Residential Land Development – Part 1
Last week I wrote an article describing how to price and develop offers on land purchases. While that information is an important part of the overall development process, it is only a small fraction of the work that needs to go into developing land for residential use. As such, I’d like to explore the residential land development process in a more thorough manner, which will include this article, and several to follow.
With that said, this article will focus on the process of land development, risks and rewards, and a few things you’ll need to get started in the business of Residential Land Development.
Land development is the process of preparing raw land for the construction of improvements.
It can include:
- Demolition of existing improvements
- Clearing and Grading
- Rezoning if required
- Installing utilities, sewers, streets, and sidewalks
- Constructing Improvements like driveways, foundations, and building pads
Although developed land creates no more income than raw land, it is nevertheless brings land one step closer to its ultimate use; a home, apartments, office buildings, hotels, etc.
Like any profession, you need the right tools to succeed, and without the right tools, failure is often the result. Among the most common reasons for failure of investors who try their hand at development are:
- Insufficient finances
- Not planning for contingencies
- Analysis Paralysis
- Inability to Seek Advice
There are few investors who can successfully make the transition to development, but those who do are able to create extreme wealth for themselves without risking much of their own capital, if any, and sometimes working only a few months out of the year.
There are six steps in the process of development.
The first few require much more research and planning than the rest, and each one builds on the step before it. If done properly each consecutive step gets easier to complete.
There are three things every developer needs to begin; a development plan, a personal financial statement, and a good team.
The Development Plan
This is essentially a business plan for the investor/developer. It can be a simple one-pager, or a more detailed analysis. Length doesn’t really matter as long as you include the reason you want to develop, the types of development you plan to start with, and at what point you consider your development/investing a success. Stating your goals is imperative. It is a defined process. Think of it as a road map taking you from point A to point B. In the case of land development, point A is always the raw land, and point B is always the finished product, like a home or commercial property. You can’t start out on the path to development without knowing where you’re going.
Here’s a sample:
Cornerstone will farm three neighborhoods of Seattle; West Seattle, White Center, and Alki Beach. We will acquire vacant lots or land with tear downs, and develop them into single family homes. Our goal is to develop one single family home per year over the next three years, two homes in year four, and three homes in year five. All the homes will be built to LEED Gold or Builtgreen 4 Star standards. The homes will be listed with local real estate brokers and marketed at median market rate. Our goal is to return a profit of at least 30% on our cost per year.
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The Personal Financial Statement
The personal financial statement (PFS) is the financial counterpart to your development plan. Every real estate investor, not just developers, should have a current personal financial statement. A PFS lists your assets, liabilities, and resolves the two to show your net worth.
Most novice investors may not have a significant net worth yet, but it’s important to set goals here too. Think of how much profit it would take for you to live the way you want to live. Maybe your goal is to quit your day job and retire early. Figure out how much money you would need to put away to make that happen and that’s your goal. When your net worth hits that level you’ve reached your personal financial goal.
Put Together Your Team
Once you’ve taken a look at your financials you can determine your starting resources. That’s where putting together a team comes in. You’ll meet alot of people in the development game, and you need to be friends with all of them. The idea is to shore up your list of resources by adding the strengths of others where you are weak.
If you have no cash on hand, but have good credit, you will probably need to start looking for a money partner. If credit is your problem and you foresee needing loans, you'll need to get a partner who can put their credit on the line. If you don't know how to build a home think about partnering with a local contractor or another developer. Don't know the local zoning codes, get on the phone to the city planners and start taking them out to lunch. Hopefully you'll never need a land use attorney, but having one on speed dial might get you some quick tips on local development trends that keep you a step ahead of the competition.
How to get Started Today
Determine your target market.
It could be your local neighborhood, a particular zip code, or the entire city. Most developers will tell you the first property they developed they found very close to home. Probably somewhere along their morning commute; something they’ve passed by every day. Developing close to home has several advantages. For one, you’ll have a greater degree of familiarity with your own neighborhood than one an hour or two away. You’ll also save money on transportation costs by staying close to home.
Don’t make the mistake of thinking you need to develop in the high-end areas. That’s not always the case. There are many developers who profit in areas that are at median income levels or below. Similarly, if property in your local area is not moving you will need to venture out a little further. To figure out the best market in which you should develop you’ll perform a Feasibility Study, the first step in the process of Residential Land Development.
You perform a feasibility study by researching the supply and demand in a given market and estimating the potential profit of a given project.
The supply is other residential homes and land currently on the market. This includes all land and residential homes for sale, as well as homes that may come on the market between now and the time your potential home is completed.
Demand is determined by researching the area’s demographics. It helps to know how many people are moving into the neighborhood and how many are moving out. You can get this information from the government census or from local economic development boards. These places will also list the breakdown of homeowners in your area. If your zip code is expecting growth of 1,000 people over the next year, and the ratio of owners to renters is 50%/50%; that means your market will need to add or absorb 500 new rental units and 500 new homes. If after checking with the local department of planning and development you discover that only 200 homes are planned to come online in the next year, you may have found a good market in which to develop. Clearly there will be some pent up demand. You have found a hot market, now all you need to do is find the available land to purchase and develop. This is called a “Use Looking for a Site.”
If you find that population is moving away or there are more units coming online than there are people to buy or rent them you may want to stay away from that area. Supply overwhelms demand, and in the end you may need to significantly discount your property to move it.
If you already control a piece of land or are able to purchase a piece of land at a discount in an area where property generally moves well you have a “Site Looking for a Use.” Generally speaking, this is where most novice developers start off. Again, driving by property on their way to work they are able to jump on a deal when it comes up, or sometimes they get tips from friends and family that allow them to beat out the competition.
Even if you’ve identified the piece of land you’ll still need to check local demographics to determine what home amenities are required for your area. If you live in a market with an average age of 60+, you may want to develop a home on one story, as opposed to a three level townhome style house. If you’re target buyer is a 30 something, you may want to include high tech wiring, an open floor plan, and a home office.
Remember, the more research and planning you do the better you’ll know your market and the fewer surprises you’ll run into later. Many developers have gone broke thinking that they can develop a lot just because the home across the street sold for a certain amount. Market’s change, costs go up and down, and contractors can get busy. Do the research, know the numbers before you start.
Once you’ve find your site or your area, you’ll want to estimate the potential future profits. This is done by performing a highest and best use analysis.
Highest and Best Use
The highest and best use of a piece of land is determined by answering four questions in the following order:
- Is your proposed project legal?
- Can it be built practically on your site?
- Will your project generate the desired return?
- Does the proposed use represent the use that will deliver the maximum return?
Since we’re developing single family homes, we must find an area that allows that kind of home to be built. If we determine the home must have at least 1,700 sf on two stories, that style home must be able to be built practically on our site. Our goal was to return a profit of 30% on our cost, so we must be able to sell the property for at least 30% more than what it will cost us to build it.
You can do that by estimating your development and construction costs, and we’ll review that in part 2.