If you are considering a land investment, be sure to analyze the documents and look for other problems, such as the use of the land and the land valuation differences for residential and commercial residual analyses.
The first issue is the land title. The land title shows the new buyer the following:
- Prior ownership
- Outstanding debt (i.e., recorded trust deeds, mechanics liens, and other liens)
- Easements and covenants (i.e., agreements with others to use the land or that impose restrictions on land use.
- Ground leases, occupied improvements, or other evidence of parties who claim an interest in the land
It is vital that the investors understand the title to know what they are buying.
- 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:
The second issue is title insurance. Title insurance provides the investor with assurance that the title shows the truth. This insurance protects the buyer from the others who might later make claims of ownership, debt, easements, or other competing rights to land use. The third issue is easements. Easements are agreements with other parties (e.g., power companies) to use the land (e.g., to put cable in the ground). A landowner may also grant access easements, which allow people to use the land for transportation (e.g., easements that allow horse owners access riding pathways on another’s land). Some easements burden your land for the benefit of others; other easements burden someone else’s land for your benefit.
The fourth issue is dirt. Dirt has a quality, just like everything else. Not all direct is the same. High-quality dirt is easily compactable and stays in place, supporting the building. Dirt problems can include non-compatible fill and expandable soil. For non-compatible fill, if a site was excavated and not refilled properly, the site might be unable to hold a foundation. The quality of the fill and its compatibility are important to the developer. Expandable soils are found in parts of the western U.S. This soil expands and contracts with moisture. Expandable soil cannot be built on, as the foundation of any building will be subject to shifting. Expandable soils must be mitigated by extracting the soil and refilling the site or by drilling pylons into the bedrock or more stable strata below-grade to support the structure.
The fifth issue is earthquakes. Land is measured by seismograph for the probability of earthquakes. If land is in an earthquake zone, the investor will be required to purchase earthquake insurance for any improvements that are constructed on the land and will need to add stability to the improvement design. The sixth issue is rock. Some soils have large rock deposits. Large rocks must be removed, as they are not considered to be compatible fill. If the rocks are too large to be removed by the machine, they can be blasted into smaller pieces by using dynamite, and then removed. This task dramatically increases the cost of development.
The seventh issue is environmental issues. Soils can be contaminated by oil, dry-cleaning fluid, or other pollutants. All land, prior to acquisition, should have a Phase I environmental study (which consists of interviews with owner, review of records, and a site inspection) to determine if the land has been contaminated. If a Phase I study finds a potential contamination, the land needs to be analyzed using a Phase II study, which consists of actually testing the soils and water samples for proof of identified potential contamination.
The eight issue is endangered species. If the land is a habitat to an animal or plant species that is on the threatened or endangered species list, the investor might be unable to develop the property or might be required to move the endangered species to a new habitat. The ninth issue is wetlands. Some land serves as marshland for nearby waterways. The U.S. Government is charged with protecting wetlands, which cannot be developed. The investor will either need to develop around or mitigate any wetlands on the property. A growing business known as wetland banks might offer mitigation opportunities.
The tenth issue is the flood plain. The U.S. Government has identified all land in area susceptible to flooding as a flood zone. This land generally cannot be developed, except for open-space amenities, such as parks and golf courses. Land in a moderate flood area requires flood insurance for improvements after development.
The eleventh issue is a complicated one and that is water. The first concern is access to water. All developments need water. Water comes from one of the following: public or private water utilities or well/ground water. In some areas, water is owned personally and corporately, like cattle. The flow of water in a stream is owned by people up and down the stream. An investor whose land is in one of these areas must understand the water rights. Another concern is water taps. Taps provide access to water utilities. If treated-water capacity is not readily available, water taps might be unavailable to the developer, or the taps (or hookups) might be very expensive. The final issue is well water. In some areas, water is accessed by drilling a well. The cost and success will be determined by the amount and quality of water in the aquifers around the property. Governmental permits might be required.
The twelfth concern is sewer access. There are two options: access to a public sewer and septic systems. One of these must be available to the property. The thirteenth issue is road access. Road access is a vital factor for all developed land. Parcels without access to public roads are known as land-locked parcels. Investors must make sure that they have access to public roads for ingress and egress. The fourteenth issue is topography. Topography is the grading and filling of the land and affects the development costs. Below are some facts:
- Flat land is the easiest and cheapest land to develop.
- The extent to which land must be moved (a process known as cut and fill) increases the cost of development. The investor must be cognizant of the topography of the land and what the costs will be to develop the land into a usable, finished product for the desired improvements.
- Investors can have a topographical survey conducted to help identify the necessary changes they need to make.
The fifteenth issue are spike strips. These are small pieces of land that are within the investor parcel, but that are owned by another person or entity. Spike-strip owners often try to leverage their position to force the primary owner to pay them more money to go away. The final concern is conditions to approval. These are required in some jurisdictions, when the local authorities want to track approval rights for things that the city needs:
- New public road right-of-way funding
- Park land
- New school funding
- Historic structure preservation
- Police, fire, and rescue funding
- Subsidized housing
Sometimes, an investor wants to purchase land that is not fully ready for development. The investor might believe that the property and surrounding area has growth potential and needs to be held until full value is achieved through a proposed development. In such cases, the investor can seek interim land uses to defray the costs of holding the land:
- Golf-course driving range: Low cost to build and maintain; provides cash flow.
- Batting cages: Another low-cost interim use; provides cash flow
- Outdoor storage: Good use and in demand by industrial companies, if zoning allows
- Farming: Growing crops or livestock on the land if soil and other conditions permit; also reduces taxes.
- Parking: A paid parking facility for commuters, are employees, or area residents.
- Seasonal uses: Christmas tree sales, Independence Day fireworks, mobile windshield repair, etc.
Remember, there is little to no cash flow in holding land. However, there are significant expenses, such as taxes, insurance, and maintenance. The taxes are determined by the zoning. Agricultural land pays the least amount of taxes. Insurance is determined by the interim use. Agricultural land has the least risk. Maintenance costs are simply the result of the need to keep the land in good condition (e.g., with cut grass). Finally, storm water drainage compliance is necessary.
Our final section in this course will focus on land valuation. Residual analysis is one of the best approaches for raw-land valuation. Residual analysis is a reverse engineering of the property, carried out by deducting all costs from the sales price to derive land value. The residual-analysis approach is different for commercial and residential properties.
Let’s take a close look at the residential residual analysis. The following data points are needed for residential residual analysis:
- Current home sales price: What are the real or current home prices in the market?
- Selling cost: Selling costs are typically 6 percent, but could be more with incentives.
- Hard construction cost (sticks and bricks): Tract homes are $80 to $85 per square foot. Custom homes are $125 to $150 per square foot.
- Soft construction: Soft construction costs are typically 10 to 15 percent of the hard costs.
- Financing costs: Financing costs are an estimate of interest costs over the holing period.
- Builder profit: Builder profit is 15 to 25 percent of house costs for custom homes, and 7 to 9 percent of house costs for tract homes.
- Lot-development costs: Home lots typically cost $20,000 to $30,000 per lot to develop.
- Lot-development profit: This profit is based on selling finished lots only; 15 to 20 percent is typical.
The figure below shows an example of residential residual analysis and assumes that the end product is a 3,000 square foot home that sells for $600,000.
As a rule, finished lot values are typically 25 percent to 35 percent of the home sales price.
Now, let’s turn our focus to the commercial residual analysis. Commercial residual analysis is based on the same theory as residential residual analysis, but the value of the completed lease-up building (which is analogous to home value) must first be calculated. To solve for the completed building value, the following data points are needed:
- Buildable square feet: How big will the building be?
- Lease rate: What gross lease rate can be achieved?
- Occupancy rate: What is the projected occupancy?
- Expense ratio: What is the proposed expense ratio? Typically, it is about 35 to 40 percent of revenues.
- Pro forma NOI: Solve for the pro forma NOI.
- Exit cap rate: Estimate the exit cap rate
- Result: Estimate the future value of the improvements on the subject commercial land parcel
The figure below shows an example of commercial residual analysis.
Land valuation is an important part of the investment process. In this assignment, explain how land is valued and the process that you would undertake to determine the value of the land.
For this assignment, please list the six capital structure products and provide your own definition of the product and an example of who would offer the product.
Are you ready?
Congratulations, you have now finished the final lesson of this course. Now we recommend you review your assignments and notes before you take the exam. If you are ready, then click the button below and begin your final exam.