As the economy slowly staggers toward recovery, the market will pick up. Deals will began to occur. Existing inventories will be reduced and acquisition for new construction will become viable. When that happens, it is sure to be accompanied by one of the oldest and deadliest mistakes in the real estate development business: overpaying for the land.
This is a mistake that is made by newcomers as well as veterans of the industry with many years and numerous projects under their belts. The only thing that can rescue a deal when the land was overpriced is a bubble in the market. BUT, as we saw with the recent real estate bubble, when it bursts, you are stuck with land on the books that is 50%, 25%, 10% of the purchase price paid for it. Sometimes it actually has a negative value in the sense that the land would have to be given away in order for a project developed on it to make sense financially.
This is why it is critically important for the developer to understand and accurately calculate the residual value of the land. It is simply the maximum amount the developer can pay for the land and still achieve the expected return on the invested capital. In essence, it’s what’s left over after all of the expenses of development and the profit margin have been accounted for. Simply put, it’s a way of backing into the purchase price of the land.
There are a number of formulas designed to determine the residual value of land. Some are relatively simple, some aren’t. One I like utilizes discounted cash flow analysis. This makes sense because real estate developments are long-term.
You start by calculating the total costs of development, which may include any or all of the following:
· Market research fees
· Marketing and advertising costs
· Expenses for demolition, environmental mitigation, and hazardous waste remediation, if necessary
· Entitlement, platting, and permitting expenses
· Engineering and legal fees
· Planning and design expenses
· Infrastructure costs
· Construction costs
· Management fees
· Costs of financing involved in the project
· Sales or leasing commissions
For example, assume you’ve identified a parcel of property on which you want to develop a 30,000 square foot suburban office building that will rent for $25 per square foot with an 8% vacancy factor and OPEX at 35%. The cap rate at sale at the end of the fifth year of operations is estimated to be 7%. There will be a one year build and stabilize period followed by five years of operations. Without rent increases, this scenario produces a present value (PV) of $6,407,153.
Assume also that the permanent loan will be interest only at 70% of PV with developer equity of 30%. The costs of sale will be 3%. The developer’s hurdle rate (desired rate of return) is 10%. For simplicity’s sake, assume the all-in costs of development to be $175 per square foot.
Under this scenario, the net present value of the project is $2,522,107. Minus the developer’s equity, the residual land value is $947,107. If the building will be three stories of 10,000 square feet each and the floor area ratio (FAR) is .25 – meaning the building can cover no more than 25% of the site, the site would have to consist of a minimum of 40,000 square feet. This works out to $23.68 per square foot. If the seller insists that the price is solid at $40 per square foot, pass on this one.
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