Finance Focus April 2008, by Steven Cole

I was recently asked, “What are land values today for tracts of residential subdivision land?” and “How do appraisers value such properties in a market with few transactions of this type of property?”

The answer to the first question is that appraisers must reflect the current actions of buyers and sellers in the market. To the extent that they anticipate the future, so must our appraisals. Often, brokers and lenders think that appraisals are historically based because appraisers use closed transactions of comparable sales in order to deduce an opinion of market value. That works when a market has stable prices. However, when prices are moving rapidly either upwards or downwards, looking backwards simply doesn’t work. In estimating market value, it is always the assignment of appraisers to accurately and competently interpret the market in order to arrive at an appropriate opinion of value. Appraisers who unthinkingly apply the three approaches to value are not doing their jobs.

Most real estate professionals know that there has been a historic change in land values in the last few years. From 2003 through the first half of 2006, prices of vacant land increased dramatically. The value of land is primarily a function of demand since additions to the supply of entitled residential property can take years to achieve. Demand for any asset is always greater when individuals believe they can make a profit by purchasing it.

It is also true that variations in land prices are much greater than the variation in prices for homes. Indeed, prices of land entitled for residential development increased much faster during the height of the real estate boom than did prices of houses. Unfortunately, there are few reliable measures of changes in vacant land prices. Typically, appraisers rely upon the sale and resale of the same property. Such paired sales can be difficult to find. Thus, measuring the increase or decrease in the prices of residential land is most often based on anecdotal evidence.

Nonetheless, the increase in the price of housing is well documented. For example, in Tucson, according to Multiple Listing Service (MLS), the average price of a single-family residential property in December, 2004 was $228,150. In 2005, the average price was $270,625, an increase of 19%. By December, 2006, the average sale price had increased to $295,044, an increase of 9%. By December, 2007, the average sale price of a single-family residential property had decreased to $277,020, a drop of approximately 7%. During this same period, it is my opinion that land prices went up far more dramatically than the increase in the price of housing, and, more importantly, they have now come down far more dramatically than the decline in prices of homes as the current demand for vacant land has evaporated.

Since the middle of 2006, when the Federal Reserve Board announced it would increase interest rates in order to slow the rampant speculation in housing, most local investors have recognized the residential land market is not what it had been in 2005. The larger variation in the prices of land than in houses reflects the higher risk associated with land. Buying land is similar to buying a technology stock on the NASDAQ versus purchasing a blue chip in the Dow Jones Industrial Average. It is a mathematical truth that can be measured that the variation in prices of these technology stocks varies more greatly than those of the blue chip index. This higher variation in prices is referred to as a higher “beta.”

To assume a higher risk, a higher return is required by investors. Local banks and financial institutions are far less likely to loan money secured by vacant land than for buildings. Indeed, the lowest risk and, therefore, the lowest interest rates are for single-family homes. Land loans from financial institutions can only be acquired in platted residential subdivisions and then only for a short period of time, like five years. The loans sometimes come with the expectation that the borrower will be building a home. Similarly, acquisition and development loans, or A&D loans, are only available from financial institutions when there is an expectation that the properties will be developed within the next two to three years.

All of this leads to the conclusion that, in a weak market, land values will decrease in value far more rapidly than those for single-family residential homes. This conclusion is supported by market evidence. In the last twelve months the average prices in the Tucson MLS declined 7%, while the median sale prices decreased by 14%. These year-over-year declines are simply one measure of the change in home prices. Other measures are available.

The two methods of valuation of improved lots of residential land or vacant tracts are: 1) the Sales Comparison Approach and 2) The Subdivision Method. As most real estate professionals know, the Sales Comparison Approach is simply a methodology in which the appraiser investigates sales of similar properties and infers the value of the property being appraised from those sales, making adjustments for differences in elements that create value. Regrettably, there are few sales in the current market which can be used. There have been some large purchases of vacant land at prices that are approximately 40% to 50% below the replacement cost of those lots. There have also been smaller transactions involving rolling options which are not truly representative of the “as cash” value of a bulk purchase of existing lots.

There have been even fewer sales of unimproved lots. The lack of sales in both of these types of properties, I believe, is a reflection of the fact that most investors hope to hold on to their properties until the market price improves. The holding costs of these lots typically consist of interest payments to the bank as well as real estate taxes, insurance, and other less significant costs. Such costs vary from property to property but can be approximated at about 10% per year of the value of these properties when they were purchased or financed. If residential demand takes three years to return with vigor and the annual holding cost is 10% per year, then holding costs may be 30% of the former value. Investors, when faced with the alternative of selling these properties at a 40% to 50% discount, have largely chosen to hold their investment if possible. Those who are unable to maintain ownership may have put the properties into the bankruptcy courts which often take an extended period of time before such properties are placed on the market.

The second methodology used by appraisers to estimate the value of residential land is known as the Subdivision Method or Discounted Cash Flow Analysis. In this method, retail lot values are estimated. Then, operating expenses primarily associated with marketing are deducted. The result is an estimated net income per time period. These estimated incomes are projected over the estimated time period necessary to sell the property’s individual lots. Since those incomes will be received in the future, they are discounted back to the present by a present value factor also known as a risk rate. The sum of the present values of the income is the estimated wholesale market value of the lots. Please see the sample Discounted Cash Flow.

This methodology is considered particularly appropriate for improved lots or partially improved lots and is meant to reflect the thinking of investors. In my Discounted Cash Flow Analysis, I made projections which I believe to be reflective of the current market. First, I reduced my estimated rate of sales or absorption from the “hot” market to be more reflective of current expectations. Second, I have estimated an attractive retail price for the lots even though this may result in emotional distress to the owner. Thirdly, I have held my price appreciation for the lots constant for at least twelve months, then applied a rate of appreciation that is relatively modest by recent historical standards. I then subtracted the operating costs, many of which are tied to the estimated sale prices such as commissions, closing costs, and marketing expenses.

The sum of the net incomes to be derived in the future from the sale of the lots is then discounted by a lower risk rate or discount rate than has been typically employed in the past. For example, in recent years past, a discount rate of the high teens to the low 20’s was deemed appropriate. Now, that discount rate has been increased to reflect the greater perceived risk associated with purchasing real estate developments in the current economic climate.

Because there are a large number of assumptions in the Discounted Cash Flow Analysis, I then compare the discounted value of the lots to the sum of the net incomes before discounting to insure that there is an adequate difference to allow for entrepreneurial incentive. The estimates of market value through the Discounted Cash Flow Method are then compared and checked with whatever sales data is available. I also confer with real estate investors and brokers to gain their perspective of the marketplace.

This is not the first real estate recession which I have observed and I suspect it will not be the last. I have confidence, however, that in the long run Tucson real estate values will resume their upward trend. When strong demand returns to the single-family residential market, be assured there will be rapid appreciation in the value of residential lots and land.

Editor’s Note:
To download a pdf of the Discounted Cash Flow Analysis.

Steven Cole, principal of Southwest Appraisal Associates, a full-service, real estate appraisal and consulting firm, is an MAI designated appraiser and has been practicing as a real estate appraiser since 1975. He can be reached at 520.327.0000 or via email at steve@swaa.biz