Even though large tracts of vacant land are scarce in New Orleans, it can be difficult to accurately value raw land. This article explains how sophisticated commercial property investors value land to determine if their development is feasible.
How property is valued will surprise you. The value depends on how the site is utilized. It’s called highest and best use. A gas station is more profitable than a car wash, so it can pay more for the land in order to get a business into commerce. A hotel is more profitable than a gas station, so it can pay more for the land. When property is put to the highest and best use, the resources are allocated properly, everyone benefits. The public benefits from the highest taxes on the property coming into the city coffers. The seller benefits from receiving the best price. The buyer benefits because the property allows a feasible project to put capital to work and earn a desired rate of return. So the value is not what the seller paid for the land. That is sunk cost and immaterial to a buyer. The value is what the highest price is that makes the new use of the property feasible.
Land Residual Technique
It is called the Land Residual Technique: a method of estimating land value in which the net operating income attributable to the land is capitalized to produce an indication of the land’s contribution to the total property.
The land residual technique is but one of the residual techniques available. Another technique, and one more common in the highest and best use analysis, is the cost analysis version. With this technique, a hypothetical building is constructed that represents the highest and best use of the site. Deductions are then made for the creation costs (i.e. labor, capital, and entrepreneurship) to arrive at a residual value for the underlying site. Both techniques have their place and, depending on the available data, can be very useful in estimating site values or in connection with a proper, well-supported highest and best use analysis. Let’s try an example. What if you were planning to build a hotel on land that is currently a parking lot? How would you value the land under a 340 room hotel assuming $200 per night rates at 60 percent occupancy with overall expenses at 60%?
◾Rent is $200.00/night.
◾Vacancy and collection loss is 40%.
◾Expenses to the landlord are 60%.
◾Overall capitalization rates for a property like the subject property are 10%.
◾Constructions costs are $175,000 per room but does not include the site value.
Determine the net operating income (IO) for the property.
Potential Gross Income (340 rooms x $200/night) $25,000,000
Less: Vacancy & Collections (40%) $10,000,000
Effective Gross Income $15,000,000
Expenses (60%) $9,000,000
NOI (IO) $6,000,000
Capitalize the NOI (IO) into a value.
VO = NOI (IO) / Cap Rate
VO= $6,000,000/ 0.10
Deduct the construction costs from the total costs (except land).
VL= $60,000,000 – $59,500,000 (340 rooms at $175,000 each)
The end value is $500,000 but that is not the value of the land. The value of the land is best determined by the market, or what the values are of other like properties that can also be purchased and put to the same use. What the end value does tell us is the maximum price the developer can pay for the land and still make the project feasible.
If the land asking price is higher than $500,000, the developer has to find a way to reduce construction costs or increase net operating income through reduced expenses or increased revenues, or not buy the property.
Sources: www.louisianacommercialrealty.com, Appraisal Institute: Advanced Spreadsheet Modeling