When real property subject to condemnation is within an area of urban renewal² or is underutilized, understanding the potential for a highest and best use that differs from a property’s current use, as of the date of condemnation, is critical. This article will explore how to identify an underutilized property, provide practical and legal considerations for counsel and appraisers as they approach the highest and best use for a property in urban renewal areas and prepare for trial, and discuss how and when urban renewal may (and may not) impact the maximum potential use of the subject property.

Urban renewal, whether it occurs organically or through government-driven development and condemnation, evokes a discussion of gentrification of neighborhoods that remains a controversial subject, with the benefits of increased economic activity offset by a decrease in affordable housing and the displacement of residents or businesses who can no longer afford rising costs. This article seeks only to provide guidance so that appraisers, condemnors, landowners, and counsel can identify transitional areas in process and effectively evaluate just compensation in an eminent domain case.

IDENTIFICATION OF AN AREA IN TRANSITION

There are a number of signposts that lead to the identification of a neighborhood that may be in transition from a blighted area to one with burgeoning economic development and improved living conditions. These signs include:

• Rehabilitation projects in the vicinity;
• Growth of restaurant, bars, and retail stores that pop up in historically industrial areas;
• Increasing sales activity and property values;
• Government investment in infrastructure and updated facilities;
• Nearby brownfields redevelopment activity;
• Increasing residential population, particularly higher-income individuals or families, attracted by lower property values and rehabilitation opportunities;
• Official local and federal government policy findings supporting or encouraging urban renewal (e.g., tax incentives or zoning overlay designations).

Not all of these signs are visible in the initial stages of transition. However, in a geographic area with significant population growth, these changes can occur rapidly. Speculative investment boosts the momentum of such changes, which can often include covered land plays where interim uses may defray the costs of holding the property until redevelopment is imminent and where an eventual sale of the property for such redevelopment would reflect a premium.

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APPRAISAL CONSIDERATIONS

Often, a landowner will identify new opportunities for the use of his property. In many circumstances, the landowner has invested in real property in an area of renewal due to the opportunity of growth and increased economic conditions and income. Longstanding property owners are often keenly aware of changing conditions and property value increases and have already considered or planned a conversion of property to a more profitable use. Less frequently, condemnors and their appraisers share this vision, particularly in the nascent phase of transition.

In cases where an appraiser evaluates the opportunity for a change in highest and best use, she must be cognizant of several factors in order to make a proper valuation analysis. These factors include, but are not limited to:

• Physical characteristics;
• Environmental condition;
• Restrictive covenants or other legal restrictions upon use;
• Surrounding uses;
• Demographics;
• Zoning and reasonable probability of rezoning;
• Feasibility/market demand;
• Consistent use theory; and
• Interim uses.

Naturally, these factors are typically examined in the context of the well-known and studied highest and best use criteria: (i) physical possibility; (ii) legal permissibility; (iii) financial feasibility; and (iv) degree of profitability.³

When determining a reasonable probability of rezoning, appraisers may need to address specific criteria, whether by statute or in relevant and binding jurisprudence. In Illinois, for example, the LaSalle/Sinclair Factors⁴ which detail the following hurdles that must be met in order to satisfy the requirements:

• The compatibility with the existing use and zoning of nearby property;
• The extent to which property values of the subject property are diminished by the existing zoning restrictions;
• The extent to which the proposed amendment promotes the public health, safety, and welfare of the municipality;
• The relative gain to the public, as compared to the hardship imposed upon the applicant;
• The sustainability of the subject property for the purpose for which it is presently zoned;
• The length of time that the subject property in question has been vacant, as presently zoned, considered in the context of development in the area where the property is located;
• The consistency of the proposed amendment with the comprehensive plan, and any adopted land use policies; and
• That the proposed amendment will benefit the needs of the community.

Other states have worded the criteria somewhat differently. For example, in Colorado, those factors include the following: (i) rezoning of nearby property; (ii) growth patterns; (iii) change of use patterns and character of the neighborhood; (iv) demand within the area for certain types of land uses; (v) sales of related or similar properties at prices reflecting anticipated rezoning; (vi) physical characteristics of the subject property and of nearby properties; and (vii) the age of the zoning ordinance.⁵

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At minimum, any appraiser should include examples of similarly rezoned properties and an analysis of the factors that would provide support that a market participant would expect future benefits. This might be inferred via land sales or sales of buildings to be adapted for reuse under the proposed (and reasonable) rezoning. In some cases where easily identified transactions are scarce or non-existent, more detailed supply/demand analyses might be necessary. Often the appraiser’s investigation must involve consultation with not only the landowner and market participants, but also environmental consultants, local zoning officials, and other professionals.

Environmental issues merit special consideration in areas transitioning from industrial to commercial or residential. In many circumstances, particularly in properties zoned and used for heavy industrial purposes, contamination is present or has been remediated. If the former, the costs of remediation must be considered in any valuation analysis involving a change of use. If the latter, there may exist restrictions on certain types of uses, or contracts with state or federal environmental agencies which restrict certain uses.

The concept of consistent use theory is sometimes overlooked. In an area of urban renewal, some appraisers will identify a highest and best use of investment (i.e., holding the property awaiting a higher value),⁶ but omit the benefits or income of an existing use in a valuation analysis. Consistent use is “the concept that land cannot be valued on the basis of one use while the improvements are valued on the basis of another.”⁷ However, using the example of a hypothetical property which serves as both a potato farm and waterfowl hunting grounds, while “it is a violation of the consistent use theory to value a parcel for two uses that are mutually exclusive, it is permissible to value a parcel for two uses that are not incompatible and can take place simultaneously.”⁸ Thus, because a property can always be used for something in addition to holding as an investment, appraisers should examine other compatible uses, even if they believe a neighborhood transition makes it prudent for a landowner to hold until values ripen. Thus, the concept of interim use, which embraces the concept of dual highest and best uses, may be suitable in most neighborhood transition cases and should be explored.

Furthermore, many market participants of properties—in the areas where the trend of development begins to be a more fundamental question in the highest and best use analysis of a particular site – will refer to income-producing sites as covered land plays. This reflects a perspective that existing and continuing income is strong enough to warrant a short-to-long-term hold, but where the majority of an investor’s return will be recovered upon sale for redevelopment. In these scenarios, capitalization rates for properties might be lower than average rates, as the overall rate must consider not only the year-over-year return, but also the return at the end of the holding period, which in cases like these would reflect a premium.

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CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Real Estate Lawyer.

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