Land development is one of the riskiest fields in real estate, but it is also potentially one of the most lucrative. The risks involve significant up front capital expenditure and a long time horizon. Furthermore due to the high levels of capital involved it often takes years to breakeven and all of your profit is made on the back end.
However due to the speculative nature of land development that profit can be significant. One of the biggest challenges in land development is simply knowing what you are buying.
It sounds simplistic but figuring out what you are buying can be very challenging, especially if you are purchasing a distressed development that has either significant debt or finished lot inventory.
When you begin working on a potential deal, the first step is to figure out whether you are buying the physical assets or the entities that own the assets. If you are buying the assets then things are a little more straightforward. Buying the entities can make the deal a little bit hairier. If you are purchasing the entities you are also purchasing their legal obligations and debt obligations.
In many failed developments members of the homeowners association sue the developers for not delivering on their promised amenities. These legal obligations can run into hundreds of thousands of dollars so it is crucial that you have a grasp of what exactly the potential liability is. The last thing you want is to purchase the development and lose 150 basis points of return on settling legal cases.
However you can get unexpected streams of revenue from the entities. We recently looked at a deal where one of the entities we purchased was a realty operation. For each lot sold to a retail consumer, the realty operation received one percent of the cost of the house built on the lot. There were over two hundred lots sold that did not have houses on them. We had underwritten average construction costs of several hundred thousand dollars per house. Since many of the amenities had not yet been built, many of the lot owners still wanted to build but they were waiting for the development to be sold so that there would be more clarity as to when the amenities would be put in. Therefore we essentially would be getting free money when the houses were built. This added a significant amount of value to the deal for us.
Another potential complication is the purchase of strategic outparcels. In some failed developments, investors will purchase paper lots at distressed prices and hold them waiting for someone to purchase the entire development which will significantly increase the value of their lots. The loss of some of your best lots can be very dilutive to your returns so during your research it is important to factor that into your valuation of the deal.
The most important part of land development is finding a choice piece of land, but the work only begins there. Often the baggage that comes with the land can make or break your deal so as you move forward with modeling the deal and doing research, make sure that you know exactly what you are buying.
