Land Development Mastery Lesson 04

Lesson Four:Land Due Diligence & Land Financing and Investment Characteristics

When analyzing land deals, you must review a significant number of issues. This lesson summarizes the key issues that investors must understand to invest in the land. In addition, we will review the land financing and investment characteristics.

4.1 Due Diligence Factors

The first concern is with Zoning. Zoning is the key to any land parcel. Zoning can be a tricky issue. Typically, zoning is described as the following:

  • Current as-is zoning
  • By-right approvals
  • Possible approvals within current zoning classification
  • Possible approval of variance to current zoning
  • Possible approvals requiring zoning changes

The second concern is the Availability of Utilities. When reviewing the land deals, consider the following utilities:

  • Water: Is there access to public water or drinkable well water?
  • Sewer: Is there access to public sewer or percolating septic system?
  • Other Utilities: Is there access to natural gas, cable, fiber optic phones, and electricity?

The third concern is Location Information. When reviewing the land deals, keep the following factors in mind:

  • Location: How does the intended use fit with existing properties in the area? Proximity to highways or public transportation can be a positive factor.
  • Neighborhoods: Is the area industrial, office, retail, or residential? What is the demographic of the population surrounding the property? What is the rating and reputation of the local school district? Is the property in any special taxing districts?
  • Property Amenities: Are there views, water, or proximity to fixed amenities (e.g., golf courses)? Can fixed amenities be easily permitted or constructed?
  • Area Amenities: Is there a local draw or attraction (e.g., schools, parks, shopping malls, downtown areas, water, industries)?
  • Other New Developments: What else is currently being developed in the area?

The fourth concern is Property-Level Information. An investor that has a specific piece of land under review should focus on several issues. The first issue is the current approval status. What is the current as-is status versus the by-right status versus the possible approval? The second issue is the soil conditions. Soil conditions are a major issue that must be addressed in early due diligence. The third issue is environmental issues. Environmental issues are another major issue that must be addressed in early due diligence.

The fourth issue is access to utilities. Utility access determines costs and feasibility. The fifth issue is existing infrastructure. Does the infrastructure (typically roads) benefit the site? If not, will the local government construct or share the cost of the required infrastructure? The sixth issue is site conditions. Factor, such as topography, vegetation, preservation requirements, and drainage dictate costs for development.

The seventh issue is grading issues. Cut and fill, as well as moving dirt, rock, and contaminants, dictate costs for development. The eighth issue is visibility. Visibility influences marketability and value. The final issue is size and shape. Size and shape influence flexibility in ultimate use.

4.2 Land Financing and Investment Characteristics

Most lenders do not like land loans. Land is illiquid and has little to no cash flow. Land investments can usually use cash for years before it generates any cash flow. As noted earlier in this course, this output is typically expensive because of needed expenditures on taxes, insurance, and maintenance. As we also discussed earlier in this course, land assets tend to be influenced more significantly by fluctuations in the general economy. For such reasons, lenders do not typically make very aggressive land loans. The typical land loan is only 50 to 65 percent of costs.

To purchase land, buyers must come up with a bigger share of cash than when buying income properties. However, there are ways that buyers can bridge the financing gap when bringing less than 40 percent of costs to closing. In the next section we will review these land financing options.

4.3 Land Financing Options

There are four financing options that we will focus on. The first is the Seller Carry-Back. It is very common for the seller to finance a portion of the sale. This is known as seller carry-back or seller take-back. The seller might finance the majority of the land by requiring a 10-to-20 percent down payment, or the seller might take a second-trust loan, subordinate in priority to the first-trust loan. The key points for the investor to consider are the interest rate, amortization, personal recourse, and the term of the loan, which should be the same as any first-trust loan involved.

The second financing option is the Lot Option Contract. A lot option contract, also known as the farmer option, involves a small down-payment with a long lead time to close. The closing is based on a given period or the achievement of an agreed upon objective, such as re-zoning. The third financing option is the Installment Sale. This method involves paying for the land over time. The deed is transferred to the buyer, but is subject to monthly, quarterly, or annual payments to retire the purchase price obligation. An installment sale is a form of seller financing and typically has better tax treatment for a seller than a take-back loan has.

The fourth option is the Seller Joint Venture. In many cases, the seller might partner with the developer and “contribute the land” to the deal, as an equity investment. In these cases, the partners need to first establish a value for the land being contributed. This can be done either through an appraisal or through the residual analysis method. Typically, if the land is being contributed “free and clear” (i.e., unhindered by any liens or restrictions), then no other equity partner is needed. The parties will want to enter into a joint-venture agreement or (more commonly) form a limited liability company (LLC) and then enter into an operating agreement.

4.4 Purchasing Land

Land can be purchased through a variety of methods. The first method is the cash contracts. The cash contract is the simplest and easiest method. The buyer pays cash at the closing to own the land. The second method is option contracts. These contracts are typically used to buy a piece of unimproved land. The buyer provides a small, non-refundable down payment and has time to pay for the rest of the land. During this time, the buyer attempts to get the land zoned or approved. If the buyer is successful, he or she then exercises the option and buys the land.

The third method is an installment contract. With this contract, the buyer owns the land at closing and can develop it as intended. Payments on the land are made over time. The seller typically holds a first-trust loan on a property until all payments are made, after which they buyer fully owns the land. The buyer will want to arrange with the seller to record the option or installment contract, or a memorandum thereof.

4.5 Structuring the Land Acquisition Transaction

After the approval risks are assessed and all land issues are resolved, the investor seeks to develop the property. As we have learned previously in this course, the investor needs to calibrate the sources and uses of funds as a first step in such development.

The first concern is the source of funds. These funds can come from a variety of sources. Let’s review these sources of funds below:

    • Cash from buyer: Sponsor-direct or sponsor-promoted equity
    • Seller financing: Seller carry-back, which can take the following forms:
  • First trust: Seller carry-back
  • Second trust: Seller carry-back (subordinate to first-trust lender)
  • Equity: Seller joint venture

The second concern is the use of funds. The first is the acquisition cost. The key to all land transactions is the acquisition price, or the basis. Most profits are made at the time of acquisition. Land buyers need to understand that the value of the land is driven by the cash flows that the building that will occupy the land will ultimately produce. This is why residential land analysis is so crucial when assessing acquisitions. The second area is the development cost. Bringing the development costs in on budget and on time is vital to profit. Sufficient contingencies need to be factored in to account in to account for any surprises.

The third use of funds is the third-party costs. Lenders require third-party documentation:

  • Appraisal report
  • Soil report
  • Title report
  • Environmental report

The final use of funds is the financing costs. There are three main costs associated with financing. The first is soft costs. Soft costs include taxes, insurance, and maintenance. The second is interest cost. If the land is financed with debt, then interest-carrying, which will add to the basis, must be built into the loan. The final cost is equity. If external equity is used, then the preferred return might need to be added to the cost and basis.

4.6 Establishing the Value of Land

Land value can be difficult to establish. Traditional appraisal methods include the following:

    • Sales comps compare the prices that the investor pays and the price that other have paid for comparable properties in similar markets. There are several issues with this approach. The first issue is that all land is different and unique. Land differences include submarket location, soil conditions, and development costs. The second issue is that these factors are difficult to sort through and create a direct comparison.
    • As-is, where-is value is the value that the land would sell for now.
    • Bulk sale value is the amount of a sale to a wholesaler rather than to a developer. This price allows for a wholesale profit and a retail profit.
    • Discounted cash flow value assumes that the property is developed over a long-term time horizon (typically 10 years) and discounted back to present. Key variables include the following:
  • Development costs
  • Lease-up time or sell-out period
  • Occupancy
  • Interest rate during the holding period
  • Terminal capitalization (cap) rates