Hypothetical Conditions (a/k/a Pie in the Sky)
2023 SME Annual Meeting and Exhibit
Denver, Colorado
February 28, 2023
Alan K. Stagg, PG, CMA
Stagg Resource Consultants, Inc.
HYPOTHETICAL CONDITION
- “[…] a condition, directly related to a specific assignment, which is contrary to what is known by the appraiser to exist on the effective date of the assignment results but is used for the purpose of analysis.”
[2020 – 2021 Uniform Standards of Professional Appraisal Practice (USPAP), p. 40]
PIE IN THE SKY
- “[…] something that you hope will happen but is very unlikely to happen.”
[Cambridge Dictionary; dictionary.cambridge.org]
HYPOTHETICAL SUBJECT PROPERTY
- Estate to be Appraised = Fee Simple
- Property Underlain by Limestone
- Rural Area
- Current Use = Agricultural
STEP ONE – MINERAL RESOURCE OR MINERAL RESERVE?
- Function of Data Available and Economics
- Assume Adequate Data to Establish Quantity and Quality
- Develop Operating Model With Positive Economic Results
- Deposit Accessible and Legally Mineable
- Deposit Warrants Classification as Mineral Reserve
STEP TWO – HIGHEST AND BEST USE
- Appraiser required to establish the Highest and Best Use of the subject property.
- Key Elements of Definition:
“The reasonably probable use of property that results in the highest value.†“The use of an asset that maximizes its potential and is possible, legally permissible, and financially feasible.â€
STEP TWO – HIGHEST AND BEST USE (CONTINUED) Key Elements of Definition:
“determined by the use that a market participant would have in mind for the asset when formulating the price that it would be willing to bid.†“The highest and most profitable use for which the property is acceptable and needed or likely to be needed in the reasonably near future.”
[The Dictionary of Real Estate Appraisal, Sixth Edition; Appraisal Institute, 2015, Page 109]
STEP TWO – HIGHEST AND BEST USE (CONTINUED)
- Four criteria – to be analyzed sequentially.
- Legally Permissible
- Physically Possible
- Financially Feasible
- Maximally Productive Use
STEP TWO – HIGHEST AND BEST USE DETERMINATION
- Legally Permissible –
- No blanket prohibitions to the development of a quarry on the Subject Property identified.
- Regulatory and zoning requirements do not preclude development.
STEP TWO – HIGHEST AND BEST USE DETERMINATION (CONTINUED)
- Physically Possible –
- Deposit is accessible.
- No adverse topographic features identified.
- No improvements located on the deposit.
STEP TWO – HIGHEST AND BEST USE DETERMINATION (CONTINUED)
- Financially Feasible –
- The economic analysis conducted in the mineral reserve determination establishes financial feasibility.
STEP TWO – HIGHEST AND BEST USE DETERMINATION (CONTINUED)
- Maximally Productive –
- Income Approach utilized and a DCF model constructed.
- Based on royalty income.
- Allows two years to acquire permits and construct facilities.
- Incorporates defensible market royalty rate.
- Yields a significant NPV.
STEP TWO – HIGHEST AND BEST USE DETERMINATION (CONTINUED)
- Initial Conclusion –
- NPV considerably higher than forecast returns from agricultural use.
- Therefore, Highest and Best Use is the development of a quarry.
- Note – DCF model explicitly presumes production would occur within two years.
FLAWS IN HIGHEST AND BEST USE ANALYSIS – SUPPLY SIDE
- Two limestone quarries adequately serve the regional market.
- Both have extensive reserves.
- Both have excess productive capacity.
FLAWS IN HIGHEST AND BEST USE ANALYSIS – DEMAND SIDE
- Demographics and population forecast show modest increases over next several decades.
- Market analysis yields no evidence of major construction projects, industrial development, or residential development.
FLAWS IN HIGHEST AND BEST USE ANALYSIS – SUBJECT PROPERTY
- Property is not leased.
- No entity has expressed an interest, begun the permitting process, and/or developed a mine plan.
REVISED ANALYSIS OF HIGHEST AND BEST USE CONCLUSION
- Initial Highest and Best Use determination does not meet defining characteristics.
- “Reasonably probable use.”
- “[…]the use that a market participant would have in mind for the asset when formulating the price that it would be willing to bid.”
- “The highest and most profitable use for which the property is acceptable and needed or likely to be needed in the reasonably near future.”
ULTIMATE CONCLUSION
- The assumption regarding quarry development on the Subject Property constitutes a Hypothetical Condition.
- It is required by USPAP that an affirmative statement to this effect be included in the appraisal report.
- A Hypothetical Condition can be used only for the purpose of analysis.
POTENTIAL BUYER (MARKET) ANALYSIS
- I think this property has development potential for limestone but uncertain of timing.
- I’ll roll the dice and buy on a speculative basis.
- I’m not paying more than its current value in the market.
- “Real World” (that is, Market) response to a technical appraisal requirement.
- Appraiser Hint – know your market.
COMMON MISUSES OF HYPOTHETICAL CONDITIONS
- Conservation Easements
- Gifting
- Condemnations
COMMON MISUSES (CONTINUED)
- Conservation Easement Hall of Famers
- Several with mirror image simultaneous development forecasts on property arbitrarily divided into two parcels.
- And the winner is – six simultaneous mirror image developments on property arbitrarily divided into six parcels.
- Brings new meaning to the concept of “chutzpah.”
- Not to mention ethics violations.
APPRAISAL FACT
Just because a deposit qualifies as a Mineral Reserve does not mean it has significant value.
REALITY CHECK – ANY MARKET VALUE APPRAISAL
- Look in the mirror and ask yourself – Would someone pay this to buy this property? (No fair crossing your fingers.)
NON-TECHNICAL DEFINITION – HYPOTHETICAL CONDITION
- Pie in The Sky
[…] something that you hope will happen but is very unlikely to happen.â€
[Cambridge Dictionary; dictionary.cambridge.org]
Alan K. Stagg, PG, CMA
Stagg Resource Consultants, Inc.
5457 Big Tyler Road
Cross Lanes, West Virginia 25313
(304) 444-4540 (cell)