Jul162007

## Land Value 101

The valuation of land used for residential housing is mysterious and often misunderstood. The purpose of this post is to explain how residential land is valued. Once the forces governing land value are understood, it becomes obvious why the Irvine Company is so protective of house prices in Irvine, and why the Irvine Company wants to maximize salable density on its land holdings.

The equations which govern the valuations of large parcels are very similar those which determine the value of an individual lot; therefore, to better understand the valuation of large parcels, one should fully understand how to evaluate an individual lot.

Individual Lots

The market value of a individual lot is equal to the revenue it could generate minus the cost of creating that revenue. Sounds simple enough, but what is the potential revenue and what are the costs?

Sales revenue will largely be determined by what can be built on the lot and how much that house would sell for in the market. The dimensions of the lot, building codes, and the local zoning ordinances will all create constraints on what can be built. Most often there will be some variety in choices available to construct on a given lot. Each of these options will have a potential revenue and an estimated cost. The combination which yields the greatest profit is the product that should be built.

Imagine a 6,000 Square Foot lot that is 60′ wide by 100′ deep. A typical lot such as this would have a front setback of 20′, side setbacks of 5′, and a rear setback of 30′ leaving a 50′ wide by 50′ deep envelope for the house foundation. This site could comfortably accommodate a 2,000 SF house (some area is lost by not making the house a perfect rectangle.) For the sake of making the calculations easy, let’s say this house could sell for \$1,000,000 (peak prices).

An individual speculator would be paying retail prices for house construction. This would be upwards of \$150 SF. The cost of construction would be around \$300,000 (2000 * 150 = \$300,000.) There would be a 6% sales commission (1,000,000 * 0.06 = \$60,000), plus financing costs, overhead costs, and other miscellaneous costs which will add up to about 10% of the project cost (1,000,000 * 0.1 = \$100,000.)

Therefore, your revenue minus expenses would be \$1,000,000 – \$60,000 – \$100,000 – \$300,000 = \$540,000. This is how much money would be available to pay for a lot at the breakeven point. Since a speculator would want to make a profit, the lot is discounted from \$540,000 until an amount is reached to compensate for the risk and the headaches that go along with the project.

Perhaps the speculator would want to make \$120,000 (approximately 12% of sales price) in order to do this work? If so, the speculator would be able to offer \$420,000 (\$540,000 – \$120,000 = \$420,000) for the lot. If they are the highest bidder, they get the lot, and the project is theirs. (BTW, this same basic calculation also works for tear-down projects — often called “scrapers.”)

Multiple Lots

Production homebuilders control the price of larger parcels with multiple lots because they can bid higher than individuals and still make a healthy profit (and they have the larger sums required to complete the purchase). They have a much lower construction cost than any individual because they are geared up for mass production. They have the buying power to squeeze costs down far lower than any individual working on their own or with a custom home builder. Production builders costs in today’s market average around \$85 SF.

A note about the numbers: Part of the process when you sell a large parcel to a production homebuilder is to come to an agreement as to the costs to complete the infrastructure of the project. In order to facilitate this negotiation, both parties often turn to a neutral third party to establish costs. In Southern California, many cost estimates are handled by Developers Research. A real cost estimate is much more detailed than what I am presenting in this post, but the numbers are reflective of a typical situation. As for the builders cost structure, this comes from my experience from sitting on both sides of the table at different points in my career and another source whom unfortunately I can’t reveal because it would give away my identity.

So let’s look at how a production builder would analyze a 100-lot subdivision in which they believe they can sell homes for an average of \$1,000,000 per unit.

\$1,000,000 Sales Price

Fixed Costs
2,000 Average Square Footage
X
\$85.00 Average Cost Per SF
===================================
\$170,000 Average “Box” Cost
+
\$40,000 Average Per lot Infrastructure Cost
===================================
\$210,000 Total Average Fixed Construction Costs

Variable Costs
* 12% Profit
* 5% Marketing
* 5% Finance
* 3% Other
===================================
28% Variable Costs Percentage

\$280,000 Variable Costs Dollars
===================================
\$490,000 Total Costs (Fixed Costs + Variable Costs)

\$510,000 Land Residual (Finished Lot Value)
X
100 Number of Lots
===================================
\$51,000,000 Finished Lot Land Value

The production builder can pay more for each lot because of their advantage in construction costs. Noticed the very large dollar amount builders were paying for finished lots during the peak of the bubble. Lately many of the builders have been taking “impairment” write-offs. Basically, they are admitting they over paid for land, and the asset on their books is not worth what they paid for it. Later in this post, we will examine the sensitivity of land price to changes in house price, and we will see why the homebuilders have been taking such huge hits to their balance sheets.

Land Price as a Residual Value

As you may have noted above, the value of a piece of land is whatever is “left over” after all the other costs of production are subtracted from revenue. This is a key point. If revenue increases — like in a bubble — the value of land increases; however, it revenue decreases — like after a bubble — the value of land decreases. If production costs increase, the value of land decreases, and visa versa.

The value of a piece of land used for residential housing is directly tied to the revenues and costs of production homebuilders.

Density and the Value of an Acre of Land

A builder is going to bid for the land based on the number of units. They don’t care if this is on a single acre or on a thousand acres: Builders pay for lots, not land. Therefore, if you are a seller of land — like the Irvine Company — you want to maximize salable density. In other words, you want to get the highest number of units per acre that you possibly can sell.

Once this point is understood, it becomes obvious why the Irvine Company is constantly trying to innovate with its high-density product, and why the density keeps increasing as they go along.

House Price and the Value of an Acre of Land

To fully understand why the Irvine Company is obsessed with maintaining high home prices, an understanding of how changes in home prices impact the value of land is required. Examine the above equation carefully, and notice that the variable costs are only 28% of the total.

This is another very important point: Land value is very sensitive to changes in house prices.

How sensitive? Let’s take a look at an example to which we can all relate: Irvine’s Woodbury.

Woodbury

Woodbury is one of the Irvine Companies newest communities. It is listed as 4,270 units. As this Village is constructed on a 1 mile square, it sits on 640 acres for a density of 6.67 dwelling units per acre (DU/AC).

Based on the equation above, we can estimate the total land value of the residential portion of the Woodbury Village:

\$650,000 Sales Price

Fixed Costs
2,000 Average Square Footage
X
\$85.00 Average Cost Per SF
===================================
\$170,000 Average “Box” Cost
+
\$40,000 Average Per lot Infrastructure Cost
===================================
\$210,000 Average Fixed Construction Costs

Variable Costs
* 12% Profit
* 5% Marketing
* 5% Finance
* 3% Other
===================================
28% Variable Costs Percentage

\$182,000 Variable Costs Dollars
===================================
\$392,000 Total Costs (Fixed Costs + Variable Costs)

\$258,000 Land Residual (Finished Lot Value)
X
4,270 Number of Lots
===================================
\$1,101,660,000 Finished Lot Land Value

\$1.1 Billion dollars worth of land — that is Billion with a “B.” If the Irvine Company can build out this village for an average home sales price of \$650,000, that is how much they stand to make (their land cost is almost zero).

Now lets look at another scenario: the housing bubble crash scenario:

\$325,000 Sales Price (50% decline)

Fixed Costs
2,000 Average Square Footage
x
\$85.00 Average Cost Per SF
===================================
\$170,000 Average “Box” Cost
+
\$40,000 Average Per lot Infrastructure Cost
===================================
\$210,000 Average Fixed Construction Costs

Variable Costs
* 12% Profit
* 5% Marketing
* 5% Finance
* 3% Other
===================================
28% Variable Costs Percentage

\$91,000 Variable Costs Dollars
===================================
\$301,000 Total Costs (Fixed Costs + Variable Costs)

\$24,000 Land Residual (Finished Lot Value)
X
4270 Number of Lots
===================================
\$102,480,000 Finished Lot Land Value

\$102 Million dollars worth of land — That is million with an “M.”

Is that right? Does a 50% reduction in home prices really reduce the land value 90%?

Yes, it does.

Can you see why the Irvine Company is so protective of home prices?

Why is land value so sensitive to home prices?

As discussed previously, variable costs are only 28% of the home sales price. Remember, land value is a residual calculation, that means everything which isn’t a cost falls to land value.

Therefore, 72% of any increase or decrease in the price of a home flows directly to land value.

In essence, this makes land an extremely leveraged commodity. If the value of a house changes by \$10,000, the value of the lot it sits on changes \$7,200. Multiply that times the 6.67 units per acre, and you can see how each \$10,000 change in the value of a house changes the value of an acre of land in Woodbury by \$48,024. Since Woodbury sits on 640 acres, the total value of Woodbury changes by \$30,735,360 for each \$10,000 change in the sales price of a home. (If you want to see a really mind-blowing number compute this for all the land in the Irvine Company’s holdings.)

The Irvine Company will capitulate.

In the end, the Irvine Company will lose its battle to prop up the market. They don’t control the market, they only control the “ask.” Potential buyers determine the “bid.” If the bids don’t reach the ask, there is no sale (which is what is happening in Portola Springs.) If there are no sales, the Irvine Company has no revenue, and without revenue, they will cease to exist. They have more holding power than most organizations, which is why The Irvine Company has not been cutting prices and offering incentives like all the homebuilders, but the Irvine Company still must sell its holdings in order to survive. If they didn’t, they could just decide all houses in Irvine must sell for \$10,000,000. In 300 years when those prices may be reasonable, they will start selling homes again. Do you see the absurdity of the Irvine Company holding to peak prices forever?

Conclusion

This is my world: I work for a company that develops raw land. The people who were actively investing in land development during the bubble made more money than you can possibly imagine. The extreme sensitivity of these investments to changes in home sales price resulted in properties obtaining sales multiples of 10 times or greater in just a few years.

As an example, I did some consulting work on a property in 2003 which was purchased by a land developer as raw, unentitled land for \$2.4 million dollars cash. When they received their entitlements in 2005, they sold the land in three phases to a production builder for a total of \$100 million dollars (4x for the entitlements and 10x for the bubble rally.)

If you thought the bubble rally was a good time to be a homeowner or a homebuilder, you were missing out on where the real action was: land development.