agreements.

Importance of Sensitivity Analysis

The previous discussion may be seen as a variant of sensitivity analysis on the structure of financing and return requirements. The next important question is, what is the sensitivity of investment land values to changes in other key parameters, such as the sale prices of the final product and construction costs? In principle, it is known that the land residual technique produces results that are very sensitive to fluctuations in these parameters. What does this mean in practical terms? Consider several quantitative examples.

For the site in Tver the mean predicted construction cost is $26 per square foot of total floor area and the mean predicted sale price is $39 per square foot. If the construction cost decreases by 8.5% from this mean value and some minor cost items decrease, respectively, then the estimated investment land value - calculated as the point estimate for some reasonable set of parameters - increases by 85% (from -$11,352 to -$1,628 per acre of salable land). If the sale price increases by 5% from the mean sale price, then the investment land value increases by 21%.

In Nizhniy Novgorod the mean predicted construction cost for one site is $26 per square foot and the sale price for housing is $37 per square foot. If the construction cost decreases by 5%, the estimated investment land value increases at 5.2 times (from $21,780 to $113,256 per acre of salable land). If the sale price increases by 5%, the estimated investment value increases by four times (up to $82,760 per acre).

Changes in the basic parameters used for these demonstration examples are very small. In an unstable market like Russia's, one should be prepared to face much bigger deviations of the parameters from averaged numbers predicted by an appraiser. But even these small changes in basic parameters produce large changes in estimated land value. This means that any point estimate of anticipated land value cannot be considered reliable nor the final appraised value accurate. Only a range of estimates or other probabilistic estimates would adequately reflect reality.

The important conclusion for appraising municipal land in urban Russia today is that there is great uncertainty about potential buyers' offers. Appraisers have a professional obligation to let city governments know that.

The question is that if a deviation of estimated land value is so big, do such estimates make any practical sense? Perhaps they do to the landowner, the city government. First of all, it shows that any concrete revenue expectations connected with such a sale is risky. Second, any calculations for the different scenarios within the estimated range could be very enlightening. For example, if an optimistic set of parameters yields an estimated land value that doesn't cover the predicted cost of utilities, the economically rational decision would be to discontinue marketing activities.

It is appropriate to mention this because appraising real estate is new to Russia, presenting a unique opportunity for appraisers to form clients' understanding of the appraisal task from the very beginning and to establish a range of value estimates or other probabilistic estimates that would become standard.

Appraiser as Consultant

By appraising municipal land, an appraiser becomes a kind of consultant to the city government. The seller, the city government, strongly influences potential land values, both investment and market, by determining some conditions that directly influence land value, including the property rights of the land offered for sale, required terms of development, and urban planning restrictions. The last item is especially important because there are no zoning regulations in Russian cities. The city government determines land regulation on a case-by-case basis, including how the land is used, how much is used, parking, and so forth. As a rule, municipal urban planners who determine these requirements do not understand the consequences that these restrictions and conditions will have on land value. Therefore, the appraiser's role is to explain these consequences and advise planners of restrictions that may reduce the profitability of the land - and even ignore the most profitable use of the land - without supporting public interest.

Any sale of municipal land should be part of some responsible land policy. What, when, and where to sell to private parties should be decided by examining investment and market values using an expanded time frame and a wider social context.

CONCLUSION

The formation of urban real estate markets in Russian cities is progressing rapidly but very unevenly across subsectors. The privatization of urban land is just emerging, and a market for land development does not yet exist. The only way to predict anticipated price offers on municipal land is to use the land residual technique.

This article argues that it is premature to apply the concept of market value to anticipated price offers for municipal land sold to private developers, and that investment value is more appropriate. At least three "pure" groups of potential buyers of municipal land are identified, each having quite different opportunity costs and return requirements. These groups are:

* Developers with 100% equity investments in construction

* Banks that take an equity position in construction projects and provide 100% financing

* Developers with 100% interest-free funds in the form of prepayments to future owners of housing or commercial units

The estimated investment values of land for these "pure" investment groups are quite different and determine the possible range of anticipated price offers. In cases of mixed financing from developers' equity, borrowed funds, and buyers' prepayments, the investment values of land will fall within this range. Estimated investment values are also very sensitive to fluctuations in other parameters, such as construction costs and sale prices of final products.

Also, anticipated offers from potential municipal land buyers are very uncertain and only a range of estimates is appropriate. Finally, as a kind of consultant to the city government, the appraiser should explain how sellers influence potential land values (both investment value and future market value) through land use restrictions, property rights offered for sale, and required terms of development.

1. Olga Z. Kaganova and Nadezhda Kosareva, "Russian Cities on the Road to a Market Economy: The Housing Sector, Privatization of Land in Russia," The Urban Age, v. 2, no. 4 (1994): 1,4-5.

2. Appraisal Institute, The Appraisal of Real Estate, 11th ed. (Chicago: Appraisal Institute, 1996), 20-24. See also Jared Shlaes, "The Market in Market Value," The Appraisal Journal (October 1984): 494-518.

3. Ira S. Lowry, "Real Estate Tenure and Taxation in the Russian Federation," prepared for The Urban Institute, Washington, D.C., UI Project 6127-XI49, June 1992.

4. J. H. Boykin, ed., Real Estate Counseling (Chicago: American Society of Real Estate Counselors, 1988), 67-81.

5. Rodney L. Jefferies, "Discounted Cash Flow Valuations - Pitfalls, Standards & Solutions," paper presented to the First International Real Estate Society Conference, Stockholm, Sweden, June 28-July 1, 1995.

6. Rodney L. Jefferies, Urban Valuations in New Zealand, 2nd ed., v. 1 (Wellington, New Zealand: The New Zealand Institute of Valuers, 1991).

7. Richard B. Peiser and Dean Schwanke, Professional Real Estate Development: The ULI Guide to Business (Washington, D.C.: Urban Land Institute and Dearborn Financial Publishing, Inc., 1992), 68-70.

8. Russian banks continue to work in two systems of currency, hard currency, and rubles. Payments for work, services, or purchases in hard currency in Russia are prohibited, but anyone (businesses and individuals) may have separate hard currency bank accounts and exchange rubles for hard currency at any time. Because ruble inflation was very high in the last few years (736% in 1993 and 316% in 1994), it became common practice to evaluate investment projects, at least in real estate, in U.S. dollars.

9. Calculated as the weighted average interest on hard currency loans for a sample of data for 17 Russian banks with the largest volume of hard currency operations, as published by Kommersant-Daily, April 12, 1995. Interest rates for loans are weighted by the amount of the loans.

10. There are no available statistics about the cost of hard currency for the banks themselves. One assumes there is one source of hard currency, deposits, and the cost is equal to the mean interest rate on deposits, 11%. In fact, there are at least three sources of hard currency: deposits with their mean cost for banks of 11%; money from operating (checking) accounts of clients, a free source; and interbank credits the cost of which is approximately 7%-10% higher than deposits.

11. Chang Chin-Oh and Charles W. R. Ward, "Forward Pricing and the Housing Market: the Pre-Sale Housing System in Taiwan," Journal of Property Research (1993): 217-227.

REFERENCES

Barrett, G. Vincent, and John P. Blair. How to Conduct and Analyze Real Estate Market and Feasibility Studies, 2nd ed. (New York City: Van Nostrand Reinhold Company, 1988), 76-79.

Fraser, R. R., and E. M. Worzala. "An Insight into the Ideas of Professor James A. Graaskamp on Practice and Reform in Appraisal," Appraisal, Market Analysis, and Public Policy in Real Estate (Boston, Massachusetts: American Real Estate Society, 1994), 237-258.

Graaskamp, James A. The Appraisal of 25 North Pinckney: A Demonstration Case for Contemporary Appraisal Methods (Madison, Wisconsin: Landmark Inc., 1977), 3-10.

Reenstierna, Eric T. "Alternatives to Point Estimates," The Appraisal Journal (January 1985): 115-126.

Smith, Halbert C. "Value Concepts as a Source of Disparity Among Appraisals," The Appraisal Journal (April 1977): 203-209.

Thair, Steven. "What's the Use? Most Probable Use Versus Highest and Best Use," The Appraisal Journal (April 1988): 190-199.

Vandell, Kerry D. "Toward Analytically Precise Definitions of Market Value and Highest and Best Use," The Appraisal Journal (April 1982): 253-268.

Olga Z. Kaganova, PhD, is a research associate with The Urban Institute, Washington, D.C., and a mathematician and an expert on the urban real estate market in Russia. She has provided technical assistance on real estate reform as the consultant for several projects of the World Bank. Ms. Kaganova earned her PhD in applied mathematics from the Institute of Biophysics of the Academy of Sciences, Krasnojark, Russia, and her BS from Novosybirsk State University. She has had numerous articles on real estate issues published in academic and professional journals in Europe and the United States.
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Author:Kaganova, Olga Z.
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Date:Jul 1, 1997
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