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Developing Real Estate: How to Price Land for Profit

by Craig Grella on October 2, 2009 · 15 comments

  

Pricing land for development can be a daunting 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 fantastic development.

However, for the savvy investor, there is one universally accepted land valuation method used by development professionals, corporations, and appraisers alike; the Land Residual Method.  By using this method you will be able to determine the current and future value of any piece of land, whether its use be residential or commercial.  You will also be able to price land, such that any development you propose will have built in profit. With some practice, you will be able to employ the land residual method in just a few moments, summing up the value of almost any property just on sight.

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.  Once you have the numbers it’s that easy.  “How do you get the numbers?”  You ask.  It takes some research, but even a novice investor can figure it out relatively quickly.

For the sake of this article I’ll be speaking to residential single family development or single family lot land.  Rest assured, commercial development uses the same principles, though the calculations are a little more in depth.

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 Seattle will probably be worth more than the same building in rural Arkansas.  Generally speaking, the land those properties sit on will be valued accordingly.  It’s one thing to accept that, but another to understand why.

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.  Hence, the larger land value.

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 a local real estate broker or agent.  Make sure you’re dealing with true comps; similar in style, size, amenities, and age.  You shouldn’t be using a 10 year old sale as a comp for an about to be built home.

For our example, let’s assume you’re building a 3 bedroom, 2 bath home, 1,500 sf in size, with a lot size of 1/2 acre.  Let’s also assume your comparable report shows the median home sales price in the last 6 months for this type of home to be $500,000.

Once you’ve arrived at an estimate for the final or completed value of your property you move on to figure out what it will cost to build your proposed property.

Development Costs

Development costs can vary wildly from state to state and city to city, dependent on things like the amount of work in the area and the cost to deliver materials to your site.  When estimating development costs I counsel investors to research their market by calling local developers.  Find out what they paid.  Talk to contractors and find out what the going rate for material and labor is.  Talk to local builders’ associations.  They often keep data on home building costs in the area.

There are two ways to estimate costs.  You can use a $/sf method, or actually go line item by line item.  The second method can only be done if you have a list of all the line items required to build your home.  The $/sf method is easier to obtain, but not as accurate as the line item method. Your goal is to determine the total soft and hard development costs.  Soft and hard costs break down as follows:

A hard cost is anything that contributes to the direct construction of the structure itself.  These are usually limited to the costs to go vertical. Soft costs are anything that do not fit into that category.  Some soft costs are brokers fees, financing fees, horizontal development like running of utilities, demolition of existing structures, clearing and grading of the land, curbs, roads, and driveways, among others.

If your local contractor tells you the average hard and soft cost to build your home would be $100/sf, then you know your total development cost would be $150,000 ($100/sf  X 1,500 sf  = $150,000).

Do the Math

Now it’s time to resolve your numbers.  The value of the completed home is estimated at $500,000, which is hopefully the amount it will fetch when you’re ready to sell.  Your development costs are  $150,000.  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 $350,000 ($500,000 – $150,000 = $350,000).

What this means, is that for you to build a home that would cost $150,000 and have a value of $500,000 in the open market, you could pay up to $350,000 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.

Work in your 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 20-30%.  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 15% and the market drops 10% you’re left with a 5% 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.

If you’re cost to develop was estimated at $150,000 and you’d like to make a 30% profit on costs, your profit margin would be $45,000 ($150,000 X 30% = $45,000).  This number is then subtracted from the residual land value of $350,000 for a maximum offer price of $305,000  ($350,000 – $45,000 = $305,000).  That means, to make a 30% profit on your development costs, you wouldn’t pay more than $305,000 for the land.

Well that’s fine and good, but most developers want to make profit on their entire project, not just the costs.  Thus we do this calculation one more time; this time on the land purchase portion as well.  Assuming you’d want to make 30% on the land portion to, how much would you have to back out?  You’d back out approximately $90,000 ($305,000 X 30% = $91,500).

Max Offer Price

Take your residual land value minus your profit on cost and your estimated profit on the land cost and you can determine your maximum land offer price.  For our example, the final land value and max offer price would be $215,000 ($305,000 – 90,000 = $215,000).

For the property cited in the example I would offer the seller no more than $215,000  to purchase their piece of land.  This ensures I can get the development done and make a nice profit for myself.  Just to check my numbers, I run the math one more time.

Check the math

To check your final expected profit, simply run the numbers forward from the start.   Here’s how it would look:

$215,000 Land Purchase

+ $150,000 Development and Construction Costs

$365,000 Total Project Cost

$500,000 Projected Revenue from Sale

-  $365,000 Total Project Cost

$135,000 Profit

$135,000 profit / $365,000 total project cost = 37% total profit Margin

Keep in mind we have not accounted for taxes of any kind.  That will of course reduce your profit margin, but still, this is not bad for a development that probably took less than a year from start to finish.

For even higher returns, your land offer would be made at an even lower number than your max offer price, in case you end up negotiating the price higher with your seller.

You can see that the residual land value method of obtaining land value is an easy and efficient way to make sure you’re paying the true market value of the land, while working in profit for your potential development.

Photo Credit: pnwra

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{ 15 comments… read them below or add one }

Craig Grella October 2, 2009 at 9:17 am

Thanks Joshua. It’s pretty basic info that i think will help potential developers out there get a good handle on pricing land, even in this up and down crazy market.

Reply

Joshua Dorkin October 2, 2009 at 9:15 am

Craig –
That is an incredible introduction primer to developing. I think you’re going to single-handedly ignite a lot of new interest in developing from the BiggerPockets and real estate community at large.

Reply

RTS October 2, 2009 at 9:58 am

As a developer I am really hesitating to invest in land now, because of the depreciation prices. Investing in land now is risky. But reading your post has given me some inspiration. I liked the calculation. Thanks.

Reply

Craig Grella October 2, 2009 at 11:13 am

If you can get a handle on entitlement risk, zoning codes, and stay conservative on your exit price you can still make speculative land deals work. There is still funding out there for these deals.

It gets easier if you’re developing a house for yourself, from a financing standpoint, but you still want to go through the exercise. In that case you’d substitute desired equity for the profit calculations, that way you have built in equity when the property is complete.

Reply

Eric October 26, 2009 at 10:55 pm

Hi Craig, perfect timing. I’ve come across a possible opportunity to purchase some land and this helps to get my mind set for the analysis. There’s a couple of factors in my situation that I hope you can help me think through.

What we have is that a developer in central California was going to build a large residential development. They went belly-up. Another investor acquired the whole piece (almost 100 lots, all finished and ready for a house to be built on it) for pretty cheap, supposedly for around $15k lot. He is considering selling these lots in groups of 5, at the rate of $25k per lot. Supposedly these are worth $40k a lot individually. This is where I might be a potential buyer, and so I”m trying to figure out how to analyze this on my own.

so, let’s say I am trying to figure out the price that a smart developer would arrive at. As I figure, 1) I should start with a probably high quality SFR would sell for on that lot at in the current environment; 2) calculate $/sf building costs; 3) back out the profit I want from the costs in order to arrive at a pre-land-profit land price, then back out the profit from the land. Does that sound about right?

If a potential buyer is an investor who may one day want to build their own house, does it make sense that they would be looking for a smaller profit/equity position? How do I take into consideration that they might now want to build on it for a long time, or if they do, they might not want to sell for a long time?

Thanks.

Reply

Craig Grella October 27, 2009 at 9:17 am

eric,
call me in the office to discuss.
206-651-4308

Reply

Keith McClean November 6, 2009 at 9:50 pm

I was searching the web and I can across your site.I am not an investor or developer,I just have a small piece of property in Brooklyn NY that I inherited from a family member(47ft x 100ft),I have no interest in keeping the property.On the land there is a very old wood frame house (1890).My question if I sell to a developer is the value of the house worked into the equation with the land.

/

Reply

Craig Grella November 7, 2009 at 11:03 am

The value of the house is only considered if it factors into the end use of the property.

Developers will work off the highest and best use. If the highest and best use is not a single family home, then most developers aren’t going to factor that house into their calcs. Even still, Brooklyn, along with most of the others areas in NY, is like its own little world when it comes to land transactions because it is not very often that land comes available there. For that reason, you might get a slight premium.

One of my partners out of our Long Island office does alot of business in Brooklyn . Should you decide to part with that property I can put you in touch with him and he can probably put you together with a few investors/developers. You can contact me in the office if you go down that route in the future.

Reply

Avi Amir June 6, 2013 at 9:52 am

Hi Craig

great article ,i find it very helpful for new developers.

i am considering in buying a land for the purpose of building townhouses.

i have couple of questions:
1.as a company(llc or inc etc.0 do i have to pay sales tax on every sale of unit?
2.what will you say the average profit mark up i should work on?
i am hearing a lot of numbers and i am not sure what is the common margin

thank you
Avi

Reply

Dean chance April 16, 2011 at 7:57 am

Hi Craig, great article. I have a question and have not found an easy answer. 2 lots, both equal zoning (multi family 3 stories), view, location etc. The difference is the size of he lot. One is 6500 sq ft. The other is 53,000 sq ft. Since the 53k lot offers a lot more flexibility with design guidelines etc, Is the 53000 sq ft worth more per sq ft than the 6500? Thank you.

Reply

Matt August 21, 2012 at 11:38 am

Dean,
Weight the average price per square foot… See if that helps…
Matt

Reply

Tiffany April 29, 2013 at 2:20 am

I came across this link through the UBG and it is very helpful! I’m getting ready to make an offer to option some land and and I wasn’t quite sure how to value the land in a way that would make selling my option profitable. Now I have several new ideas/tools. Thanks.

Reply

Rohit Yadav February 15, 2014 at 11:35 pm

Very nice post. Real estate is good option for investment. If you are thinking about investing Real Estate in Gurgaon than go for Emaar mgf palm drive.

Reply

Arthur March 12, 2014 at 2:01 pm

Hi Craig,
I found your calculation rather unrealistic because of the fact that cost of building a home structure alone will be much higher. For the builder to acquire a residential land at that high cost in ($200K range) would drive the final price of the home perhaps in the 600K range or even higher -dependent on location.

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v September 12, 2014 at 10:06 am

His pricing from this article is more than 5 years ago, so inflation in 5 years could account for the 50k difference in avg residential building costs.

Reply

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