Commercial Real Estate

5 Easy Steps to Value Land for Development (& Work in a Profit!)

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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 (“comps”) 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 technique. By using this method, you will be able to determine the current and future value of any piece of land, whether its use is 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 on sight.

The land residual technique has a fancy-sounding name, but to use it, all you need is an understanding of some simple math. The land residual technique 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. So, how do you get the numbers? 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 phrase “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 than land based farther 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.

Related: Why I Decided to Develop a 13-Story, 84-Unit, 95,522-Square Foot High Rise

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 is 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 return on investment (ROI).

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 square feet in size, with a lot size of 0.5 acre. Let’s also assume your comparable report shows the median home sales price in the last six 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.

parking lot butting up against vacant land

5 Steps to Find Out How Much to Offer on Land You Plan on Developing

1. Figure out your development costs.

Development costs can vary wildly from state to state and city to city, depending 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 price per square foot 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 price per square foot method is easier to do but not as accurate. 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 that go vertical. Soft costs are anything that do not fit into that category. Some soft costs are broker’s fees; financing fees; horizontal development like running of utilities, demolition of existing structures, clearing and grading of the land, curbs, roads, and driveways; and many other items.

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

2. 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.

But they don’t stop at the residual land value. They go one step further by working in their profit.

3. 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 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.

Related: Urban Redevelopment & How to Capitalize on a Profitable Trend

If your 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 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, too, how much would you have to back out? You’d back out approximately $90,000 ($305,000 x 30% = $91,500).

limit-liability-landlords

4. Establish your 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.

5. 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

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+ $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, just in case you end up negotiating the price higher with your seller. As you can see, the residual land value technique 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 a profit for your potential development.

Any questions about the above equation? How do you value land for development?

Comment below!

I co-founded Cornerstone Funding Services, Inc - a holding company for several real estate related firms including CreativeREO, which helps clients finance their real estate and business ventures, and HardMoneyU.com which provides education, resources, and online classes for hard money professionals.

    Joshua Dorkin
    Replied almost 10 years ago
    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.
    Craig Grella
    Replied almost 10 years ago
    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.
    RTS
    Replied almost 10 years ago
    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.
    Craig Grella
    Replied almost 10 years ago
    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.
    Eric
    Replied almost 10 years ago
    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.
    Craig Grella
    Replied almost 10 years ago
    eric, call me in the office to discuss. 206-651-4308
    Keith McClean
    Replied almost 10 years ago
    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. /
    Craig Grella
    Replied almost 10 years ago
    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.
    Avi Amir
    Replied about 6 years ago
    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 Report comment
    Avi Amir
    Replied about 6 years ago
    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
    Dean chance
    Replied over 8 years ago
    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.
    Dean chance
    Replied over 8 years ago
    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.
    Matt
    Replied almost 7 years ago
    Dean, Weight the average price per square foot… See if that helps… Matt
    Tiffany
    Replied over 6 years ago
    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.
    Rohit Yadav
    Replied over 5 years ago
    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.
    Rohit Yadav
    Replied over 5 years ago
    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.
    Arthur
    Replied over 5 years ago
    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.
    v
    Replied almost 5 years ago
    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.
    Val
    Replied almost 5 years ago
    Hi Craig I own a piece of land free and clear in VA in a single family subdivision. I want to structure a deal so that I can make most money. I know if I just sell the land, I won’t make enough. If i build the house on it and sell it then I will make good profit. At the same time I do not want to put my own money on construction of the house. How can I finance this deal? For example: If the construction cost is $20k and sale price is $50k than I want to make $30k total with out putting my own money. Thanks in advance.
    Aidan K. from Dublin, Dublin
    Replied over 4 years ago
    Hi Craig, Thanks for the article. I just had a couple of questions. You calculated the profit on the land portion of the deal at around 42% (90,000/215,000=41.86%) even though you said you wanted a 30% profit. Should you have taken the value you arrived at accounting only for development profit and divided this by 1.3 (130%) to arrive at your residual value with 30% profit built in (305,000/1.3=234,615) or is how you have done it how it is usually done. Working back from my figures gives a profit of $115,385 (500,000-234,615-150,000=115,385). This equates to an overall profit of 30% (115,385/(234,615+150000)=30%). Also, I was wondering how much having planning permission to build on a plot of land adds to the value of the plot? For example, if you found a suburban infill site for a single family home which was zoned residential and purchased it for x. You then get architectural drawings and permission to build from the local authority and wish to sell the site for x + Y. How much is Y likely to be? Cheers Aidan
    Henry
    Replied about 4 years ago
    Great article! Very helpful for all kinds of investors, novice to advanced. The formula is easy to figure out and makes sense. I agree with the author it is about location, location, location and the specific zip code more specifically that the property/land is located in. Also one thing people forget to take into account is the transfer/recording fees. These can usually range from as little as $10 anywhere up to a couple $1,000. If you are looking to purchase vacant land at a super discounted below market value price there is one site that has super deals: http://www.cheaplands.com
    Kyle Ransom Investor from Atlanta, Georgia
    Replied almost 3 years ago
    Great article! thanks so much for sharing
    Mark Hettrich
    Replied over 2 years ago
    I’m just starting in the land market as an agent and found this very helpful.
    Teddy Smith Real Estate Broker from Wilmington, NC
    Replied over 2 years ago
    Fantastic article, Craig.
    Abulele Woldulele from Castro Valley, California
    Replied almost 2 years ago
    Great read. Thanks Craig.
    Kevin Keithley Developer from Menlo Park, CA
    Replied almost 2 years ago
    Very interesting post.
    Bhavesh Patel from Newnan, Georgia
    Replied over 1 year ago
    Good information for investment
    Alex
    Replied over 1 year ago
    I am at the end stages of getting a piece of land fully entitled and engineered for 4 duplex lots, and I am working on coming up with a list price. In your “cost to develop number” does the potential developer include exit/closing costs (6.5% of total value) and/or holding costs (interest only bank payments, taxes, insurance, marketing, etc.) during the life of the project in their desired profit margin percentage? Please let me know. Thank you!
    Alex
    Replied over 1 year ago
    I am at the end stages of getting a piece of land fully entitled and engineered for 4 duplex lots, and I am working on coming up with a list price. In your “cost to develop number” does the potential developer include exit/closing costs (6.5% of total value) and/or holding costs (interest only bank payments, taxes, insurance, marketing, etc.) during the life of the project in their desired profit margin percentage? Please let me know. Thank you!
    Matthew Allen Flipper from San Antonio, Texas
    Replied about 1 year ago
    Great article! I like the simple approach on this one.