In my last column, we started a discussion about investing in real estate and how raw pre-development land was in my opinion the best option. I also promised that in this column we would discuss how to understand the true value of land.
One prime method the majority of land investors use to establish the value of a tract of land (or any real estate for that matter) is by comparing other comparable sales. I personally have found this method an easy trap in which to get snared when used as the exclusive method of valuation.
Granted, I do look at other comparable land transactions in making my analysis, but it is not my principal tool. If you are going to use comparable sales, allow me to share a few observations. First, do not compare asking prices of other tracts around you. They are usually inflated because of the pride of ownership. What everyone is asking is not near as important as what has sold and to whom.
Sales of comparables can be useful in negotiations if you fully research your comparable: who was the buyer; what were the terms; and what is the zoning for the tract. If the buyer is McDonalds, Home Depot, or Ross Perot, its sale is probably a good indication of true market value. Such buyers do extensive research prior to making an acquisition. On the other hand, if the buyer is Joe Blow syndications and his merry group of investors, take it with a grain of salt. Many investor groups buy stories, concepts and pretty illustrations that sometimes have nothing to do with real future value.
The best method I have found to determine value is to determine the future best use of the land. You can best determine the future ultimate value of land once you first understand that land is worthless until you can put something on it that generates an income stream. The capitalization of that income stream denotes its ultimate true value.
If a tract is farmland and will not have usable utilities for at least 20 more years according to the nearest city’s plan, I do not care how many speculators like its location or freeway frontage, or whatever – to me this land is farmland for a long time to come. Since time is a very important part of the investment-return equation, you have to factor into this process how long it will be before a tract of land can produce revenue.
In the above example, farmland’s value can be determined by its potential productivity. If it can generate $200 an acre, if you want a 10 percent return, then its worth is $2,000 an acre.
If, however, the farmland becomes surrounded by development, utilities arrive and you can divide that acre into 4 lots and sell them for $50,000 each, then you can calculate your development costs and build in your profits to determine the land’s true future value.
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Once land becomes scarcer and the population density increases around it to the point it can be zoned and justifies multi-family development, then the value for the same acre of dirt magnifies again. This is because you can now rent that foot of ground monthly and create a continuous stream of income. That income stream when capitalized at the desired rate of return determines its value.
If the acre happens to later end up as a corner intersection with a high traffic count and the acre can be zoned retail, its value changes once again. The reason is because now instead of a one-time rent per month like apartments, you can sell products from that same square foot of land, over and over again several times each day, generating higher profits.
Finally, once you have land in an area that is so densely populated, you can justify building on the same square foot into the air over and over again, you have reached land’s ultimate value: a high rise development. Its value again will be determined on the amount of net revenue that can be generated from rents, so that will be greatly determined by how many stories high can be successfully developed.
Let us go back to our original premise that dirt is worthless. If a piece of land is ultimately going to be developed as a shopping center, then you can gauge its ultimate value by determining what major developers have just paid for shopping center land they are currently developing. Once you determine this, you can work backwards to determine a fair value today. Simply anticipate the projected period for this tract to fully mature to prime development status, and then calculate your desired return. Using this approach, you can arrive at what you are willing to pay today.
In my next column we will look at the impact that all of this has on commercial undeveloped land values.