Student Post: Methods of Real Estate Valuation in Eminent Domain

The Constitution requires that parties whose property is taken by eminent domain for a “public use” shall receive “just compensation”.  The use of eminent domain by state and local governments is commonplace in many sectors of the energy industry. Private property is often taken (in whole or in part) for any number of “public uses” including: construction of electrical transmission and distribution lines, electrical substations, oil and gas pipelines, solar and wind power facilities, and other energy-related projects.

National and state regulatory authorities have been charged with ensuring access to affordable and reliable energy and the public has grown accustomed to the relatively cheap and plentiful sources of such energy. These regulators have a duty to implement energy policies primarily to protect consumer interests.

Growing populations and increased demand for energy has led to the need for takings of private property by eminent domain. While the primary concern for regulators is protection of consumers, private property rights cannot simply be disregarded for the greater good. The owners of property taken by eminent domain must receive “just compensation”. And while the concept of “just compensation” is simple, its application often is not.

Real estate is difficult to value for one simple reason. It is unique. A particular piece of land can be found in one place and one place only- its current location! While personal property and financial instruments regularly have active markets where supply and demand indicate a generally accepted “fair market value”, real estate rarely does. This fact is significant when calculating “just compensation” for property taken by eminent domain.

There are generally three accepted methods for calculating “just compensation” for property taken by eminent domain:

·         Market Data Approach: Based upon the sales of comparable property in the relevant market.

·         Income Approach: Based upon a capitalization of net income from the property.

·         Cost Approach: Based upon the value of the land plus the depreciated replacement cost of any existing structures.

Market Data Approach

This approach is generally the most reliable, assuming there is an active market for the particular type of property being taken. The factors usually considered include whether:

·         The comparable property has at least a general similarity to the property taken; and

·         The sale was reasonably close in time to the taking; and

·         The sale was voluntary and not under compulsion.

Whether these factors are useful depends largely upon the specific type and location of the property taken. The underlying theory behind this approach is that recent voluntary sales of similar properties is strongly indicative of the value of the property being taken. These factors are very fact specific and cannot be applied mechanically. Without a reasonable number of sales of similar properties in the area, this approach will not provide a valid approximation of fair market value for calculation of “just compensation”.

Income Approach

This approach recognizes that land is income-producing. It can be used or rented to create income for the owner. Because of the inherent risk of investing capital in real estate, those risking such capital require a higher return on investment than other less-risky investments. If the income producing potential and required rate of return are known, it is possible to calculate a “fair market value” by using a fairly simple formula: net income divided by annual rate of return.

For example, if it is known that a particular property can produce $7,000 net income per year, it is also possible to calculate the value of the property if the rate at which the income was generated is known. Assuming a reasonable estimate of this yearly rate of return is 7%, the value of the property would be $100,000 (or $7,000/.07).

Most jurisdictions base “just compensation” off of the rental value of the property and do not allow compensation for loss of business profits. But even in those jurisdictions that do allow for such compensation, a business’s loss of goodwill and going concern value are generally not compensable. Computation of loss of business profits is dependent on numerous factors such as the economic climate and quality of service, which are not easily predictable. Despite this, some jurisdictions do allow the recovery of business profits and even good will.

While this approach is theoretically sound, its application is contingent upon the use of accurate assumptions. Because it is difficult to precisely calculate the actual rate of return required, any number used will only be a rough approximation.

The problem with assumptions is further worsened when the property taken is a public utility or other income producing business. Assuming a jurisdiction allows for recovery of business profits and goodwill, the calculation of these items is based upon often unreliable predictions of future market conditions and expected future costs. These estimates vary widely and are generally not reliable enough to state with much certainty. Therefore, the income approach may be inappropriate for calculation of “just compensation” in many instances.

Cost Approach

This approach is fairly straightforward, although less reliable as a valid indicator of fair market value. Essentially, “just compensation” is whatever a reasonably prudent buyer would pay for land and buildings that are physically and functionally similar to those being taken, constructed using modern construction methods. This calculation essentially seeks to calculate the cost of obtaining and building a functionally similar property with a similar level of depreciation.

Although this approach is generally less reliable, it may provide an acceptable fallback when other approaches to calculation are simply inadequate.

Conclusion

While none of these approaches are particularly accurate or reliable, they are all based upon valid theories of market valuation and provide at the very least a starting point for the determination of “just compensation”.  A voluntary sale of the property is of course preferable to the use of eminent domain. However, there are occasions when the use of eminent domain is justified and these methods of valuation must be applied to satisfy constitutional requirements.