Appropriate Use of the Development Cost Approach in Condemnation

By: Christopher J. Stockness

In the majority of condemnation cases, damages relate to the loss of value under a property’s highest and best use (HBU) – often the property’s current use. A knowledgeable appraiser can quantify this loss by performing a before and after valuation using the three standard approaches to value. However, what happens if the condemned property is in transition from one use to another?

Consider the owner who was in the midst of developing or redeveloping a site at the time it was condemned. The condemnation process burdens the property owner beyond the fee simple market loss of the property’s HBU. A promising development may be delayed; diminished in size by the taking; or incur unexpected costs in addition to the time and money already invested during the planning stages. In fact, the impact of the taking may render the project physically and/or financially unfeasible.

Unlike the cost, income and market approaches to value, the development cost approach (which incorporates all three approaches) allows the appraiser to quantify the full impact of the taking. The analyst calculates the market value of the proposed development (including land and buildings), subtracts the building costs and then factors in the damages to the project. Using an income analysis, the appraiser establishes the current price a potential buyer would be willing to pay for the land based on the costs of developing it and the likely proceeds from the sale of the development in the future: a before-the-taking value. Once the initial value is determined the income analysis is repeated; this time, the appraiser’s adjustments include the impact of the taking on current property value: an after-the-taking value.

The development cost approach was first recognized by the Minnesota Supreme Court as a valid technique in determining damages for eminent domain purposes in: County of Ramsey v. Miller, 316N.W.2d 917, 919 (Minn. 1982). As to when it is appropriate to use the development cost approach for determining damages, the Minnesota Supreme Court identified three criteria that must be met:

• The land is ripe for development
• The owner can reasonably expect to secure the necessary zoning and other permits required for development to take place
• The development will not take place at too remote of a time

Recently in Winona, Minnesota, a portion of the land owned by Mikrut Properties, LLLP was acquired by the City of Winona. The owners were in the process of developing an intermodal (rail and truck) transit facility (ITF) using the existing land when approximately 20,000 square feet of frontage was taken for the upgrade and expansion of Pelzer Street. Pelzer Street is a major thoroughfare providing access to industrial properties in the immediate area. The taking was deemed necessary to accommodate a bridge across the Canadian Pacific railroad tracks. Unfortunately, the location of the railroad overpass effectively prevented access to the subject from Pelzer Street. The property lost its main access and was forced to utilize a secondary access to the site: a residential road not designed to accommodate heavy commercial truck traffic.

As a result of the taking, what was an underdeveloped industrial land site in the process of being redeveloped was now likely to remain an underdeveloped industrial site with minimal or reduced redevelopment potential due to poor access. Not only was access limited to a residential road, it was problematic (in the after condition) whether residents and local officials would approve a re-development that resulted in heavy truck traffic and noise in their neighborhood.

Clearly, the taking changed the highest and best use of the land from a prime rail transit site in the before condition to continued use as a low intensity industrial site in the after condition. The involved parties agreed that the HBU in the after condition was continued development. After trial, the jury concluded that a cost to cure measure providing an upgraded access via the residential thoroughfare (recognized only in the development cost approach) properly reflected the damages to the subject as compared to the loss in market value resulting from continued use as a low intensity industrial site. Improved access mitigated much of the long term damage, but the project was delayed for a long period while the residential road was upgraded to a commercial thoroughfare. The jury was also presented with a standard direct sales comparison approach analysis for damages that did not, and could not, recognize the cost to cure. That approach was rejected by the jury.

Not every development project under the threat of condemnation will fit into the criteria set forth by the courts. However, since the subject property met all three conditions, using the cost development approach to value was appropriate and effective. Let’s review each the three points:

1. The Land Is Ripe for Development of the ITF?
   At the time of the taking, the land was underutilized with industrial development located in the north corner of the site, leaving excess land available for an additional development of ±12 acres. A highest and best use analysis determined that the physical, legal, and economically viable uses of the property supported the proposed re-development. Additionally, due to the geographic constraints of having the railroad tracks located between the Mississippi River and the surrounding bluffs, substitute sites for this re-development were virtually non-existent and development opportunities were extremely limited in the Winona Area. Clearly, the land was ripe for development.
2. The Developer Could Expect to Secure the Necessary Zoning and Permits Required for the Development to Take Place
   The site was zoned M-2 General Manufacturing District which allowed for heavy industrial uses including railroad and transit facilities. The property owner had been negotiating with the Canadian Pacific Railway (CPR) to develop a railroad spur allowing rail access to the subject. CPR expressed strong interest in the development and verbally committed to a spur connection. Discussions with the City of Winona confirmed the viability of the site for development into a rail and truck facility. Additionally, the City of Winona was aware of the property owners’ development plans and had designed the rail overpass to accommodate the spur extension to the site.
3. The Development Will Not Take Place at too Remote of a Time

The developer was in the advanced planning stages of development at the time of the taking and was preparing the site to accommodate the proposed development. If not for the taking, the developer would have continued to develop the site for use as an intermodal facility. Due to the loss of access from Pelzer Street, the taking forced the development to be delayed indefinitely until the issue of access could be resolved.

The property and the proposed development met all three criteria; it was deemed appropriate and necessary to utilize the development cost approach to determine the damages to the subject based on the taking. The taking of the subject land occurred on May 12, 2005. A court appointed Commissioners’ Hearing took place on June 6 and June 7, 2006. Shenehon Company provided the appraisal and testified to the damages to the subject property relying on the development cost approach. In contrast, the appraiser for the City of Winona relied on a sales comparison analysis and concluded significantly lower damages.

On September 11, 2006 the Commissioners awarded $903,000 in damages to the property owner. They were persuaded that the highest and best use was for an intermodal transit facility and agreed that the development cost approach was the proper method with which to value the subject citing that the three criteria for the development cost approach had been met.

The City of Winona appealed the case and a jury trial was scheduled to take place in November of 2007. Prior to the trial, the City of Winona filed a motion to Exclude Improper Evidence Regarding Valuation claiming that the property owner’s appraisal report methodology did not appropriately utilize a “development cost approach.” The motion for exclusion of the appraisal was overruled and the trial was re-scheduled for November of 2008.

At trial, the jury listened to testimony from both sides’ appraisers and awarded $570,000 in damages to the property owner. The damage award at trial was less than the Commissioners’ award because the City of Winona altered its position regarding reconstruction of the road.

Before the Commissioners, the City (condemnor) made no commitment to rebuild the road and the Commissioners included the cost to rebuild the road in its award. At trial, before the jury, the Public Works Director with the City of Winona indicated his recommendation for the City of Winona to upgrade the road for the proposed development – the property owner would not be assessed for the upgrade. The cost of the road upgrade was estimated at $355,000. The $570,000 jury award reflected a cost to cure of acquiring residential properties fronting the rebuilt road. This had previously been included in the Commissioners’ award. Thus, the combination of the jury award plus commitment to rebuild the road by the City at no cost to the owner was basically equivalent to the prior Commissioners’ award.

In conclusion, the development cost approach to valuation is a valid appraisal technique if a proposed development meets the three tests set forth by the Minnesota Supreme Court in the case of County of Ramsey v. Miller. If the validity tests (ripeness of development; legal feasibility; and a reasonable development time frame) are not met, the objectivity of the appraisal is compromised. Application of the development cost approach in eminent domain law is an important valuation tool which the appraiser can rely upon to measure “just compensation”.