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In even the most developed neighborhoods, there’s usually an empty lot sitting idle that begs the question: How much is that “piece of dirt” worth? Compared to the values of the existing homes nearby, it’s not readily apparent what the value of that empty lot might be. But it’s got to be worth something, right?
The fact is, valuing a vacant lot, in concept, is pretty simple under a commercially-recognized valuation technique called Residual Land Valuation (RLV).
Residual Land Valuation is simple and straightforward for single-unit development. It becomes vastly more complex as other kinds of development options are introduced (apartments, condos retail, office, industrial) and when city, state, local planning group’s constraints are factored in, as well as other economic variables, like zoning laws, average daily traffic count (ADT), costs of construction, NIMBYism, floor area ratio (FAR).
But for an experienced, prudent developer who is considering buying a single-family-zoned lot to build a house upon, there is a formula that helps determine the kind of profit such a deal could yield.
First, the developer needs to determine the “product” or kind of house they are going to build and for how much the finished product will sell. They review the immediate housing marketplace, talk to real estate agents, review comps, and determine that in order to maximize their profit, they should build a 2,600-square foot house on the lot (Note: Different developers may see a different market, size, luxury fixtures, sales price, cost to build).
That house, based on real estate market conditions, will sell for an estimated $ 850,000. The builder estimates “all in” that it will cost $ 400,000 to build the house – sticks, bricks, permits, architectural, loan interest, fees, everything, except land, plus 7% in sales costs (commission, escrow, title, etc.).
Now we can figure out the RLV, which equates to how much a developer might offer for the lot and the maximum he should pay.
If the developer starts with the $ 850,000 sales price, he then subtracts the sales costs to arrive at a net sales price of $ 790,500. Then he subtracts the cost to build, and builder-required profit that he hopes to earn, and what is left over is what he can pay for the land. That’s estimated at $ 340,500 in this example, which is the RLV.
If his estimated RLV is $ 340,500, he might start his offer at $ 250,000 and might be willing to pay up to $ 350,000. But if the seller demands $ 450,000, the builder will not make any money, so he’ll pass on this lot.
Mathematically, it’s really that simple. The hard part is accurately estimating the sales price the property will command and the actual amount that it will end up costing to build. If one misses the mark on those, that’s the difference between making a profit or losing one’s shirt!
However, there is one last item to note — and it’s the toughest part of all for builders when it comes to making a good estimate on profitability on a project: Finding a land owner who is willing to sell at a price where the developer can still make a profit. Many a builder or developer has overpaid for land.
To restate the process for anyone curious about determining the value of an empty building lot, here’s what you should ask yourself:
- What can be built and how much will be the estimated final product sales price?
- How much are the costs of sale, construction costs, and builder required profit?
- The net leftover is what a prudent developer can pay for the land and still earn a fair profit – the “Residual Land Value”.
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a Zillow Blogger, the author of several books including “Real Estate Ownership, Investment and Due Diligence 101 – A Smarter Way to Buy Real Estate.” Read useful tips for real estate buyers in his blog, Making Smart and Safe Real Estate Decisions. See more at ProfessorBaron.com.
Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.