How to calculate land value in 8 easy steps?

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How to calculate land value?

When you are looking to invest in raw land, one of the most important things you need to figure out is what the property is worth. Determining the vacant land value can be tricky- there are a number of ways to do it, and not all of them will give you an accurate estimate. Here are 8 steps for estimating the value of vacant land. Read on and get the best valuation for your land.

How to calculate land value in 8 easy steps

Steps to calculate land values

Steps to calculate land values

1. Determine feasible alternative uses of land

The majority of collected residential properties and commercial properties have potential other financially viable uses. Future preservation will be influenced by identifying practical alternative applications because the value of development rights determines the donor's eligibility for tax credits.

Collectible lands can generate money from mining, oil and gas, wood, and other natural resources, even for the more mainstream investor. Lands may be leased for various uses, temporarily or permanently. 

You can achieve an outstanding value split by holding a remaining stake in the land while leasing it to a commercial user. The commercial user enjoys the current practicable usage and pays rent by it, while the landowner keeps the capital gains.

Conceptually, the discounted present value of expected income and the DCF of anticipated capital gains determine an asset's worth:

Value

Value

Of course, things become interesting because the present "revenue" can come from either rents or investments. Practically speaking, the value of any income-producing asset depends on its potential annual income and any potential capital gains upon selling. 

Take a look at the direct capitalisation land valuation formula:

Direct capitalisation land valuation process

Direct capitalisation land valuation process

The capitalisation of current income (NOI) is accounted for in this formula, but the capitalisation of the eventual resale is not. 

The NOI capitalisation itself buried the eventual selling. The capitalisation of future cash flows at the moment of sale would be the only factor in determining value.

If we don't count things like selling costs, paying off loans, etc., we could say that the value of a project with constant NOI and an expected sale in a year is:

Value with constant NOI

Value with constant NOI

Even though it may all seem blatantly obvious, it highlights a crucial fact regarding pricing in general and the valuation of land holdings in particular.

The valuation technique is immaterial, assuming a constant cap rate, R0, and the same discount factor for current income and future gains.

For one, the cap rate is merely a comparison between the predicted, steady NOI and the price existing real estate investors are willing to pay for that unending supply of NOI. As real estate performance impacts and modifies investor expectations, expected NOI and R0 fluctuate frequently and quickly. 

Second, even in a dream world where NOI and property investor expectations don't change, the cap rate for highly speculative future gains will differ from the cap rate for much less speculative current income.

Therefore, the investor's future plans for the property type may have a significant impact on the projected present value. Consider two instances where you have a net ground lease on a piece of property. 

According to the first scenario, the land will be rented out indefinitely at a $140,000 annual NOI to the investor. Given that investors in the current market anticipate a 7% cap rate on such perpetuities, the investment is worth:

Value = 140,000/.07 = $2 million 

Assume for a moment that the lease will expire in five years. The landlord/investor plans to sell at that point for the current capitalized value. The NOI and cap rates are taken as constants for simplicity's sake. 

The discount rate on current income is also 7%, but it is 9% for future capital gains that are relatively risky. The valuation equation now resembles this:

DCF 7% (140000) + DCF 9% (140000/.07) = $1,873,890

As a result, the projected value today is significantly impacted by turning otherwise anticipated annual rents—a somewhat less speculative cash flow—into a more speculative capital gain at year 5.

Naturally, this does not account for any tax consequences in year 5 or for the value of being able to reinvest in other endeavours. Some investors use "buy and hold" tactics, while others make money when a value is added and there are capital gains.

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2. Make the highest and best use of vacant land

For a developed site, we consider the highest and best use (HBU) as if it were vacant, accounting for the expense of tearing down any existing improvements and getting the property ready for reuse. 

The HBU needs a reverse determination—what is the value as if developed—for a land that is already vacant. Any ethically correct, physically practical, and economically viable usage could qualify as HBU. 

An existing developed site frequently has a bias in favor of continuing to use "as is." The HBU is a blank canvas with only a range of possible applications as restrictions while the site is unoccupied.

Consider a location with commercial zoning that could be transformed into one of the following four structures: offices, apartments, standalone restaurants, or light retail. The table below reflects raw land development.

Alternative HBU Calculations

Alternative HBU Calculations

It's interesting to note that the project's overall worth is not more than the value assigned to the location. Building an office complex will cost $10,100,000 to develop but will only generate a profit of $1,100,000. 

In contrast, building light retail will cost less to complete but will provide an enormous profit of $1,600,000. Therefore, in this case, HBU calls for light retail growth.

Mixed-use land developments are becoming more and more prevalent today. For starters, zoning and land use regulations may stipulate that mixed-use be permitted in densely populated urban areas. 

On the other hand, mixed-use can increase rents and create synergies between different land uses, even in suburban or less densely populated areas. The HBU for a vacant site may therefore involve optimising several applications rather than being a straightforward solution. 

Usually, this is a two-step procedure. The most significant amount of space the market will accept will be considered first, typically in terms of square footage. Additionally, we will consider the smallest square footage that can be built and maintained. 

Building a complex with 50 or even 100 apartments might be possible. However, running a 10-unit apartment complex could not be profitable or marketable to investors.

Second, think about the expenses and earnings per square foot. Standard features, such as green space, meeting spaces, community use spaces, or other recreational spaces that may be required by ordinance or enhance the overall site's marketability, will also need to be considered. 

3. Find land size by comparing various elements

How do we calculate the size of the vacant land? Acreage? Based on square footage? Or something altogether different?

First, it is essential to be aware of surplus and excess land.

Any area of the property not currently required to support the existing improvement and does not have a separate highest and best use is considered surplus land. Surplus land may have no intrinsic worth.

A factory might need a 10-acre site to construct the building, supply parking for employees, and construct ramps for vehicles and exterior fixtures. The additional 2 acres offer little value if the location is 12 acres. Because there are two additional acres, no buyer of this factory will pay more.

Surplus and excess land

Surplus and Excess Land

On the other hand, surplus land could have a unique highest and best use and value. 

Use the same scenario, but suppose the site is 22 acres instead of 12. The additional 10 acres have contributed value because they might be individually sold off as a location for a different factory of a comparable type.

Consider a plot of land in a typical, unexceptional, mainstream neighborhood. The lots in the development were initially meant to be roughly the same size and sell for roughly the same price or something similar. 

Creating cookie-cutter lots will typically be defeated by considerations like topography, street design, preservation of trees and other vegetation, local land use regulations, and the desire to create an attractive neighborhood. Some lots will indeed end up being significantly more prominent than others. 

Some lots may be much larger and more private, particularly at the ends of cul-de-sacs. The average lot in a relatively affluent suburban neighborhood may be 8,000 square feet in gross area, but a few may be closer to 10,000 or even 12,000 feet.

In the report's assumptions and limiting circumstances, appraisers admit that they lack surveying expertise and often rely on land measurements from surveys or publicly available data. 

As a result, the degree of precision and the units of measurement directly relate to the calibre of the underlying data sources. If the survey or tax assessment map showed square footage, the appraisal report also shows square footage. 

The fact that some surveys and public publications will give land dimensions but not size complicates the situation. There are legal justifications for this in a few jurisdictions. It is up to the appraisers to do their math for land valuation. 

Although various convenient and affordable computerized measuring equipment is available, the measurements' accuracy varies greatly. Some reports imply an accuracy that is just illogical. 

When a tract is listed as having 42.837 acres in an appraisal, it means that the exact size, down to the thousandth of an acre, is known. The size of a powder room is around 44 square feet or one-thousandth of an acre. This degree of precision begs belief.

The topography should be taken into account while determining property size. A 10-acre site perched on a mountainside is less valuable than a site of the same size that is mostly level. 

The gently rolling terrain is suitable for residential subdivision building sites, whereas commercial property locations require a bat, with a slight slope for drainage. You should also consider questions about the shape, road frontage, and visibility. 

The size of the site only communicates part of the story. To effectively analyze the worth and evaluate the value determination, the size must be considered in addition to other physical characteristics. 

To ascertain whether the value estimations are accurate and sufficient and whether the development or rental value is sustainable, readers of appraisal reports must carefully examine the quality and sufficiency of the site description.

4. Conduct feasibility test

If the potential earnings from an investment property can cover a reasonable rate of return on its entire cost (including indirect expenditures), that is, if the expected value upon completion is equal to or greater than the estimated cost, then the property is economically feasible.

Economic feasibility is established for any other non-real estate investment if the venture turns a profit. The weighted average cost of capital (WACC), which incorporates a return on equity investment, is one implicit cost for a project. 

The "fair return" is typically broken out as a separate line item in real estate analysis. This is due to the possibility that various alternative site uses may have various needed rates of return. 

Always combine sensitivity analysis with the feasibility analysis for every specific planned site use. To figure out different valuations, key variables should be changed for various possible outcomes. 

To make an accurate Monte Carlo simulation, you can give these possible outcomes probabilities. Lenders are looking for these kinds of simulations more and more, and they often call them "stress tests."

Several essential parts of a feasibility analysis need to be looked at carefully. These things are:

  • Do some market research. 
  • Find the best combination of tenants or the best set of uses for a mixed-use proposal.
  • Determine assumptions in detail.
  • Find the acceptable range of those assumptions. 
  • Ensure simplicity. 
  • Separate the variables under the investor's control from those that are not.

An excellent feasibility study will rank the options for the investor and calculate the value differential between the best option and the other options. 

The investor has a tool that may be used and reviewed during the project management phase if the feasibility study outlines the impact of control factors separately from external variables. These should be included in an appraisal, but they lack depth and complexity too frequently.

Know your number with instant access to the Property Development Feasibility Suite.

5. Net ground leases

A net ground lease enables a renter to develop a plot for a time. The improvements and the land revert to the landlord after the lease is over, subject to any option or renewal conditions. 

Taxes, insurance, and maintenance fees are the tenant's responsibility for the lease term, while the landlord will likely maintain general liability insurance and incur monitoring, legal, and accounting costs

Most leases have terms of 20 years or longer, while net ground leases with terms of less than 10 years are uncommon. Major chain store tenants often have ground leases.

In contrast to standard triple net leases, net ground leases place no responsibility for the building on the landlord. Traditional triple net leases involve the tenant leasing the land and the improvements, with the landlord typically constructing the building themselves. 

The renter is often in charge of maintenance, which may be specified in the lease. In a net ground lease, the tenant constructs the building (sometimes with landlord approval) and is in charge of all costs throughout the lease term.

There are typically two types of ground leases: subordinated and unsubordinated. To allow the tenant to finance the development, the ground owner consents to give construction or permanent lenders a lower priority in the first case. 

The landlord essentially takes on the role of a junior lender for the project. The penalty of this subordination is typically a higher rent and additional concessions from the landlord. 

In an unsubordinated lease, lenders will often still lend to tenants with good credit; they'll just consider the lease when figuring out how much they can lend.

Theoretically, there is no distinction between the value of a net ground lease and any other contractual cash flow with a remaining interest at the end of the term. Of course, the difficulty with land leases is that the residual value is a topic of considerable speculation. 

Many ground leases are simply valued as raw land without considering the lease. For the investors, the ground lease or leases becomes more critical. While underlying quantification (matched pairs, trend lines), specific changes are significant and loaded with assumptions. 

The starting point for any negotiations will always be the reconciled value from such an appraisal, even though the actual investment value can be quite different. 

Clear delineation of contract rent, net effective rent, and market rent, as well as the remaining term of the lease, the manner in which improvements will revert to the landlord, any discrepancies between the contract and market rent, and the time horizon are essential considerations in any net ground lease appraisal.

The income analysis should be simple if you value a property using market rentals and market cap rates. However, utilizing contract rents to value a leased fee interest implies an additional level of complexity, including:

  • What is the timeline for payments?
  • Is it anticipated that the buyer or property owner would keep the investment until the lease expires?
  • What particular risk exists for tenants?
  • Are the lease terms similar to other leases available on the market?
  • Can the lease be transferred?
  • What are the reversion value's underlying assumptions?
  • What factors determine discount rates?

These issues could not be adequately covered if the appraisal only uses a sales comparison. They are crucial to evaluate the viability of a net ground lease from an investment standpoint.

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6. Assessing property subject to improvement

You wish to purchase a plot of land for renovation or investment, but there is already a structure there. There is a considerable difference between the seller's perception of the property's "value in use" or "investment worth" and your assumption that the HBU is for demolition and reconstruction. 

You employ a valuer to estimate the tract's value "as if vacant." This is simple if there are sufficient neighbouring unoccupied land sites. The appraiser will turn to a land extraction if there are no comparable local properties or if they are insufficient to support the valuation. 

We value the entire property and then deduct everything that is not the vacant land to create a cost method that works backwards.

Finding sales or rent comps can be challenging, given HBU's controversy. The reader may erroneously concentrate on the land value without paying enough attention to the underlying assumption when interpreting and using the appraisal. 

A building for an HBU move can have suffered much depreciation. Depreciation may, in fact, equal or come close to equaling the replacement cost. The "completely depreciated" structure may nevertheless receive rents or other benefits, which is a paradox to be aware of.

The rentals are frequently insufficient to support a "value in use" yet sufficient in many circumstances. In appraisals, you may identify more techniques with varying degrees of accuracy. These consist of:

Assessing property subject to improvement

Land distribution

Tax assessments are used as leverage in this. The tax assessor divides the fair market value (FMV) between the land and the improvements in the majority of jurisdictions. 

The allocation ratio may be fair even if the total FMV is off. Therefore, comparing the allocations of similar properties to the sales prices of nearby homes with comparable sites may provide insight into the site's worth. 

Let's say we looked at the tax assessments of a few recent comparable sales and discovered that the county typically gives the building a 75% assessment and the land a 25% assessment. Our most comparable comparison, Comp A, just sold for $1,600,000. The value is then simply allocated as shown:

1600000 =.75 (1600000) + .25 (1600000)

Division of property

The evaluation may look at the expense of developing unimproved tracts into improved tracts and raw land. It is beneficial when there are many neighboring sales of raw land but few sales of improved sites.

Frontage and depth factor analysis

Site depth may be a deciding issue, especially in some metropolitan areas, as long as the site width is sufficient to comply with HBU's "physically practicable" and "legally permitted" standards. 

Frontage may play a decisive role in high-amenity settings (such as beachfront property). When there is some dissociation between value and site size, both methods may help find values.

7. Perform subdivision analysis

Many parcels are bought to develop or divide them. Although land can be divided for residential and commercial uses, when the phrase "subdivision" is used, it typically connotes a residential community. 

Industrial parks and out-parcels from shopping centres are two popular non-residential subdivision investments.

The sales comparison approach is typically highlighted when the appraisal is being used for loan purposes. Four stages are used to value the land:

  • Undeveloped property in need of development (the "as-is" condition)
  • The developed lots as if sold at wholesale (such as a builder purchasing bulk lots)
  • Land with the entitlements, permits, and all legal prerequisites to begin construction.
  • The worth of completed lots after deducting the cost of marketing (a DCF model)

The land development analysis is separated from any subsequent site uses, even when a developer doubles as the end user, like a homebuilder or a retail centre developer. As a result, the land development ROI, feasibility, and valuation must be self-sufficient.

Reviewing the process of developing the undeveloped property into a subdivision of homes or businesses may be helpful. Almost always, this takes several years to complete. 

Subdivision developments are "phased in" over several years since land development takes time. A developer may decide to construct 1,000 homes on a plot measuring 250 acres if the market can support 200 new residences annually. 

Some infrastructure will need to be erected initially, but much of this may wait. Finalized plans frequently change over time. The market need could change, causing the next phase to switch to bigger or smaller lots or possibly another purpose (such as condominiums rather than single-family homes). 

It gives the developer considerable flexibility and eliminates the requirement for an upfront financial commitment. The analysis will include discounted cash flows, just like any project with erratic cash flows. 

From month to month, cash inflows and outflows will vary greatly, and the risks associated with each could be highly different. As a result, several discount rates might be used.

Finally, launching a project of this scale is unusual without sophisticated funding. Even in the planning stages, the capital structure must be integrated with the valuation research.

A tract designated for a specific development is purchased by the developer or offered as an option. Developers are often specialized; those who create residential developments don't often dabble in creating shopping malls. 

The developer has probably done some preliminary market research and is aware of the level and timing of demand before optioning or purchasing the tract. Perhaps the developer is looking for a location to build a shopping complex in a specific city. 

The developer will complete the market analysis once a potential tract has been found. The developer can proceed with the initial entitlements and permitting once the land has been optioned. From place to place, this procedure will be different. 

The developer will ensure all essential utilities, access roads, and other community amenities are present. The developer will investigate zoning and permitting requirements and will likely hold in-depth negotiations with regional permitting authorities. 

Land planners, architects, engineers, and attorneys knowledgeable about the subtleties of development in this area will support the developer. The developer will exercise the option and buy the land as soon as it is clear that the necessary entitlements, permits, and zoning criteria can be met. 

The landowner may occasionally join as a partner and subordinate the fee simple interest to construction or development funding. From a cash-flow standpoint, both the developer and the land seller may benefit from this.

A general contracting company will be in charge of breaking ground, typically under the supervision of an architect and engineering firm. The site will be graded, roads will be laid out, some underground utilities will be installed, and other utilities will be coordinated by general contractors specializing in land development. 

Curbs and sidewalks are poured after the subsurface utilities are installed and the final pavement is completed. Because the heavy machinery required for the concrete work will harm the road paving, curbs and walkways are often installed before the final pavement. Public authorities will inspect all this work, and a surveyor will record a final plat.

It is incredibly simplified, and no two subdivision developments are the same. Local customs, the climate, the topography, and legal considerations will be considered during the actual procedure. A subdivision being built in a rural setting is very different from an urban infill being built in a big city.

The developer will have decided on the disposition of developed lots early in the process. A developer might keep all the lots and sell them over several years. These sales typically don't take place in a tidy sequence. A few sales may occur in the early months, increasing to a crescendo and tapering off around the five-year point.

The proformas and DCF will need to include these projections, and sensitivity analysis can be performed on all of this. By the way, it is uncommon for all lots to sell for the same price; thus, the analysis will need to account for differential pricing and price variations over time.

It should be clear that this project is structured like a sizable spreadsheet. A year of permitting, a year of general contracting, and two or three more years of general contracting may be needed for the five-year residential subdivision build-out. 

Seven years may elapse from the time of creation—the first day a dollar is spent on any type of analysis—and the very last sale. An in-depth examination resembles a spreadsheet with 84 columns because seven years are equivalent to 84 months.

Two linked analyses—the valuation (a DCF of all income and expenditure flows) and the investment—begin with this enormous spreadsheet. 

These two evaluations should agree since monthly net revenue—positive or negative—determines the amount of cash needed for investments.

Due to this, investors frequently undervalue subdivision development transactions. Investors frequently start with the investment study and then give the appraiser those spreadsheets as the basis for the valuation as a fait accompli. 

Why not conduct both evaluations concurrently and independently because the investor will be responsible for their costs? There will undoubtedly be some fundamental information provided to both analysts, but how the two studies use the data can be pretty instructive. 

An accessible approach to sanity-check the development finances is to have the investment analysis and the appraisal completed concurrently by different experts, as both will eventually need to be done!

8. Solve unique problems in condemnation

Is it real estate or a business? The price may include the case of hotels, restaurants, and car dealerships, and the valuation may be clouded by business, franchise, and investment values. 

There are disagreements among appraisers regarding enterprise value versus real estate value in large shopping complexes because they are collections of contractual connections. 

There are many distinct schools of thought regarding this appraisal issue, especially in hotels, and various allocations may cause the appraisal to be located in various areas.

The figure below illustrates how two distinct appraisal procedures may produce the same overall value but use a different methodology to assign value to specific sub-components.

Different approaches to allocating value

Different approaches to allocating value

An investor may favour one allocation above another for tax-related reasons. Recall that real estate (land and structures) usually is compensable in condemnation proceedings, but business values (everything else) are not.

A similar issue frequently affects hotels. The site value of a hotel can be significantly impacted by the loss of parking, especially if the property is a convention hotel and depends on parking. 

Some approaches could classify the loss as non-compensable commercial site value, while others might see it as having an outsized impact on the entire hotel real estate site value.

Investment-grade real estate is frequently the target of inverse (regulatory) condemnation actions and physical condemnations. Investors, especially their attorneys, frequently make poor decisions when taking these steps.

Summary

Investing in idle land can be lucrative, especially risk-wise. Knowledgeable and experienced developers know how to investigate an empty site, deal with service and material providers, and build a subdivision. 

Many wealthy families invest in development land for one purpose. More extensive, more valuable tracts sometimes have dual uses. Different purposes may require different valuations. Net ground leases can give decades of stable, inflation-hedged cash flows.

Even the most straightforward land development project might take a few years, and net ground leases can last decades. Mixed-use developments and ground leases add to the complexity. Varying components entail different risks. Hence overall IRRs and current numbers may not reflect component weighting variations.

Changing a 50-50 apartments-retail project to 90% retail (and 10% apartments) may increase cash flow. The higher risk may diminish the risk-adjusted value. Land projects are long-term investments that require sensitivity analysis and feasibility studies. 

These should separate real estate from investment value. The evaluation should be ordered separately from the investment feasibility study and capital structure analysis. Cash flow assessments are essential to feed investor-level studies in the appraisal scope of work.

A simple sales comparison can contain assumptions, mainly if allocation or extraction is used. This is another reason why DCF or capitalisation may be preferred in unoccupied site appraisals.

FAQs

What is the market value of a land?

There is no simple answer to this question, as the market value of a land can vary depending on a number of factors, including the location, size, and zoning of the property. Generally speaking, though, the market value of an undeveloped lot is much lower than that of a developed lot, since the potential for future development increases the value of a piece of land.

Does capital value include land value?

The capital value of a property includes both the land and the buildings on it. The value of the land is typically a fraction of the total capital value, but it can be significant depending on the location and development potential of the property.

How does leasehold affect property value?

It can affect the value of a property in different ways, depending on the leasehold agreement.

For example, if the leasehold agreement gives the landlord the right to renew the lease at a cost that is above market rate, then this will reduce the value of the property. On the other hand, if there is a clause in the leasehold agreement that allows the tenant to purchase the freehold after a certain number of years, then this will increase the value of the property.

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