Land development is the process of preparing raw land for the construction of improvements.
Pricing land for development can be a difficult task for the untrained investor. As a niche subset of both residential and commercial real estate, using comparables for land can be as dangerous to a developer as it is mysterious, sometimes causing the failure of what was certain to be a great development.
There is one universally accepted land valuation method used by development professionals, corporations, and appraisers alike; the Land Residual Method. Using this method is to determine the current and future value of any piece of land, whether its use be residential or commercial.
The land residual method has a fancy sounding name, but to use it all you need is an understanding of some simple math. The land residual method is a calculation that takes the highest and best use of a particular piece of property and subtracts out the total cost of development to arrive at the residual value: the land value.
Use and Utility
You’ve heard the term “Location, Location, Location” thrown around in many real estate circles. It is never more true than when developing land. While I don’t recommend using any type of comparables for valuing land, it’s generally accepted that land near the ocean, or any other high priced corridor, has a higher intrinsic value that land based further away from a hub or commercial center. It boils down to use and utility. For instance, a 100 unit office building in downtown Miami will probably be worth more than the same building in rural areas. Generally speaking, the land those properties sit on will be valued accordingly.
Property value is determined by its highest and best use. A piece of property that can be developed into a regional shopping mall will be more valuable than a property that can only be developed into a single family home. This is because the end use of the former has a much higher finished value than the latter. The value of the materials are more and the expected income from renting or owning the first is significantly more valuable than the second. It all comes down to profit and a return on investment. Generally speaking there is more profit to be made in larger commercial buildings than a single family home. However, the commercial property takes significantly more risk and money to develop.
The first part of the land residual method is to estimate the final or future value of the proposed property. This can be done by several approaches. In the case of a single family home development it can be quickly estimated by using recent sales comps from. Make sure you’re dealing with true comps; similar in style, size, amenities, and age.
Example: The value of the completed home is estimated at $500,000, which is the goal when you’re ready to sell. Your development costs are $200,000. The residual land value is the difference between finished value and development costs. In our example, the residual land value of the proposed property is $300,000 ($500,000 – $200,000 = $300,000).
What this means, is that for you to build a home that would cost $200,000 and have a value of $500,000 in the open market, you could pay up to $300,000 for that piece of land. This is the break even point. If you pay more for the land there is a great potential for you to lose money. If you pay less for the land you’re potentially building in profit. And that’s exactly how a professional developer would do it. They don’t stop at the residual land value. They go one step further by working in their profit.
As a developer/investor you’re here to make a profit. You want to work that into the equation before you price your land and make your offer. Most developers of residential property like to make between 25-35%. Anything below that will be hard to finance through a conventional lender, and would also be a risk on your part. Markets move up and down, sometimes as much as 10% in a few months. If your profit margin was only 20% and the market drops 10% you’re left with a 10% profit. For that kind of money you don’t need the risk of development you can just go out, buy a T-Bill, and sip iced tea on your front porch until retirement.
There are six steps in the process of development.