When you're starting a new development project, one of the very first things you do is start shopping for land. Yet, it can be difficult to know what to offer for each tract of land, especially if you're dealing with raw land. That's where a residual land value comes into play.
To that end, we've created a guide on this equation below. Read on to learn more about what residual land value is, how it works, and why you should use this equation when building out your portfolio.
What is residual land value?
At its core, a residual land value is an equation that's used to find land valuation. It's used by property developers and real estate investors to figure out how much they can afford to spend on a parcel of raw land that they intend to develop. Since it can be difficult to arrive at a true appraised value for land, especially before submitting an offer, this equation can provide a decent estimate.
This equation is found by subtracting all of the expenses associated with the development, including profit, from the total development cost. Once that's done, you should be left with the total land cost.
How to calculate residual land value
Now that you have a better idea of what residual valuation is and why it matters in a development deal, it's time to take a closer look at its calculation. The basic equation for this is as follows:
Residual land value = (Gross development value) - (Construction costs + Fees + Profit)
However, if we really drill down into each of those components, a more detailed equation looks something like this:
Residual land value = (Gross development value) - (Build costs + Construction costs + Finance costs + Real estate commissions + Professional fee for the architect + Developer's profit)
Before you can find the residual value, you first need to estimate all of the components of the equation. Let's examine what's involved with each one:
- Gross development value (GDV): Your GDV estimate represents your total development cost, including profit. You can find this by researching the value of similar properties in the area as well as market trends and interest rates.
- Build costs: These are the costs associated with taking raw land and making it usable. They include grading and clearing costs, the cost of constructing roads and utilities, and the cost of obtaining permits.
- Construction costs: As usual, your construction costs will include materials and labor.
- Finance costs: As you might be able to guess, the finance costs for buying real estate generally include interest charges and any fees necessary to close on the loan, such as an origination fee or application fee.
- Real estate commissions: This fee is usually split between the buyer and the seller in real estate transactions and can be around 2%-6% of the property's purchase price. However, in cases where the land prices are relatively affordable, commission may be higher.
- Professional fee: According to the American Institute of Architects, this fee is usually based on a percentage of the construction costs.
- Developer's profit: This estimate is generally found by using the income method of appraisal.
How to use the residual technique as a real estate investor
From an investing perspective, the residual technique is particularly important for property developers and investors to understand because it impacts your bottom line. Put simply, if you offer too much for the raw land, your profit margin is going to take a hit, even if the completed development brings in a lot of income.
While this equation may take a lot of research and legwork on your part, it's worth doing. Once it's done, you'll know right away if certain land prices are too high for your budget or if a particular parcel is worth considering for your portfolio.
The bottom line
Whether you're involved in developing commercial real estate or residential real estate, at the end of the day, every project is an investment. As the investor, that means it's up to you to keep an eye on your bottom line. Although it may be complicated to perform, the residual method is one way for you to ensure you're not spending too much money on your land costs. Use this equation to help ensure that you're happy with your profit margin on every development project you undertake.