Development Residual: A Test of Land Pricing

By
Real Estate Agent with Kiemle & Hagood
http://actvra.in/pLG

Land Residual Analysis: What is it and why it's important?

I've been employing various versions of a land residual or development residual analysis as a check on land prices for the past 15+ years as a test of highest and best use and the indicated land value from the sales comparison approach. However, when applying the residual analysis here in North Idaho, there is reason for concern.

What is the residual analysis? The residual analysis is basically the calculation of what a developer or owner occupant can afford to pay for the underlying dirt, considering the value of the completed project as proposed. Performing the analysis can be complicated and involve a variety of cash flow models that take into account profit, holding costs, absorption periods, cost trending, etc., but for our purpose let's use a very simple static model.

Prospective Project Value at Completion
Less: Construction Hard Costs
Less: Development Soft Costs
Less: Entrepreneurial/Developer Profit

Land Residual

Let's use a simple example of a suburban, low rise office building*:

Project Value at Completion and Stabilization

$1,600,000
= 10,000 SqFt, $22/SqFt FSG, 10% vacancy, 35% expenses, 8% cap rate

Less: Construction Costs

($1,100,000)
= 10,000 SqFt, $110/SqFt

Less: Soft Costs

($265,000)
= $55,000 leasing commissions, $110,000 absorption, $100,000 permits, fees, etc.

Less: Profit Margin

($137,000)

= 10% of hard cost and soft cost

Land Residual

$98,000

The typical land to building ratio for garden style, suburban office space, is 4:1 or even 5:1, which for our example would equate to at least 40,000 SqFt. With a residual at $98,000, this equates to $2.45/SqFt on the land area.

So what does it say for markets, like ours, where well located, ready to develop commercial land simply can't be found under $10/SqFt in some areas or $20/SqFt in places like Sandpoint? We've seen development on land sold valued as high as $35/SqFt. At those prices not only is there no profit but there is significant external obsolescence (costs significantly outweigh value) even prior to construction, meaning development is simply not feasible.

This form of analysis is absolutely key when pricing land for sale, considering new development and when assessing the relative strength or weakness of a particular market or a particular site. Some simple conclusions that come from this analysis:

Residual > Land Prices = Expect to see significant market activity.

Residual < Land Prices = Expect to see extremely limited, new speculative development.

Residual = Land Prices = Market is balanced.

When you do witness new development in markets with elevated land prices, you are almost sure to find that the developer has owned the land for a considerable time and their basis is not today's asking prices but pricing from 5, 10 or more years ago.

So why do land sales occur when prices are elevated? In some instances, speculation is occurring where a buyer is expecting the top line on the residual analysis to soar. Such was the case in Sandpoint, where many investors felt rental rates would soar thus driving the value of new projects up substantially. In other instances, adequate attention is not paid to the residual analysis. Buyers are not properly informed of true market value (like assuming 10% growth in rents annually and a 5% cap rate on resale), they do not understand what construction really costs (they may only account for hard costs and not consider soft costs), or there are other outside motivating factors that drive the purchase.

As I mentioned, this is overly simplified but it's a simple quick, reality check. To truly analyze the development potential of a property, requires significant time and expertise. This is where a team of experienced professionals including a commercial broker, appraiser, banker, and contractor can bring a lot of value.

* These figures are for example only, based on averages from national cost publications, and should not be universally applied.

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Rainmaker
255,968
Tim Bradley
Contour Investment Properties - Jackson Hole, WY
Commercial Real Estate Expert in Jackson Hole, WY

Nicely put, Chris. Land prices in my market have outstripped the value indicated by a land residual model for years, but have come crashing down in the past few months. As a commercial appraiser and a broker (and fellow CCIM), I've used the land residual model many times, only to watch buyers and sellers conduct transactions on the expectation of prices continuing to go up, simply because "they only go up here".

Apr 14, 2009 11:31 AM #1
Anonymous
Anonymous
Eddie Prosser, TheLandMatch.com & Trinity Capital Advisors, LLC

Yes.  Good simple explanation.  Only if more people would have conducted thoughtful analysis and understood market trends, then maybe there wouldn't be so many developers stuck with personal guarantees for development and construction loans.  Also, I am working on an automated land residual model, which I am hoping to have working by the end of the year.  www.thelandmatch.com

Sep 01, 2009 05:43 PM #2
Rainer
11,887
Chris Schreiber
Kiemle & Hagood - Sandpoint, ID
CCIM

Thanks for the feedback.  This article, expanded upon, is scheduled to be published in this month's Idaho Business Review!

 

 

Sep 04, 2009 11:44 AM #3
Rainmaker
230,431
Anne Lok
Homelife Realty One Ltd. Brokerage - Toronto, ON
Homes for Modern City Dwellers

Chris- this is very useful information as the starting point for my research on the fundamentals on land pricing.

Nov 15, 2013 09:40 AM #4
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Rainer
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Chris Schreiber

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