In real estate development there are many reasons and ways to determine what a parcel of land is worth. It’s easy to figure out what a house in a neighborhood that has an abundance of sales activity is worth. We all start with the average sales price per square foot on recently sold homes in the same neighborhood. Adjust the per sq ft number up or down based on the level of finish (floors, counters, fixtures, etc.), amenities (pool, outdoor kitchen, 3 car garage) and precise location (backs up to permanent open space, views, away from heavy vehicular traffic).
It’s far more imprecise when considering the value of that neighborhood’s vacant land in the state when no development improvements had begun, and houses had yet to be constructed or sold. Appraisers are independent certified professionals who can offer an opinion of value on the land, your building, your house, or whatever else you need. They’re most often called in when you’re securing debt on property, from a construction loan to mortgage, or even the public financing options that I discussed in the previous blog post. Appraisers are hired by the group or institution that is doing the lending to provide some comfort that there is value in excess of the debt to be provided.
Appraisers are doing the same work as the county assessor and the underwriter for the developer who is trying to figure out what a piece of land is worth. There are two key ways to determine value on an undeveloped land parcel. Appraisers use discounted cash flow models or look for market comparables. In a perfect world they have both.
A discounted cash flow is a business model that shows the cash flows, in and out, over the life of the project. In real estate development the first big outflow will be for acquisition. Second, you’ll see outflows to design the project and obtain county or city approvals. Next, you’ll see outflows for construction of infrastructure and for the team to manage the process. Finally, you’ll see marketing outflows that ideally soon generate sales, and cash inflows.
The discounted cash flow (DCF) will take those periodic cash flows and discount them by a factor that incorporates the relative risk of the project, inflation, and bakes in the cost of the invested capital that is used to fund the costs. DCFs are strange in that the discount rate is negotiable but should be relatively similar to projects with similar profiles and life spans. Regardless, take all the cash flows in and out over time, apply the discount rate, and you have a present value of the project. The appraiser is generally going to start with the developer’s model since it’s presumed the developer has a reasonable handle on the costs and the market for sales.
In almost every instance the developer wants the appraisal or valuation to come in as high as possible. Except when you’re dealing with the county assessor, in which case you want their DCF to generate as low a present value as possible. Adjusting costs higher or lower, adjusting sales volume and pace, and tinkering with the discount rate will all drastically change a project’s value. Excel is the tool most everyone uses.
This just begins to touch on the art and science of valuation. There is a lot of gray area, but it can be critically important in determining if a project will get off the ground.
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