Raw Land investments offer great opportunities within the Real Estate space. They are also the most adventurous, in the sense of risky. They also offer the highest potential rewards. J.J. Astor knew that well, he become a millionaire in the 1800s through buying parcels in north Manhattan, making a fortune as the city expanded. Undeveloped land is worth much less than a finished project with a property, all permits and income stream in place. But the road from undeveloped parcel to a fully operating property is not easy and full of uncertainty.
It has some similarities with buying vacant land for personal home building. But in the case of commercial Raw Land development you are looking to make an investment that may be 3 to 5 years from maturity as opposed to your first residence which may have a much longer time horizon. You are also looking to make a healthy profit for taking on the risk, time and effort to source and implement your project. Raw Land for commercial development, whether it is for commercial or residential property, is therefore looked at on a risk return basis.
Process from Raw Land to finished property
Real Estate development entails a process that helps mitigate the risks of falling into a money pit. You need a clear plan of action that defines all the necessary steps to go from raw land to finished project. First of all you need to identify a piece of land to target and then make an estimation of the marketing potential and profitability of the finished project. Once the figures make sense you then proceed with the purchase and raising the necessary finance. Then comes the development stage, design, permits and license approvals and building the structure. Lastly leasing and managing the project and eventually the sale of the property.
What is the land to be used for?
You need to consider what the end use of the raw land is going to be. A parcel of land in a suburban neighbourhood is almost very likely only going to receive residential housing permits. A parcel that is in an industrial estate will most likely only be suitable for plant construction. To understand what the best usage of the land is you need to know what options may be on the table for that parcel.
A phone call to the local planning and zoning department should clarify this. They should have all the areas classified as to what the possible land uses are. They should also be able to give concrete examples of what is possible to build. Parcels in central parts of large cities may offer more opportunities and will of course also be much more expensive. Landmark sites are usually the domain of Private Equity Real Estate funds or other Real Estate partnerships.
How to evaluate the investment
One way of considering investing in raw land is by looking at the purchase as if it were a series of call options. You basically buy a parcel that may or may not end up as a developed property; the cost of the first option is the price of the land itself. Then you will need to invest in land development, sewage, electricity lines, permits and so on, this would be the cost of the second option. At each stage you are in the position of choosing whether to continue the development and continue to buy the next call option.
For example if after the acquisition of the land you find that the permits you required for the completion and operation of the project were not available, you would desist from investing in the next stage.
When considering residential land if it is in an area already classified for construction you shouldn’t have any problems. Situations of uncertainty arise when the land you are investing in for a determined project depends on the success of a third party’s project.
For example you are considering buying a parcel of land for development into a restaurant which is next to a future large commercial outlet. You buy the land with the premise that the commercial outlet also obtains the necessary permits and licenses. Should they fail your second option of developing the land to start construction becomes worthless as the possibility of this restaurant being an attractive investment has diminished sharply. It goes without saying that at this point you would not proceed with the project. You might hold onto the land and wait for the property to appreciate in price or you may flip it back to the market. In either case your initial investment idea didn’t go through and it may have cost you some money. Having said that, buying the raw land at an early stage and seeing the project through to termination could hand you a handsome profit.
How to price raw land
The value of raw land for commercial development is dictated by the value stream of the finished property. In the above case of the restaurant it will be the value of the sale of the finished project.
Let’s say the estimated sale price of the restaurant is $500,000 that’s for the land and structure no business is involved. Including a business in the sale means a whole new series of skills are needed. That may not be within the reach or realm of a property developer.
The estimated value of the land if the project is not finished is say $150,000, and presuming the project would take two years to finish. One year to get all the necessary permits once the construction of the commercial outlet is confirmed. And another year to develop the land and build the structure including the parking lot.
In theory the land is worth $500,000 discounted to present value. However that would mean that you are 100% certain of obtaining the necessary permits and that the outlet will be built to begin with. Let’s say the outlet seems very likely to happen and call it an 80% probability of success. Then the land is worth the probability of success times the finished project value plus the probability of no success times the value of the raw land. This value then needs to be discounted to present value, as we are talking about the value 2 years away.
Where V is the value of the land p is the probability of success, Cap is the Capitalization Rate and t is the number of years. A Capitalization Rate is the desired return of an investment in Real Estate. With a Cap of 8% this would give a value for the above land of $368,655
This is not an exact estimate as there may be many factors in play but it does give a good idea of how profitable a development may be.