With house prices rising, the value of lots and raw land skyrockets

The valuation of land used for residential housing is mysterious and often misunderstood. The valuation of lots and raw land requires a detailed knowledge of construction and marketing costs as well as a good estimate of the sales price of the final product: a residential housing unit. In short, the value of a lot is the total revenue (sales price of the home) minus the costs of production and the necessary profit. Land value is a residual calculation.

The value of a piece of land is whatever is “left over” after all the other costs of production and profits are subtracted from revenue. This is a key point. Land for residential home use has no intrinsic value. It is a commodity useful for the production of houses just like lumber or concrete. For a given price level, if the cost of house construction increases, the value of land decreases; if the cost of house construction decreases, the value of land increases. This last point is often confusing as the inverse relationship between building cost and land value does not seem intuitive, but since land value is a residual calculation, this relationship is the reality of the marketplace. The value of a piece of land used for residential housing is directly tied to the revenues and costs of house construction.

A Simple Example

Let’s say a 2,000 square foot house sells for $400,000. That comes to $200/SF. The actual construction cost for the sticks and bricks is about $100/SF for a production builder. That means $100/SF of house price is left over to pay builder overhead, profit, and land costs. If profit and overhead run at about 20%, then 30% of the sales price is the value of the lot that sits on it. In this example, that’s $120,000.

Now let’s say the same 2000 SF home gets inflated in value to $600,000 (similar to what we’ve just seen in our local market). The cost of production of the home hasn’t changed. It’s still $100/SF. However, with the higher sales price, builders will be willing to pay much more for a lot to build that house on because they can still make a profit. If profit and overhead is 20% of the price ($600,000 x 0.2 = $120,000) and the cost of construction is $100/SF ($100/SF x 2,000 = $200,000), the lot is now worth $280,000 ($600,000 – $120,000 – $200,000 = $280,000.

Notice the $200,000 increase in house price caused a $160,000 increase in the value of the lot. The value of the lot increased 150% while the house price only rose 50%. In my opinion, the people speculating on higher house prices are missing the real opportunity for leveraged capital growth available in finished lots. If you really believe house prices are going to continue to go up, and it’s purely a capital appreciation investment, finished lots will give you much more bang for the buck. Of course, if prices go down, the magnified impact cuts both ways.

U.S. Land Gets More Expensive

By ROBBIE WHELAN — April 9, 2013, 7:19 p.m. ET

…  The rebounding housing market has sparked a sharp rise in land prices, creating big profits for land investors but putting pressure on builders to further increase the price of new homes.

For consumers, costlier land means more-expensive houses. Land cost constitutes 21.7% of the final sale price of a new home, according to the National Association of Home Builders. As land prices rise, builders tend to pass 100% of those costs on to consumers. …

That is a completely erroneous way to look at land prices. Land prices don’t drive anything. Land prices are driven by house prices.

Land prices rise because house prices rise. In reality, the rising house prices get passed on to the landowners who receive the residual value left over after the cost of production is backed out.

This is a significant shift from the economic downturn, when builders halted development and liquidated land for pennies on the dollar. From 2006 through 2011, residential land lost a cumulative 58% of its value, Zelman says.

Since land is a residual calculation, land values can go negative. If it costs $100/SF to build a house, and houses only sell for $80/SF — which happened in Las Vegas — the residual value is negative.

In the real world, nobody pays you to take their lot, but until house prices rose above construction costs, builders weren’t going to buy more lots or build more houses.

To be sure, land prices nationally are still far from the peak levels reached in 2005 and 2006. They also are notoriously volatile.

Of course land values are volatile. Once you understand how their calculated you see they move $3 or $4 for every dollar in house price — up or down. That’s volatility!

That is great news for private-equity firms and other land investors, including Paulson & Co., Angelo, Gordon & Co. and Starwood Capital Group, that crowded into the land market at its 2009 trough.”This is exactly what we predicted would happen,” said Tom Shapiro, president of GTIS Partners, a New York-based private-equity firm that 3½ years ago started buying lots in suburban new-home communities at an average of about 20% of peak pricing. “The rate of recovery in some of these markets has just been incredible,” he said.

Since 2010, GTIS has amassed a portfolio of about 30,000 home sites and has started selling out of its land positions for large profits. In the past three months, the firm says it has almost sold out 400 lots in Carillon South Lake, a development near Dallas, where it bought land in 2010. “We doubled our equity,” said Rob Vahradian, a senior managing director with GTIS.

He was right, and so were the other investors who went into beaten down markets with patient money. He was also lucky because the efforts to reflate the bubble made his investment pay off several years ahead of schedule. His return on investment will be astronomical.