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Residential Land Development – Part 2: Determining Economic Feasibility

by Craig Grella on October 16, 2009 · 1 comment

  

This is Part 2 in the Residential Land Development series showing you how to find, price, and develop land for residential single family property.

If you’ve followed Residential Land Development Part 1 you’ve put together your development team, done a little research into the type of property you want to build and the market you will farm for potential land purchases.  You’ve determined the highest and best use, researched zoning and other legal matters, and now need to determine  the economic feasibility of the project.  We do this by estimating the overall costs of the project. The results of your down and dirty, quick economic feasibility analysis will determine whether you move forward with your project, or whether you dump it and move on to the next piece of land. Here’s what you’ll do:

  1. Set your profit
  2. Estimate unit size
  3. Estimate project cost
  4. Estimate project revenue
  5. Determine overall return
  6. Make your first go / no-go decision
  7. Refine numbers (if necessary)

Set Your Profit

When developing land it is preferable to set your desired return before you start building.  This is how smart developers, builders, and investors do it.  Don’t wait until you’re done and at the whims of the market to figure out your numbers.  That’s the fast track to bankruptcy and development jail!  IF you plan to use bank money to finance your development, your profit will need to be at least 15% of total project cost.  Banks want to see at least this much built in to account for possible downward movement in the market when sales time comes around.  I like to see developers setting their profits in the 20-30% range.  In our example, lets assume you’ve found a square lot, roughly 1/2 acre in size.  Let’s say 20,000 sf.  You’d like to make a 30% return on the overall project costs.

Estimate Unit Size

Your demographic research and neighborhood profile will determine what amenities are required in your market and this will determine your unit size, measured in square feet. If your market area is made up primarily of senior citizens that don’t like stairs you’ll need to develop a ranch style, one story home, which might limit the size of your home if you are working with a small lot.  If the prevailing style in your market area is a three story town home style building you might be able to go up three stories. Continuing with our example introduced above, let’s assume you’re going to build a single story, ranch style home about 2,000 sf in size.

Estimate Project Cost

Your project cost can be estimated by calling local contractors, builders, and architects.  What you want here is a quick all-in number that includes lot development and vertical construction costs on a $/sf basis.  Costs can be tiered based on finish quality of the home.  Again, you’ll go back to the neighborhood style to figure this one out.  If your neighborhood is mainly craftsman style homes built in the 1950′s you’ll probably not want to build an ultra-modern home with windows from floor to ceiling.  Higher end finishes might cost as much as double than a simple build and that can affect your downstream profit margins.  For our example, let’s stick with the craftsman style home, average level finishes.  We’ve called a few contractors and architects and got a few free quotes.  They’re happy to do this for free because we will eventually call on them when it’s time to build.  We were quoted at $150/sf all in.  This means our total development cost will be $300,000 (2,000sf  x $150/sf).

Estimate Project Revenue

Again, we’re doing a down and dirty analysis for the first trial run here.  Your estimated revenue will come from a comparable sales report for your area.  This can be accomplished easily if you have MLS access.  If not, make a phone call to one of your agent or broker team members to get this report.  Make sure it lists recently sold and truly comparable properties.  If you’ve paid attention to neighborhood style and amenities you should developing a home that fits in well and has a wealth of similar comparable data to draw from.  Once you have that comparable data in hand you want to take each home’s sale price and divide that by it’s size in sf to determine its sales price per sf.  When you have this done for each home in the comparable report you can determine your averages sales price per sf for your immediate area.  This is the average sales price per square foot you would expect to receive if your home were built and you were selling it right now.  That’s a good starting point for us to estimate revenue.  Let’s assume the comparable report determined our average sales price/ sf was $300/sf.  We can apply that to our home and expect a completed sales price of $600,000 (2,000 sf x $300/sf).

Determine Overall Project Return

We’ll take everything we’ve analyzed up to this point and apply it to determine whether this project will meet our 20% desired return requirement.  It helps to have a piece of software like Microsoft Excel to help you with these calculations.  It’s easy to change numbers quickly and you don’t’ have to worry about losing numbers in a hand calculator.  We start with the price of the land which the seller is asking.  We add to that the cost of development to estimate the total project cost.  Now we multiply that number by our desired profit margin to determine our required profit dollar amount.  Put that number aside for a moment.  Now, we take our expected revenue and subtract selling costs from that number.  I always assume 10% for selling costs, which covers a 6% broker fee, local excise tax, title and other third party costs that might come up.  That number is subtracted from expected sales price to determine our gross revenue.  From that number, we subtract our total project cost to determine our net project revenue.  If that number is higher than our required profit amount then we will move forward with the development.  Let’s look at the numbers for our example:

Asking Price for Land: $100,000

Development Costs: $300,000

Total Project Cost:  $400,000

Desired Profit Margin: 30% = $120,000

Expected Sales Price = $600,000

Sales Costs = 10% = $60,000

Gross Revenue = $540,000

Minus Total Project Cost = $400,000

Net Project Revenue = $140,000

Desired Profit = $120,000

Net Project Revenue > Desired profit = Project is a GO!

Project is a GO…now what?

You’ve proven your potential development is physically and economically feasible and you’re ready to move forward.  What do you do now?  You do the numbers again.  Really.  This time, you’re going to get even more detailed.

You will now go back to all those contractors and architects you spoke with earlier and ask them to submit actual bids.  They should be able to so this without having detailed architectural plans.  If the contractor you want requires plans, then you’ll have to get the architect working and you may have to start spending money here.

Once you have the detailed bids in hand you will replace your estimates of project cost with the real numbers.  You will then run the analysis again to make sure the project can return you’re desired profit.  This will help you make your second go/no-go decision.  If the analysis is confirmed you move forward.  If costs went up  in the actual bid and the numbers don’t work anymore you have to go back and change something.  Start with the contractors costs.  Ask them to lower their fees.  If the numbers still don’t work after lowering their fees you will have to start cutting into your profit.  Again, try not to go below 20% if you don’t have to.  If you can make the numbers work by reducing your required profit to 25%, it might still be worth moving forward.  If you have to drop your profit to 10% to make the numbers work you probably shouldn’t go forward with the development.  Another area where you can cut back is on the land price.  Taking a holistic view of the project costs, including land price, will help you arrive at your max land price offer.

If you’ve gotten to this point, congratulations; you’ve found a great piece of land with really good potential for development.  The next step in the development process is to go back to the drawing board once again and really hone in on the actual design.  This will require you doing some zoning research and narrowing down your final home design.  We’ll get into that in the next part of this article series.

Photo Credit: Vincepal via Flikr

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{ 1 comment… read it below or add one }

Liz October 16, 2009 at 4:52 pm

Great article and lists many items REALTORS don’t think about with raw land. RLI offers courses that get in to more depth for development for those who want to learn more.

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