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Investing in “Raw Land” and Adding Value Through Entitlements

Part 4 in a Series: Investment Strategies for a Post-Peak Economy

The least understood real estate asset class is Land.  This blog post will take a deep dive into how real estate developers and home builders value land.  And it will describe the risks and rewards in this very specialized asset class. Land investments are not for the faint of heart!

The Wrong Way to Value Land:

Simply pulling “land comps,” which many inexperienced realtors use when marketing an undeveloped property, is fundamentally flawed.  

Looking at comparables – “comps” – works for two homes that are similar size, in the same neighborhood.  But land has many other variables.

This is because the cost to grade, to bring utilities to the site, for any mitigation needed, and for the level of on-and-off site improvements – these all vary greatly from one development to the next.  One property may need large retaining walls, another may require undergrounding of utility lines.

Not to mention zoning.  A small parcel in an urban area that is zoned for mid-or-high rise construction will have more value than a small parcel zoned for a single home.

So the comps method of valuation typically does not work to value land.  The exception is when two very similar properties, with the same underlying zoning, have recently sold.  

How Home Builders Value Land:

Because of the different characteristics of undeveloped land, home builders value land using a Land Residual financial model.

Early in my career, a mentor described it to me simply:  Land value is based on what income one can derive from the land.  It’s that simple – yet to get that answer can be complex.

For residential land, we work backwards and start with the estimated value of a hypothetical finished home.  “If I built a 3,000 s.f. home on a ¼ acre lot, what would it sell for?” This should be relatively easy to solve, based on the home sale comps in the area.  

  • If a 20-year old neighboring home recently sold for, say $800,000, then I can reasonably expect a new home of similar size will sell for $900,000 or more.  Buyers will pay a premium for a new home. But in my underwriting for a land acquisition, I’ll usually use $800,000 as my finished home value, in order to be conservative and protect against downturns.

The builder then subtracts all of the costs to build that home, and subtracts their financing costs, and their projected profit margin, and the residual of that simple equation is what they can afford to pay for the land:  

  • Finished home value minus all costs to build minus financing costs minus profit = residual land value of an undeveloped lot. 

Turn this equation around in order to look at it from the home builder’s perspective:  

“If I can sell an $800,000 home that I know costs $494,000 to build, finance, and pay all the consultants, and after I pay $50,000 in government fees, my profit will be $96,000 per home – 12%.”

Using this equation and the above assumptions, a fully “entitled” lot is worth $160,000:  

  • $800,000 – $494,000 – $50,000 – $96,000 = $160,000

Adding Value Through Entitlements

Entitlements are loosely defined as the legal right to build on the land.  In California, this is typically a long approval process through the City or County that has jurisdiction of the property.  

When a property is subdivided, meaning one legal parcel is legally divided into five or more parcels, that is referred to a Tract Map (TM).  A TM will come with Conditions of Approval that must be met prior to the owner/developer recording a Final Map. These conditions typically include right-of-way dedications, street improvements like stop lights and street widening, sidewalks, and landscaping.

The tentative map is a legally binding document and allows the builder to move forward towards final engineering and pulling building permits to start construction.  Therefore, an approved Tentative Map is typically what is referred to as an entitled property.

For smaller projects, where the builder’s proposal meets all the zoning guidelines, an “entitlement” can even be as simple as administrative approval of the conceptual design, needing only City or County staff approval, and avoiding the longer process of Planning Commission or City Council approval.

For Land Developers, we aim to add significant value to a property by going through this process.

Going back to the example above, if a home builder were to pay $160,000 for an unentitled lot, they would lose money in building the home.  That is because they did not adequately factor in the cost, time, and risk of getting through a local City’s approval process.

For a typical residential subdivision, the land developer will need to hire the following consultants:  civil engineer, multiple environmental consultants, utility consultants, historical consultants, cultural resource consultants, plus traffic, fire, and many others.  And, the jurisdiction that grants a Tract Map approval will have their own application and processing fees.

Add these up, and the typical subdivision approval costs a multiple of six figures in California.  And that’s if things go relatively smoothly, and the land developer is following the existing zoning.

When one proposes a zone change, or a development near the coast, or anything with sensitive habitat or environmental concerns, then hold on to your hat.  The cost can then climb into the seven figures, and take many, many years.

The risk side also needs to be considered:  if the land developer’s proposed use is not approved, but he/she paid top dollar assuming the entitlements would be quick and easy, they will quickly be underwater.

Often home builders avoid the entitlement process, because it’s not what they do best.  It’s highly specialized, takes a lot of time, and involves a lot of risk. Homebuilding is risky, too, of course.  But that is their specialty and they will typically look to acquire land after the legal entitlements are approved.

Paper Lots to Blue Top Lots to Finished Lots

After land entitlements are approved, the land developer then has options:  build the proposed project themselves, sell the land and all the legal entitlements to a home builder, or enter into a joint venture with a builder.

When selling the land outright, it is typical for smaller land developers to sell “as-is” and not put any improvements into the land.  

In large master-planned communities, however, the land developer will often grade the lots, to what is referred to a “blue top” condition.  A home builder may buy based on that level of finish, or if the master developer puts in the roads, curbs, and gutters, and stubs utilities to each fully graded site, then that is a “finished lot.”

This is important, because the “finished lot” is a crucial value in negotiations for the land developer to sell to the home builder.

The reason for this, is that once a lot is “finished,” the builder can quickly determine the costs to pour the foundation and build the home.  Builders typically repeat floor plans and have strong data from their previous subdivisions. Vertical construction is much more standardized, whereas the costs to get to a finished lot will vary greatly from subdivision to subdivision. 

Completing the Land Residual Model

A good rule of thumb is that a “finished lot” is typically worth 35% – 45% of the anticipated finished value of the completed home.  

So from this “finished lot basis,” the cost of all grading and site work, and government fees, are subtracted, to calculate a “paper lot value.”

This is what the Land Developer will often sell – paper lots.  

Example of a Land Residual Value

Based on the methodology above, and the assumptions below, a land developer will anticipate selling “paper lots” for approx. $160,000 per lot.

LandResidualModelChart.png

Note that every dollar difference in the Lot Finishing Cost is a 1-to-1 difference in the paper lot value.  So if the cost is actually $100,000 per lot instead of $110,000 per lot, then the paper lot value will go up from $160,000 to $170,000.  The inverse is also true.

Should Real Estate Investors Invest in Land Development?

As noted at the beginning of the article, land development is a highly specialized asset class within real estate investing.  I do not recommend investing in this asset class unless: 1) the Developer with whom you are investing has many years’ experience processing tract maps and going through the entitlement process, , and 3) the Investor is very comfortable taking a passive position in an illiquid asset.

Other reasons to not invest in land:

  • Typically, the land generates zero cash flow.  So during the entitlement phase, there is no income to pay consultants, property taxes, or loan payments if the owner uses leverage.  All the cash needed will come from equity investment, not the property, unlike say, an apartment.
  • During recessions, if builders stop building new homes, there may not be a buyer for the land after the entitlements are approved.  This could mean sitting on the land for much longer than originally anticipated, and must be factored into the business plan. Or if the owner needs to sell, they risk selling at a deep discount, in a distressed sale scenario

Scenarios where land investment is appropriate:

  • The investor is partnering with an experienced land developer
  • The land basis – the price they pay for the dirt – is low enough to absorb economic downturns
  • The investor is highly liquid and/or invested in other asset classes that generate cash flow.  If they may need the money in less than a few years’ time, the investor should stay away
  • From an asset allocation standpoint, land should be in the “speculative/risky” bucket.  A successful project may double the investor’s money. But when these types of investments go wrong, they can have the opposite outcome

Conclusions:

The land entitlement process in California is highly regulated, time consuming, and expensive.  

The value of land is determined by the income that the owner or developer can derive from it, typically calculated through a land residual model.  Comps work very poorly in valuing land.

Investors should be very cautious when investing in this asset class.

McNamara Ventures is currently managing two residential subdivision investments in San Diego County.

Our partnership includes Oscar Uranga, a land entitlement guru with IMG Construction Management, and a sophisticated group of investors.

We are being highly selective in future land investments.

About McNamara Ventures, MV Properties, and Keegan McNamara:

McNamara Ventures and MV Properties exist to serve our clients in building their wealth through real estate investments. Services include: investment offerings, property management, and boutique brokerage.

We guide our clients through creating customized real estate investment strategies.

We analyze our clients’ portfolios, looking at return on equity, debt strategies, and tax efficient planning, and develop a plan specific to each clients’ needs. 

We let the numbers tell us the strategy, as each situation is different.


Keegan McNamara is a real estate investor, developer, and broker. He owns McNamara Ventures, a development and investment company, and MV Properties, a residential brokerage and property management firm. Keegan can be reached atkeegan@mcnamaraventures.com.

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