Investing in Commercial Land

Why invest in land?

Although returns are certainly by no means guaranteed, there are a range of benefits to purchasing raw land in general.

Land has similarities to improved residential or commercial real estate in that it may generate passive income or significant profits depending on how it is acquired and sold. Purchasing the right piece of land at the right price can lead to high-double-digit returns, and there are ways to gain residual passive income even with vacant land.

The value of land is determined by the area, form of land, and size of the parcel being sold. Some undeveloped land can cost hundreds of thousands of dollars to millions of dollars, while other undeveloped land can be as cheap as a few thousand dollars. Land can be a low-cost investment that doesn't need a bank loan to get started for most people.

Land, as a resource, benefits from high demand in general. Rising populations correlate to an increased demand for development property, as well as a concomitant decrease in the availability of land for development.

Another benefit of raw land is that here is no property to manage or tenants to deal with. It's widely considered to be a low-maintenance investment, apart from paying property taxes and keeping the land mowed or protected.

Finally, investing in land is often thought to be less competitive than investing in residential or commercial real estate. There are, of course, other land investors out there, but there is generally more land than there is competition, which means a patient, savvy investor can eventually source profitable opportunities if they’re willing to do put in the effort or find a knowledgeable partner in the local real estate market.

Important Terms to Understand for Land Investing

As contrasted to other forms of investment, land investing involves a range of terms that are unique to the sector. Following are some of the terms more commonly experienced in the land investment industry.

Air rights:

The area above the property or the surface of the Earth. Air rights allow you to use, rent, or build in this space without interference from others.

Ingress and Egress:

The right of a property owner to enter (ingress) and leave (egress) their property. In the absence of direct road access to a parcel, ingress and egress rights become especially pertinent to a property owner.

Mineral Rights:

For a given parcel of land, bundle of rights pertaining to the extraction of oil, gas, coal, metal ores, stones, sands, or salts, among other things.

Land Bank:

Entity organized for the purpose of helping to maintain and dispose of empty buildings, vacant land, or tax-delinquent properties so that they can be redeveloped for a different, more practicable purpose.

Parcel of Land:

A tract or lot of land, typically as specified by local government.

Subdividing:

The division of one or more parcels of land into a larger number of parcels, such that each region can be developed independently of the others, thereby enhancing the value, development potential, or space usage.

Water Rights:

Water rights are conferred when a body of water, such as a stream, spring, lake, river, gulf, or ocean is immediately adjacent to the land. These rights, also referred to as littoral rights, permit the owner of the land to use the area of water as long as it does not affect those upstream or downstream.

Zoning:

Rules or regulations established by local government organizations that dictating the types of activities permissible on a specific property.

Zoning Variance:

A request for an exception from the existing zoning ordinance.

The Basics of Land Valuation

Land value can be calculated using a number of different methods. Some seasoned real estate developers have developed the ability to estimate land value off the top of their heads with a relatively low margin of error. We’ll let their track record speak for itself. The most popular methods, however are described below.

Before we get into the strategies, keep in mind that the selling price of real estate includes the cost of the property as well as the cost of the improvements, particularly the buildings. This is typically not reflected in the closing statement, which will usually only stage the final closing price. This can be further complicated on some commercial transactions when there is a value assigned to a business changing hands along with the real property.

With that in mind, we will take a look at some of the more commonly employed land valuation methods.

1. Assessed value

The appraised land value is the amount that the government assigns to a piece of property in order to calculate property taxes. The calculated value is an estimation based on current market conditions, it should act as a fair estimate.

Remember that the county will be familiar with zoning, master plans, and so on. As a result, their valuation approach is based on more reliable qualitative and quantitative data.

If you paid $200,000 for a property and the assessed value is $160,000, which includes $40,000 for land and $120,000 for improvements, it is reasonable to assume that the value of land is 25% of the overall value. Since land will be worth $50,000, or 25% of the total value, the annual depreciation cost on improvements will be based on the remaining $150,000 of the purchase price (75 percent of $200,000).

2. Appraised value

Banks are an integral part of the real estate investment process and their business model is dependent on accurately assessing the existing the security of their funds by determining the existing and improved values for commercial properties. As a result, they are professionally motivated to be as precise as possible when it comes to mortgage valuations, so the financing process will always include an appraisal conducted by a qualified appraiser.

By way of example, on a property that was purchased for $400 thousand and receives a bank appraisal of $500 thousand ($400 thousand for the improvements and $100 thousand for the land), then it would be fair to conclude that the land value is equal to 25% of the total value of the property. This is important as it relates to depreciation, since the starting point for this figure will be the value of the improvements, in this example $300 thousand.

3. Replacement value

Insurers play many roles in the real estate process, however most of us interact with them through the property insurance process. Prevention of losses on their part is very much dependent on accurate determination of the replacement cost of a house when determining the premium required for a policy.

The replacement cost is the cost of replacing the improvements on a property with new ones if an incident occurs that essentially condemns the structures. If you paid $500 thousand for a property and the replacement value for the improvements is $350 thousand, the land has an estimated value of $150 thousand, or 30 percent of the total value. In this case, depreciation would be calculated using the $350 thousand in value attributed to the improvements. Land is not considered when calculating replacement value.

Choosing a Land Valuation Method

Each method of determining valuation has a different basis and each may be justified or even required by fiduciary or legal requirements depending on the specifics of each situation.

The selection of a particular method may also change depending on the outcome desired, such as the need to benefit from depreciation or goodwill. When in doubt, seek the advice of a competent tax advisor and/or an attorney with real estate expertise.

Strategies for Purchasing Land

Buying land should be predicated on serious assessment of the outcome desired. Obviously, many investors will approach this from many different directions, as there is no single approach that will or even should work for everyone. It would not be unusual to expect different investors to approach the same piece of land in very different ways. Likewise, the same investor might approach two separate plots of land from two different perspectives.

The following are some of the more common strategies when buying land:

1. Buy and sell

This approach is very similar to the concept of flipping, inasmuch as you are working under the assumption that you can or will pay less than market value for the land and can then find a buyer willing to pay at or above market value. The approach assumes that there will be no improvements or holding costs.

2. Buy and hold

This strategy involves purchasing land and keeping it for a period of time. You assume the land's value will rise over time. During this time, you will absorb expenses associated with the asset, such as taxes on the property as well as any extra costs associated with its upkeep. This tends to work well in gentrifying neighborhoods, typically resulting in the investor selling to a developer as the area grows in popularity.

3. Buy, develop, and hold

In this strategy, the investor buys a piece of undeveloped land with the goal of developing it yourself. You might, for example, build a self storage facility that you will manage and rent to customers. This is also a popular approach for developing small multifamily developments.

4. Buy, cultivate, and hold

For those that may want to use the land for agricultural or silvicultural purposes, this approach provides an alternative to building property on the land. Actively managing the land in this way allows the investor to profit off of the ownership the property and possibly qualify for some additional tax breaks.

5. Buy, go through the entitlement process, and sell

This scenario involves adding value to land through the regulatory process. Often, an investor will buy, or even just control, an asset, then go through the process of having the property zoned for a specific use. For example, a specific plot may presently be zoned for single family residential, but as the area around it has developed, it has become suitable for a mixed-use building with multifamily and street level retail. Rezoning the land would make the land immediately more valuable to developers with no dirt being moved by the investor.

6. Buy, develop, and sell

This strategy has become common for both industrial and self storage in recent years. Developers skilled at site selection with the capital to develop the site and possibly lease it through stabilization will sell their improved real estate to investors seeking the income generating assets.

7. Buy, develop, and rent

Finally, you might develop the property with the intent of renting it out to others. This requires a careful assessment of demand. Some areas where this may be successful are parking lots and warehouse space.

Risks to Consider When Buying Land

Zoning Classification

When purchasing property, one potential hurdle you can face relates to the zoning restrictions affecting how the land can be used. Land-use plans developed by each municipality divide the land into various zones, such as commercial, residential, agricultural, manufacturing, historical, or mixed-use, each of which may be subject to specified allowable uses and other restrictions. Adjustments to the way the land is zoned will often require the approval of multiple governmental boards, as well as being subject to citizen input. If the proposed changes are compatible with land-use plans, the pushback may be minimal, otherwise your mileage may vary considerably.

To get the land reclassified, you'll need to file a petition with the municipality. Many towns would require you to demonstrate that there has been a significant improvement in the area that justifies the zoning change. You must apply a plan for what you want to construct on the site. You must demonstrate that the project is consistent with the town's current land development plan and that it will have no negative consequences, such as flooding surrounding areas or increasing traffic.

To get the land reclassified, you'll need to file a petition with the municipality. Many towns would require you to demonstrate that there has been a significant improvement in the area that justifies the zoning change. A public hearing will almost certainly be held. Even if you can persuade the town or county council to get behind the proposed change, you may face a separate battle with vocal citizens that may be adamantly opposed to the proposed plan.

Zoning Restrictions

The size of the development you will be able to create is another factor to consider when buying land. There would almost certainly be zoning criteria for the floor area ratio or the size of the structure you may build. Other factors to consider are:

Setback requirements:

These are typically codes stating that the improvements must be constructed a certain minimum distance from neighboring property lines. Included in this are the street frontage, the two sides, and the back. Any permanent structure must be constructed at least a certain distance from the property line. This can have particularly significant impacts on the potential profitability of narrow or shallow lots.

Lot coverage

This type of zoning code is designed to reduce the potential for flooding of adjacent properties by ensuring that a minimum perentage of the lot surface is available for the infiltration of surface water. Rain must be able to seep into the soil and not flood adjacent properties.

Floor area ratio

The total floor area is limited to a certain percentage of the lot size, which is determined by each municipality and calculated by adding the square footage of each floor of the building, then dividing by the lot size. This may or may not include basement square footage.

Height

You must know the maximum height of the structure you can build. If you wanted to build a three-family house but the town won't let you build more than two stories at that site, you won't be able to afford it.

Accessory buildings

Zoning restrictions will typically limit the size and location of structures such as garages and sheds. Related to this, code provisions may dictate the number of parking spaces available based on the size of the property and may also mandate that these areas be covered or include parking for disabled persons or bicycles.

Environmental Issues

A potential buyer of raw land should always be ware of the potential issues lying beneath the surface of the earth. Prior land uses, or even natural contaminants, may have rendered the parcel unsuitable for construction. There are geological concerns as well and if you build on unstable land, the foundation could be at risk.

The property must also be evaluated for floodplain considerations. There may be options to address floodplain issues, however they can be expensive and one must consider the eventual ramifications for end-users or future buyers. There are certainly exceptions, though, where large swaths of land fall within a floodplain designation yet remain extremely valuable to existing owners and future developers.

Access to Utilities

Access to utilities is an important consideration. This may include sewer, running water, electricity, coal, telephone, cable, and the internet access.

Land without access to the public sewer system can have a percolation test performed on to see if the soils are suitable for a septic tank. This test will determine the speed at which water drains through the soil. Water in these areas will most likely need to be supplied by a well, which can be a fairly significant investment in most areas.

The cost of bringing these services into your property can be substantial and the inability to gain access to necessary utilities could have devastating implications for a potential development.

Cash Flows One Direction

One of the concerns with purchasing raw land is that it is not generating income. It typically requires a significant cash outlay, since the asset will not be producing income, so there is lost opportunity for that cash to produce income elsewhere. There will also be expenses on the land, such as taxes and maintenance or upkeep.

Land Real Estate : Your Next Steps

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