How Comps Skew Residential Land Value Expectations
The “comp” or comparable sale is everywhere in real estate. When people list their homes for sale, they rely on the data from recent sales of similar homes to arrive at a price for their home. Square footage, lot size, the number of bathrooms, and more are all taken into consideration when making comparisons. A similar process occurs for commercial transactions, i.e. apartment buildings, office buildings, shopping centers, etc.
Following the comp logic, one need not look further than recent sales of similar plots of land when valuing land, right? Not exactly. When it comes to valuing residential land, comps are no more than a starting point.
Unfortunately for landowners the comp can be very misleading. With homes and even apartment buildings you can get a rough idea of value using comps, but blindly using comps to value land can lead to huge disparities between real and perceived values.
Land value is based on the potential use of the land, not the land itself.
The potential value is based on potential revenues which you can find from home sale comps. Often though, this is where huge disparities between the perceived and real value arise. Using only comps (from home or land sales) fails to recognize that the value of land also depends on the cost of those potential revenues. The cost of revenues is unique to every deal and that’s where relying on just comps gets dicey.
The price paid for land is based on cost assumptions that, without expert knowledge, are very difficult to estimate. The comp’s price does not tell you, among other things:
- Direct building costs
- Permits & Fees
- Intract Improvements
- Backbone Improvements
- Profit Margin
Building costs rise or fall constantly. Cities offer fee credits, raise fees, and implement new fees all the time. Laws change. Some deals require offsite improvements or extensive grading. Different environmental studies may be required. Side deals may need to be made to appease interest groups.
Also, due to the complicated nature of these transactions, many land sales involve different deal structures that influence the ultimate sales price. For example, a developer may opt for a deal structure that involves profit sharing, or the developer may offer flexible terms, taking on extra risk to pump up the sales price. These factors add, or remove from the number that shows up as a comp.
Knowing that the fifty lots on the other side of town sold for $50,000 per lot might be useful, but you don’t know without the proper context.
How much did those lots cost to complete? Were there view premiums? What kind of architecture did the city require? Did the buyer have to build a new traffic signal? A comp raises more questions than it answers.
To solve this problem, land experts use something called residual land analysis. It sounds fancy, but it’s as simple as estimating the revenue generated from a home sale and subtracting the cost of building that home.
This method, unlike relying on land sale comps, forces analysts to treat each new deal as it is: a unique piece of land with distinct opportunities and challenges. Like any analysis, the accuracy of the estimate relies on assumptions that are put into the equation. This is where the expertise of professionals and extensive research come in.
Land professionals can give you a rough estimate using a residual analysis. But the assumptions must be refined over the life of the project as new information comes in and starts to answer the questions above.
Residual analysis is an iterative process that assimilates new data to come up with the most accurate value as opposed to relying on comps which rely on old and incomplete data.
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