In the past couple of columns, we’ve discussed the benefits of investing in raw, predeveloped land and how to determine the true value of a tract of land. Now, let’s look at the impact all of this has on commercial undeveloped land values. Land values are a floating variable within the fixed development equation.
Let me state that again because it is very important: Land values are a floating variable within the fixed development equation.
For example, if a developer wants to earn a 10 percent total return on his investment, he would simply take the projected net operating income, or NOI, from the proposed project and divide it by his desired yield to determine the project’s maximum projected development costs. This process allows us to determine exactly what the land is worth as part of that project.
Let me demonstrate. Assume that the net operating income for a new proposed development is projected at $500,000 when this project is 95 percent occupied. If we divide the $500,000 net operating income by the desired 10 percent return, the developer then determines that he can justify spending up to $5 million building this project. Therefore, he knows his maximum budget for everything must be less than $5 million.
Total development costs for any project can be broken down into three different categories. First, there are the soft costs such as architectural fees, loan brokerage points, building permit fees, interim financing costs, etc.
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Next, there are the hard costs of the development, such as, concrete, steel, lumber, electrical, plumbing, windows, doors, labor, etc. Finally, there is the cost of the land.
Since the hard and soft costs are relatively fixed, based on a competitive market, the variable in this equation becomes what we can justify in paying for the land. In other words, if the hard costs of this project are projected to be $3 million and the soft costs to be $1 million, then the land’s value is the remaining $1 million of the $5 million development costs.
Now let’s see what happens when rental rates dramatically increase in a short period, say from $12 to $18 per square foot for office rent. This type of dramatic increase is what occurs at the beginning of most real-estate booms because during the bust, as things stagnated, rent likewise declined as well.
What’s the direct impact a 50 percent increase in rents will have on land values? Will the value of land rise an equal 50 percent? Let’s use our little formula to see.
If our net operating income in the above illustration was based on rents of $12 per square foot, which then subsequently increased to $18 per square foot (over a two-year period), then the net operating income would grow from $500,000 to $750,000.
Now, if we take the exact same project but use $750,000 as the projected net operating income, let’s see what happens:
The $750,000 NOI is divided by the same 10 percent desired investment yield, which now produces a new total development cost of $7.5 million. In other words, the developer under these new income projections will now see this project as capable of supporting a $7.5 million development price tag. However, since neither the hard nor the soft costs should have escalated very much, the remaining variable in this equation is land value.
So using the same factors as before, we can determine the effect that a 50 percent increase in NOI will have on undeveloped land values. If we take a $7.5 million project and spend $3 million in hard costs and $1 million in soft costs, that means the true value of the land is the remaining $3.5 million. Like I said earlier, land values are a floating variable within the fixed development equation.
The land value in this example, therefore, has increased from $1 million to $3.5 million (a 350 percent increase) due to an increase in NOI of only 50 percent.
Now understanding this concept, let us assume we want to buy a tract of pre-development land as an investment that’s three to five years away from being ready for development. We can then project its future value based on today as explained above and then discount that price backward based on our projected holding time, plus what we would like to earn on our money in this investment. This will establish a purchase price that we can pay, hold the property for the anticipated time and still meet our desired investment yield.
Now, what if you find a tract that meets your goals, but the seller of that tract wants a higher price than you can pay? What if all the comparable recent land sales prices in that area are higher than your established price? What if other speculative investors have already raised the value of all land in this area past your desired comfort level? Then I go back to my philosophy that dirt is basically worthless until it can generate income, and it is safer to pass on this opportunity.
If the development market has determined a maximum purchase price for the land based on the above illustration and I cannot buy a piece of property at the discounted determined price, hold it for the necessary time and still generate my expected return, I’ll pass on this investment opportunity.
Quite often, investors develop a fury of land speculation that heats up land prices well in excess of today’s true value. This is called the greater fool theory: “I am going to pay more than I know it is worth because this market is so hot I can find a bigger fool to sell it to and make a profit.” When this happens, these inflated prices don’t raise the real value of the land. That usually means that sometime in the near future, someone is going to get burned.
This is where the contrarian philosophy will serve you well because it will allow you to enter the market when it is ending a bust and all the other investors are still too scared to participate and then sell into the boom that follows as everyone is trying to get into the game. In later columns, I’ll explain more about how to read cycles so you can do this.