When a commercial real estate developer is considering the construction of a new project, there are two major groups of development costs to consider. First, is the cost of vertical construction, which includes line items like lumber, drywall, electrical, plumbing, landscaping, roofing, architecture, and legal. These line items represent the bulk of the cost of the development and they help a developer back into how much they can afford to pay for the second major cost group, which is the land.
In this article, we are going to discuss a term known as “residual land value.” As it relates to a commercial property, we will describe what it is, how to calculate it, and why it is important. By the end, readers will have the information needed to perform more thorough due diligence on potential investments that involve ground up development.
At First National Realty Partners, we don’t typically develop properties from the ground up, but that doesn’t lessen the importance of knowing what the residual land value is. We still consider it as part of our due diligence process. To learn more about our current commercial real estate investment opportunities, click here.
What is Residual Land Value?
Residual land value is a commercial real estate metric that estimates the valuation of raw land based on the planned improvements for it.
How To Calculate Residual Land Value
There are a number of valuation methods and residual techniques that can be used to calculate residual land value, including the sales comparison approach. But, for the purposes of this article, we derive the residual land value from the project cost as follows:
Residual Land Value = Gross Development Value – (Construction Cost + Fees + Developer Profit)
In order to understand exactly how this equation works, let’s dig into each of these components:
Gross Development Value (GDV): The total development cost, inclusive of the developer’s profit. This value can be calculated based on knowledge of development costs, market trends, and interest rates.
Construction Cost: The total cost of constructing the project including the land entitlement, utilities, infrastructure, and all materials and labor.
Fees: A ground up property development usually includes architecture fees, financing costs and loan origination fees, as well as real estate broker commissions and other professional fees.
Developer Profit: Finally, in their financial projections for the development project, the developer builds in a certain amount of profit based on the difference between inputs like the development cost and the projected sales price once the project is complete.
The tricky part about residual land valuation is that these build costs are estimated prior to the beginning of construction. The actual costs could be materially different. As such, the residual land value should be considered more of an estimate, not an exact measurement.
Why The Residual Land Value is Important
The residual land value is an important component of real estate investment analysis because it helps the developer/builder “back into” the appropriate value of the land, which informs the purchase price that they are willing to pay. This input, along with the prices paid for comparable properties can help an investor determine the market value of the property.
Residual Land Value and Commercial Real Estate
From a developer’s standpoint, the residual land value is important because it has a major impact on the profitability of the project. If the land cost is too high, then there may not be enough profit for the risk taken to build the project.
Using Residual Land Value as An Investor
From a real estate investor’s standpoint, it is important to know how to calculate residual land value as part of the investment due diligence process. It is not unheard of for a developer to be optimistic in their financial projections, which results in an attractive looking potential return. So, it is important for individual investors to calculate residual land value on their own as a check on the developer’s estimates. If there is a material difference, it may be worth a discussion to reconcile them.
Summary of Residual Land Value in CRE
Residual land value is a commercial real estate valuation metric used to help developers determine the appropriate land prices to be paid.
The equation used to calculate residual land value is the gross development value less the total project cost, including fees and developer profit.
Calculating the residual land value as part of a real estate development is important because it helps the builder/developer determine the appropriate price to pay for the raw land upon which the project will be constructed.
From an investor’s standpoint, it is also important to calculate the residual land value, independent of the developer, to ensure it is fair and reasonable.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.