Chris Schreiber
I’ve been employing various versions of a land residual or development residual analysis as a check on land prices and a test of highest and best use and the indicated land value from the sales comparison approach for the past 15 years. However, when applying the residual analysis here in Idaho, there appears to be real reason for concern.
What is the development approach? The development approach is basically the calculation of what a developer can afford to pay for the underlying dirt, considering the value of property as if built out to its highest and best use today. Performing the analysis can be complicated and involve a variety of cash-flow models taking into account profit, holding costs, absorption periods, cost trending, etc. For our purpose, let’s use a very simple static model:
Estimated Project Value
– Construction Costs, Soft Costs and Profit
Implied Land Residual
Now, we’ll put in fabricated numbers for multi-tenant light industrial park:
$3,800,000 (50,000 square feet at $9/SF [10% vacancy, 25% expenses, 8% cap])
– $2,750,000 in Construction Costs (50,000 square feet at $55 per square foot)
– $435,000 in Soft Costs (leasing commissions, absorption and permits and fees)
– $318,500 Profit (10% of Hard and Soft costs)
$296,500
The typical land to building ratio for single-story, light industrial space with adequate room for parking, loading, landscaping, snow removal and drainage is 5:1. For our example, this would equate to at least 250,000 square feet. With a residual at $98,000, we could pay $1.20 per square foot on the land area.
So what does it say for markets where industrial land that is primed for development simply can’t be found under $5 to $10 per square foot? In Idaho, we’ve seen development on land sold valued as high as $15 per square foot. At those prices, not only is there no profit, but there is significant external obsolescence even prior to construction, meaning development is simply not feasible.
This form of analysis is absolutely key when pricing land for sale, considering new development and when assessing the relative strength or weakness of a particular market or a particular site. We can draw some simple conclusions from this exercise:
Residual > Actual Land Prices = Expect to see significant market activity.
Residual < Actual Land Prices = Expect to see extremely limited, new speculative development.
Residual = Actual Land Prices = Market is balanced.
When you see new development in markets with elevated land prices, you’re almost sure to find that the developer has owned the land for a considerable time and their basis is not based on today’s asking prices. The developer could be using pricing from 5 to 10 or more years ago.
This raises an obvious question: Why do land sales occur when prices are elevated? In some instances, speculation occurs when a buyer expects the top line on the residual analysis to soar. Such was the case in some of our smaller resort towns here in Idaho, such as Sandpoint or McCall; many investors felt rental rates would soar, driving the value of new projects up substantially. In other instances, adequate attention is not paid to the development approach. Buyers are not properly informed of true market value, they do not understand what construction really costs (they may only account for hard costs and not consider soft costs), or there are other outside motivating factors that drive the purchase.
As I mentioned, this is overly simplified, but it’s a simple, quick reality check. To truly analyze the development potential of a property requires significant time and expertise by a team of experienced professionals, including a commercial broker, an appraiser, a banker and a contractor.
— Chris Schreiber is an associate broker in Kiemle & Hagood Company’s Coeur d’Alene, Idaho, office.