INVESTMENT ANALYSIS
By Michael J . Rohm , CCIM , MAI
UNDERSTANDING LAND VALUE
Residual land analysis is an ideal way to calculate land value based on building area , cost estimates , and development risk .
Residual land analysis is a method for determining the value of development land and is calculated by subtracting all costs associated with development from the total value of a hypothetically complete development , including profit but excluding the cost of the land . The amount left over is the residual land value — or the amount the developer can pay for the land given the assumed value of the “ as complete ” development , the assumed project costs , and the developer ’ s desired profit .
In its simplest form , residual land valuation follows this formula :
“ As Complete ” Value – Cost of Development
Land Value
In other words , the land residual analysis answers the question : “ What can I pay for land in order to maintain project feasibility ?”
Although our attention is primarily on commercial real estate , the most understandable application of the land residual formula is with residential lots in a tract subdivision , because of the relatively small variations in the completed home values . This consistency translates into more credible “ as complete ” value estimates . The residual land valuation will always begin with the “ as complete ” value of a proposed development alternative . For instance , in the case of a tract development , a custom homebuilder will offer a buyer seemingly endless upgrades . Not all upgrades will be financially feasible . Some will be , but most will not , as the upgrades — and more importantly the combination of the upgrades — will not perfectly reflect typical market desires . These upgrades often reflect personal tastes and wants , which are rarely consistent with the typical market participant and may not always optimize the property ’ s resale value .
Upgrades and alternatives for custom homes are not always limited to interior modifications ; they can include differences in size and exterior building materials . For our discussion , we will focus on interior alternatives to show the concept of a residual land analysis . The table ( on pg . 15 ) shows a land residual analysis based on three development alternatives .
Alternative 1 : This option is a 2,500- sf single-family home with four bedrooms and three bathrooms with carpet throughout ( with the exception of the kitchen and bathrooms ). This home costs $ 550,275 to develop and will be worth $ 600,000 when complete . The analysis translates into a residual land value of $ 49,725 ($ 600,000 - $ 550,275 ) for an approvable raw lot .
Alternative 2 : This option is the same as Alternative 1 , only with hardwood floors throughout ( except for the kitchen and bathrooms ). This home costs $ 569,250 to develop and will be worth $ 625,000 when complete . The analysis translates into a residual land value of $ 55,750 ($ 625,000 - $ 569,250 ) for an approvable raw lot .
Alternative 3 : This option is a 2,500-sf single-family home with four bedrooms and 2.5 bathrooms with hardwood floors throughout ( except for the kitchen and bathrooms ). This home costs $ 531,300 to develop and will be worth $ 575,000 when complete . The analysis translates into a residual land value of $ 43,700 ($ 575,000 - $ 531,300 ) for an approvable raw lot .
As is inferred via the analysis , hardwood floors cost more than carpet and bathrooms cost more than common areas . Bathrooms and hardwood floors also contribute more value to the property , all else being equal .
Based on the residual land analysis , a four-bedroom , three-bathroom home with hardwood floors throughout ( Alternative 2 ) is the highest and best use for the vacant site because it produces the highest residual land value . Put another way , this is the development alternative that returns the most value to the land .
One weakness in the land residual approach is the sensitivity of the analysis . This approach is limited as the value and costs are dynamic , which will be reflected over the course of the development rather than at a single point . For example , rising labor and material costs along with unforeseen expenses associated with site infrastructure could increase the final development costs , which in turn negatively impact the residual land value . This approach to analysis also does not explicitly consider holding costs and time value of money , so it is important to consider recent land sales to support the conclusion .
The weakness in relying exclusively on comparable land sales is that buyers do not always make land purchase decisions based on the real estate-related financial feasibility of proposed improvements — especially proposed build-to-suit improvements for owner-occupants or partial owner-occupants . From a commercial development perspective , owner-user
14
COMMERCIAL INVESTMENT REAL ESTATE MAGAZINE SUMMER 2022