Knowing what a piece of commercial land is worth will help you avoid overpaying for it. Here is your complete guide to understanding how to conduct commercial land valuation.
“Price is what you pay, value is what you get,” said Warren Buffett. Though he made this statement in relation to stock investing, it also applies strongly to commercial real estate investing. Knowing how much commercial land is worth is crucial to the success or failure of any investor.
Pay too much for a commercial property (be it multifamily, retail, office space, buildings, retail, etc.) and you may be on the road to losing money; pay what correlates to its true (or intrinsic) value and you will be on the road to wealth.
But determining how much commercial land is worth is hard. Different methods will yield different values and even the same method, applied by different people, can also produce dissimilar results.
In what follows, we will examine what land value is all about, the various methods to calculate it and how investors can use these calculations to ensure they are getting good value for their investment.
We’ll cover:
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Investopedia defines land value as “the value of a piece of property including both the value of the land itself as well as any improvements that have been made to it.” Zolo, a real estate listing website, lists better access and drainage as examples of what constitutes improvement to a land.
The value of a land is to be distinguished from the value of the property that has been built on it. This is because the property can lose value at the same time that the land is gaining.
The former can happen if the demand for the property reduces (for example, the demographics of a community can change to the extent that an amusement park becomes irrelevant) and the latter can happen if the demand for the land increases (it is the perfect land for a new commercial use – such as a new warehouse, for example).
This is why many investors buy properties and demolish them so they can use the land for something else. In these scenarios, the land value is more important than the property value.
There are several factors that will affect the value of a commercial land. Some of them include:
Land is often measured in acres. A standard acre is 4,840 square yards while a commercial acre is 4,000 square yards or 83% of a standard acre. This difference accounts for “aspects of the [commercial] property the owner cannot modify, such as alleyways, sidewalks, and roads,” according to Clever, a network for real estate buyers and sellers.
Alternatively, land can also be measured in square feet, where an acre of land is 43,560 square feet. If we follow the above definition, then a commercial acre will be 36,154.8 sq ft (83% of 43,560).
Land value can be expressed as a whole or as a dollar amount per acre or yard or square footage. For example, if the total value of land owned by Mr. Ben is $120,000 and the land is 6 acres, we can also express the value as $20,000 per acre or $30 per square yard or $0.55 per square footage.
Knowing how much is commercial land worth per acre (or square yard or square foot) is helpful for comparison between lands of different sizes.
Now that we know the factors determining the value of land, let’s consider how much is commercial land worth.
The same valuation methods that can be used to determine the value of a commercial property can also be applied to commercial land. These include:
A sales comparison (sales comps) approach involves checking the average price or market value of similar land that is currently listed or has been recently sold.
This method will work well if the comparable land has the same characteristics: location, size, shape, environmental risk, and the other factors considered above.
Where land is not comparable in this way, there might be a need for a downward or upward revision to reflect this fact.
For example, if the land that was recently sold for $100,000 is closer to many amenities and the land being valued is not (and they are the same in all other respects), the latter’s value must be revised downwards from $100,000.
On the contrary, if the land recently sold for $150,000 has environmental risk but the one being valued does not, then the latter can be revised upwards from $150,000.
In essence, the value of commercial land = market price of a comparable land + (-) adjustments for differences.
Source: Research Gate
Given the complexities, many investors find it more convenient to outsource the whole valuation process to expert appraisers.
With this approach, the value of the land is its historical cost (how much it was bought for) + the cost of any improvements made on the land (including structures) – depreciation.
To take an example, suppose a large tract of land was purchased for $900,000. Suppose also that a total of $600,000 had been spent to improve the land and depreciation is estimated at $60,000.
In this case, the land value will be $900,000 + $600,000 - $60,000 or $1,440,000.
Source: James Colin Campbell
While the other approaches are directly useful to the investor (buyer), this one can only be used by the owner of the land. Only the owner of the land knows the purchase price, the cost of improvements, and a reasonable depreciation.
When putting the land for sale, the owner will typically add a profit margin to this value to arrive at the selling price (which is the price the buyer will see).
The income approach focuses on the net income that the land can earn.
If the land is currently rented out, the net operating income is the rental income minus any operating expenses incurred by the owner. If the land is not rented out, the rental income of similar land can be used for the valuation (similar to the sales comparison approach).
Recall that the formula for the capitalization rate is net operating income divided by the current market value. In this case, the current market value is unknown and it is equal to the net operating income (NOI) divided by the cap rate. (Market value = Net operating income / capitalization rate)
Source: WallStreet Mojo
The owner (or the party interested in the valuation) can assume a capitalization rate (rate of return) that will be appropriate for this type of land (cap rate typically ranges from 4% to 12%) or check the capitalization rate of similar lands that have just been sold.
Let’s take an example. Suppose a large tract of commercial land has a net operating income (from rent) of $50,000. If the appraiser assumes a capitalization rate of 5%, the market value is $50,000/5% or $1 million. Suppose the cap rate of a similar property that has just been sold is 7%, then the market value of the property is $714,285.
The gross rent multiplier (GRM) is the property’s value divided by the gross rental income. This formula can also be rewritten to make the investment property’s value the unknown, where it is equal to the GRM multiplied by the gross rental income (GRM * gross rental income).
Source: WallStreet Prep
We can use this same formula for our land valuation. Here, the land’s market value = GRM * gross rental income.
Assume that in the previous example the gross rental income is $60,000 and the operating expense is $10,000. Also, assume that the GRM for this property based on comparable ones is 5 (GRM typically ranges from 4-7).
In this case, the real estate value will be $60,000 * 5, which is $300,000.
Again, remember that we can rewrite all these values given the different measurement standards we have considered. If we want to know how much is an acre of commercial land worth, we can divide the total value (as given by any of the methods above) by the number of acres. And we can do the same on a square yard or square foot basis.
The goal of investors is to ensure that they buy good properties at good prices. And the only way to know if a price is good is to compare it with the value of what is being sold.
Suppose Investor A has valued a piece of land at $800,000. However, the owner of the property insists on selling it for $1.6 million. If Investor A goes on with the purchase, they have agreed to pay a 100% premium on the true value of the property.
Is such a purchase worth it?
If the investor is sure that the $800,000 is truly reflective of the property’s value, then the transaction does not make sense.
But defining what is truly reflective of the property’s value is not simple, as we have seen. Is that based on the sales comparison or cost or income or GRM approach? Perhaps it is better to take an average of the values from each approach or outsource the whole process to professional valuers.
In any case, calculating land value is still an important part of the investment process. It provides a rough guideline that investors can use to evaluate investment opportunities and ensure that they are getting value for their money.
Of course, there will be times when supply and demand will force investors to pay a premium but, generally, the land value will provide a reasonable limit beyond which they must not be willing to go.
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