What's my Land Worth? A Dive into the
Land Residual Model

Definitions of the above terms are as follows:

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Hard costs include all labor and materials required for construction. In this case, vertical hard costs (building material and labor) and horizontal hard costs (site development material and labor)

are itemized separately.

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Soft costs include architectural, planning, and engineering fees. They also may include legal fees, permits, and taxes, property and construction insurance. Construction loan application fees/origination fees, interest payments, and other related financing fees.

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Entrepreneurial incentive is the minimum amount of profit necessary to entice a developer to take on the time, effort and risk of a new development. When supply and demand are imbalanced in the market, potential profit on a development is below entrepreneurial incentive.

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Site improvements are physical site improvements to the land that are depreciable components. Examples include sidewalks, driveways, curbing, and landscaping.

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Site infrastructure are physical site improvements to the land that are not depreciable. Examples include grading, storm basins, water & sewer line extension and connection, and electrical line extension and connection.

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A summary of the land residual analysis is as follows:

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Alternative 1:  2,500 square foot single-family home with 4-bedrooms and 3 bathrooms with carpet throughout (with exception to kitchen and bathrooms). This home will be worth $600,000 when complete and costs $550,275 to develop – inclusive of hard costs, soft costs, entrepreneurial incentive, site improvements, and site infrastructure. The analysis translates into a residual land value of $49,725 ($600,000 - $550,275) for an approvable raw [3] lot.

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Alternative 2:  2,500 square foot single-family home with 4-bedrooms and 3 bathrooms with hardwood throughout (with exception to kitchen and bathrooms). This home will be worth $625,000 when complete and costs $569,250 to develop – inclusive of hard costs, soft costs, entrepreneurial incentive, site improvements, and site infrastructure. The analysis translates into a residual land value of $55,750 ($625,000 - $569,250) for an approvable raw lot.

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Alternative 3:  2,500 square foot single-family home with 4-bedrooms and 2 ½ bathrooms with hardwood throughout (with exception to kitchen and bathrooms). This home will be worth $575,000 when complete and costs $531,300 to develop – inclusive of hard costs, soft costs, entrepreneurial incentive, site improvements, and site infrastructure. The analysis translates into a residual land value of $43,700 ($575,000 - $531,300) for an approvable raw lot.

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As is inferred via the analysis, hardwood costs more than carpet (Comparison of Alternative 1 and 2) and bathrooms cost more than common areas (Comparison of Alternative 2 and 3).

Bathrooms and hardwood also contribute more value to the property, all else being equal.

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Based on the residual land analysis, a 4-bedroom, 3-bathroom home with hardwood throughout (Alternative 2) is the highest and best use for the vacant site because it produces the highest residual land value. Put another way, this is the development alternative that returns the most value to the land.

 

The weakness in the land residual approach is the sensitivity of the analysis.

 

Limitations to this approach primarily include that value and costs are dynamic – and will be reflected in different periods over the course of development rather than at a single period of time.

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For example, rising labor and material costs along with unforeseen expenses associated with the land (subsurface rock, for example) could increase the final development costs which negatively impact the residual land value. It is also noted that analysis does not explicitly consider holding costs [4] 

and time value of money [5]; therefore, it is important to consider recent land sales to support the conclusion.

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The weakness in relying exclusively on comparable land sales is that buyers do not always make land purchase decisions based on the real estate-related financial feasibility of proposed improvements – especially proposed build-to-suit improvements for owner-occupants or partial owner-occupants.

From a commercial development perspective, often times, owner-user decisions are based on enhancements to business value as a result of relocating, renovating, or ground-up developing in a visible or accessible location.

 

These decisions rarely result in real estate financial feasibility due to location and development criteria specific to each user. In other words, the project may be financially feasible holistically, but it is not financially feasible from a strictly real estate perspective.

 

This is a concept known as “Transferred Value” which has been written about previously.

In this way, owner-users who develop land may employ a land residual analysis based on a combination of 1) the value of the real estate when complete, and 2) the increase in business value from having a better location and newer buildings to flaunt to clients, thus resulting in a willingness to pay an amount for land that rarely “pencils” from a strictly real estate feasibility perspective.

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It is also noted that without a site survey or engineer analysis of development potential based on zoning requirements, the differences in development density between sites may significantly deviate, therefore making sales comparison less credible.

 

Moreover, it is sometimes difficult to identify associated entitlements to support credible adjustments for land development risk differences between properties. In short, the residual analysis is an ideal analysis if approvable building area, estimated cost to construct, and development risk are credibly input.