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I have just started investing in real estate and am looking at 4-families to start with. My agent has shown me probably 20 properties all over the city, and I can’t see how anyone makes money at the prices these things are selling for! My agent says that some of them are real bargains, because they’re listed for $10K-$20K below what other 4-families have sold for, but I just can’t make the numbers work. Am I being too conservative, or is everyone else overpaying?
S.M., Seattle. via email

The Truth About 4-Families

Many of them sell at a price where the purchasers will not see a dime in positive cash flow for 10 years or more. Why? In my humble opinion, there are several reasons. First, 4-families are very much in demand among newer investors who, in all honesty, don’t have the first idea how to properly evaluate cash flow. These buyers fall into the trap of determining the value by looking at what other people have paid for comparable 4-families to determine value, rather than doing a cash flow analysis to see how much money they’ll make at a particular purchase price. As a result, they pay what everyone else is paying—which, as you’ve already seen, is often more than one can pay and make any money!

Compounding the problem is the fact that many 4-families are sold by agents who also have no investing expertise. I’ve had many an agent “prove” to me that a 4-family is a good deal because it has a positive cash flow after mortgage payment, taxes, insurance, utilities, vacancy loss, and maintenance fees are taken out. What they don’t seem to understand is that, as the owner, I would also have to pay for extermination, evictions, mileage and wear-and-tear on my car, bank fees on my business account, accounting fees to keep my taxes straight, turnover and advertising costs associated with those vacancies, and the all-important replacement reserves for items that wear out slowly, such as boilers, roofs, and so on. When I show an agent that my real, true-to-God expenses on a particular building will outstrip income by 25% or more, they invariably tell me that I’m exaggerating—after all, the CURRENT owner makes money hand over fist! (Sure he does—he paid $20,000 for the building in 1954!)

Another reason for the gap between selling price and price at which a buyer could make money is that 4-families seem to be a favorite of super-conservative investors, many of whom pay all cash or a very hefty down payment, and, as a result, are able to get cash flow out of even the most overpriced properties. Think about it: if you didn’t have a mortgage payment on these properties you’re looking at, would they make money? Of course! Would they make a decent return on your investment? Heck no! But some investors aren’t looking for double-digit returns; they’re looking for an attractive, easy-to-manage property where they can sink their money and get a (more-or-less) guaranteed return.

My suggestion is this: leave the 4-families to the under-educated and over-conservative, and focus on the slightly larger properties that small investors like yourself can both afford and actually make money on. Five to 12 unit buildings give you the benefits of size plus eliminate the competition from over-paying amateurs and the better-funded corporate investors (who want much larger properties. And as an added bonus, it’s much easier to negotiate owner financing on these properties!
Good luck.

How do you know what an income property is worth? How do you know that if you pay X amount for a property that you can get the return you desire on your investment? Is there some way to calculate the maximum you can pay for an investment and still achieve your investment goals? Do you know how to get the answers to these questions? This article is written to give you a valuable tool to use in answering the critical questions regarding the value of an income property.

Among the many tools used by investors to gauge the worth of an income property, one of the most popular is a capitalization rate, aka cap rate. But as it is typically used, it is probably the one most misused concept in the real estate investment business. While brokers, sellers and lenders alike are fond of quoting deals based on the “cap rate”, the way it is typically used they are really shortcutting the true use of a valuable tool.

The typical way a broker prices a property is to take the Net Operating Income (NOI), divide it by the sales price, and voila!, there’s the cap rate. Example: Say the property has an NOI of $125,000, and the price is $1,125,000. Then

$125,000/ $1,125,000 = 11.1% cap rate.

But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it show?

What the cap rate represents as used above is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt). Then we calculate the debt service, subtract it from the Net Operating Income, and then calculate our return. If the debt terms change, or loan to value, or our return requirement, then the whole calculation has to be performed again. That’s not exactly an efficient use of time or knowledge.

Brokers are also fond of quoting a “market cap rate.” This is an effort to legitimize an assumption, but it is flawed in its source.

As a comparison tool it is almost impossible by any means to find out what other properties have sold for on the basis of the cap rate. In order to correctly calculate a cap rate, and get an apples-to-apples comparison, we must know the correct income and expenses for the property, and that the calculations of each were done in the same way as will be explained below. This information is not part of any public record. The only way to access the information would be to contact a principal in the deal, and that just isn’t done because the information is generally held in the strictest confidence. A broker may have the details pertaining to several deals in the marketplace, and with enough information about enough deals the information may rise to the level of a market cap rate. But very few brokers are involved in enough deals in one market to have that much information. So the conventional wisdom becomes a range of cap rates for property types, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements.

So what do you do when you’ve found a property that looks promising, and the broker tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing? For years I would immediately jump in the car, go take a look, and then start crunching numbers making assumption after assumption to arrive at some estimate of value. The truth is I was guessing. I wasn’t looking at the right numbers, and I spent a lot of time guessing. There is a better way. It is not a magic bullet, but it does give an investor a powerful tool to use in gauging value.

What’s it Worth to YOU?
The real question in valuation is not how much I, or any other investor, or even an appraiser value a property at, nor the value from a cap rate estimated in the market, but rather the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis. I can give you a tool that will give you that answer. I promise you if you learn how to do this it will give you a leg up on 90% of the brokers and investors out there.

First, we have to become conversant with the terminology.

Critical to this calculation is that the NOI (Net Operating Income) is figured consistently with industry norms. The generally accepted definition of NOI is:

Gross Income – Operating Expenses = NOI

Please note that the operating expenses do not include debt service, or the interest component of debt service.

Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.

On the expense side, normal due diligence includes verifying with third party suppliers as many of the expenses as possible. Care must be taken in evaluating the operating expenses to uncover any anomalies that may exist under the present ownership. Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as “office expense” or “professional fees” or “auto expense” may or may not be property specific. In short, before accepting the NOI presented, effort must be made to understand what is behind the numbers. This is known as “normalizing” the numbers. You can also tweak the numbers to reflect the way you will own and manage the property. No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOIs, and two widely divergent values, and both are right.

That’s why appraisers use comparable sales, replacement value and the income approach as part of a three-pronged methodology in estimating value. They are charged with making the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market. The third method, the income approach, is usually given the most weight. That method is also known as the “band of investment” method of estimating the present value of future cash flows. That method addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.

Deriving Your Cap Rate

After I am reasonably certain that the NOI is accurate the best way to get an initial value indication is to use a “derived” capitalization rate. That requires two more pieces of information. You have to know the terms of financing available to you and the return you want on your investment. We can then use these terms for both debt and equity to indicate the value at one precise point in time–the instance of when the operating numbers are calculated–to derive the cap rate that reflects those terms. (The value in future years is another discussion.)

Deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.

The Bank’s Return: the Loan Constant

Let’s start with the finance piece. We need to know the terms of the financing available, and from that we can develop what is known as the loan constant, also called a mortgage constant.

The loan’s constant, when multiplied by the loan amount, gives the payment needed to fully repay the debt over the specified amortization period. IT IS NOT AN INTEREST RATE, but a derivative of a specific interest rate AND amortization period. When deriving a cap rate, one must use the constant since it encompasses amortization and rate, rather than just the rate. Using just the interest rate would indicate an interest only payment and distort the overall capitalization process.

The formula for developing a constant is:

Annual Debt Service/Loan Principal Amount = Loan Constant

You can use ANY principal amount for the calculation, then calculate the debt service and complete the formula. The constant will be the same for any loan amount. For example, say your bank says they will generally make an acquisition loan at a two points over prime, with twenty-year amortization, with a maximum loan amount of 75% of the lower of cost or value.

Say prime is at its current 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator or loan chart, find the payment for those terms. On a loan for $10,000, the annual debt service required is $894.72. Divide that by $10,000 to find the constant.

894.72/10,000= .08947

Using these terms, the loan constant for that loan would be .08947 (I usually round to four or five digits… depending on the level of exactitude desired, you can use as many as you like.) The answer will be the same if you use $100,000 or any other number as the principal amount. (One hint though: do not use a principal number with less than five digits, because the rounding will affect the outcome.)

You might note here that the mortgage constant is basically the lender’s cap rate on his piece of the investment. Both the mortgage constant and “cash-on-cash” rates for equity are “cap” rates in their basic forms. A cap rate is any rate that capitalizes a single year’s income into value (as opposed to a yield rate).

Your Return: Cash-on-Cash Return
The next step is to provide for the return on the equity.

Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%. The “cash-on-cash” rate is also known variously as the equity dividend rate, equity cap rate, and cash-throw-off rate. It represents the “cap” rate to the equity position, and to be consistent we will call it the equity constant. If an investor puts in $30,000 and requires a 20% pre-tax return, then his annual cash in the pocket after paying the mortgage (but before income taxes) would have to be $6,000.

In this case, the equity constant is .20.

Put It All Together: Weighted Average

Each of these cap rates is then weighted based on the loan-to-value ratio of each of the debt and equity positions to build the “overall cap rate”. The formula looks like this:

(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant) = derived cap rate

To finish the example, using the mortgage terms given above, and the desired 20% cash on cash return, the following would be the “overall cap rate” with a 75% loan-to-value on the debt component:

(.75 x 0.08947) + (.25 x 0.20) = .1171
or
.0671 + .05 = .1171

To convert to a percentage, move the decimal two places, and therefore, under the stated conditions, the required cap rate for the property (income stream) is 11.71%. Using the normalized NOI figure, then the indicated value is calculated with this formula:

NOI/Cap Rate = Maximum Purchase Price

For the original deal above, the value would be calculated thusly to attain the desired return:

$125,000/11.71% = $1, 067,464

The asking price of $1,125,000 is very close (within 10%) to the indicated value of $1,067,464. This is a deal that would definitely be worth taking a look at. Had the deal been priced at a 10% cap rate, or $1,250,000, then I might still take a run at it since the indicated value is within ten to fifteen percent of the asking price. In a normal market, California aside, most sellers do not expect the property to sell for the asking price.

Not a Magic Bullet

Now please note that I said at the beginning that this is a starting point. It is not the end-all-and-be-all of valuation, nor should it be. That doesn’t exist.

Many factors can influence the value of an income property both up and down. Some of the most important include deferred maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and local market conditions. These factors speak to the relative risk and effort involved in the continuance of the income stream. As risk or effort increases, so does the investor’s required return on equity. Increase the required equity return and the cap rate changes, and so does the value. At this point you literally write your own paycheck.

This is a powerful tool if understood and applied correctly. Play around with some alternative scenarios of returns, loan terms and rates, etc. and you will see the effect of changing different parts of deal structure. You should also now see why it is so critical to verify EXISTING income and expense BEFORE establishing value. This little exercise also shows why I harp all the time on no two investors coming up with the same value for the same property.

DO NOT however, use this as a “magic bullet”, and stop your analysis after the calculation. I cannot stress enough the importance of performing thorough due diligence in commercial income properties. That alone is what determines the difference between being a true “investor”, and the next “don’t wanter” seller.

My thanks to several people who posted valuable input on the commercial newsgroup at CRE Online. They include Paul Ness, MAI, Jim Rayner, and Jerry Menke.

The topic of pre-construction investing has rapidly gained popularity in our real estate investing community. The reason it has gained such popularity is because pre-construction investing offers some unique advantages that other types of real estate investing simply can not offer.

Pre-construction investing is exactly what is sounds like…locking up a property when it is pre-construction. In other words…the property has not been built yet. Currently the parcel of property is nothing more than a piece of vacant land. Then, over the next 12 to 24 months, the piece of real estate is constructed. During that period of time, there are things that happen. It is these unique occurrences that make pre-construction investing so desirable. The thing that makes pre-construction the greatest of all, is when it is done in the emerging market. I invest only in the emerging markets. More on that in a moment.

When a Property Is Pre-Construction, It Comes at a Lower Price

The very first thing that happens is that a pre-construction investor is able to lock-in the price on his property at a price that is lower than what the price will be after construction has been completed. As a development gets completed, the prices continue to increase from one phase to another.

During the Build Cycle, Appreciation Increases Value

In addition to our price increase on the front end, values also increase in another way. I only invest in two types of markets, (1) A market that is currently appreciating, (2) A market that will soon be appreciating. By only investing in the right markets, I have added an additional profit center to my investing…appreciation. While the property is being built, it is also appreciating in value.

No Payments Are Required During the Build Cycle

When a property is pre-construction, in many cases no mortgage is required. And if no mortgage is required, you got it…no payments are required. The construction is being completed with the developer’s financing. You would not need to obtain a mortgage until the property is completed, and if you want to hold the property long term. Many pre-construction investors sell their property before that point, and do not need to qualify for a mortgage at all.

When the Property Is Completed, We Have Locked-In Equity, and Also a Piece of Brand-New Construction

By obtaining a discounted price on the front end, and also appreciation during the build cycle, we have set ourselves up for success. By the time the project is completed we have obtained an equity position that allows us to profit as an investor. We also have the type of real estate that is easiest to sell…a piece of brand new construction. This further expedites our exit strategy.

As you can see, pre-construction investing offers some significant advantages that other types of real estate investing simply can’t offer. This is why so many real estate investors have one or two pre-construction properties churning away in the background while they also do their other types of real estate investing.

When pre-construction done in the emerging market, it is phenomenal way to invest in real estate. The emerging market is a market that is getting ready to appreciate, because of very specific factors that are getting ready to play out in the market. During our meeting with your group I will be discussing how I find these emerging markets and why they are such a powerful investment play. See you then!

The quickest way I know to make significant profits with commercial real estate is to do deals with substantial upside potential.
But first let’s define “upside”. I’m not talking about a paper increase in value due to scheduled rental increases, or replacing “below-market” leases, as many for-sale brochures define the term.

My definition of upside is to unlock hidden potential in a property that creates triple digit percentage gains on investment, provides positive cash flow along the way, and avoids major risks of loss. The upside may come from expansion, redevelopment, or by changing the market position of the property with major improvements.
How do you do that?

It boils down to three critical factors: the local market conditions; good structural bones; and a willing seller. When all three are present the deal is there for the taking, but only if the investor can design and implement the proper structure. The focus of this discussion will be in creating a structure to create and capture upside.

Market Is King

First and foremost is the local market. Regardless of property type, the first rule of real estate investing is we do not make markets—we serve them. A poor market will stop any plan dead in its tracks, so the first priority for any strategy is make sure the area demographics of population, income and employment are in a positive trend. Basic demographic research includes statistics for a three- to five-year period to show the trends. One year’s data is useless. To say a market had a 2% population growth in the previous year means nothing. But if the current 2% increase is up from 5% loss over the last five years indicates the market is turning and worthy of further investigation. With that knowledge we can be confident in seeking out the worst property we can find in a good location, because that’s where we’ll make the most money.

Good Bones

What we’re looking for is the things that can’t be changed being sound. We look beyond the cosmetics to the structural elements, such as foundations and basic construction of the buildings, the systems, and the grounds. If the structural elements are failing, then the property may not be suitable for turnaround without expending more funds than can be recovered. Aesthetics can be fixed.

Unless you are an expert in building systems, construction and environmental issues it is advisable to hire experts to inspect the relevant elements of the property. The cost is negligible when compared to the cost of fixing a mistake, or worse, not being able to fix it. Location is something else that can’t be changed. Don’t fall for the old sales line of “priced below replacement cost”. My first question is always “If given the chance to replace it, would I?” Understand the local market and how it works. A great deal in a bad location is not a deal… it’s a problem looking for an owner.

Seller Motivation and Deal Structure

The final question is to assess the seller’s willingness to help us solve his problem. There are a number of ways to accomplish that, and it takes some digging to get into the seller’s mind and discover his true motivations. Most commonly the property has existing debt. The seller may offer to finance part of the purchase price as a second mortgage. But the property can rarely support a new loan, and that requires the buyer to fund improvements from cash out-of-pocket. That’s hardly an attractive proposition, as the cash flow is usually not sufficient to carry the additional debt of the seller’s note and provide a return on the investor’s capital.

Typically the alternative is for the seller to greatly reduce the price, even below the amount of current debt, or accept a subordinated note with no payments. With those options many sellers will opt to keep the property rather than take the risk for no money. The deal falls apart for lack of an alternative structure. The ideal structure would allow the investor to obtain new financing that includes the funds needed for improvements, the seller to realize some of the upside in return for staying in the deal, and designed so the property produces a positive cash flow. Can that be done? Yes it can, as the following example from my files demonstrates.

The Deal

The deal was a 54-Unit apartment complex, well-located in a great college-town market. The owner had let the property decline to the point that the performance had suffered tremendously. The expenses were high and the income unstable due to the poor condition of the property. The buildings needed new roofs, windows, kitchens, paving, heat pumps and new appliances. The existing NOI (net operating income) was about $145,000. The owner had existing debt of $950,000. The improvements were estimated to cost $350,000. The as-is appraised value (and the asking price) was $1,200,000, reflecting an as-is 12% cap rate. The projected value after the improvements was estimated to be $1,750,000, using the same NOI but a lower cap rate (8%) to reflect the completion of the capital improvements.

The Structure

We came up with the following deal structure: In lieu of down payment, the seller would get 20% equity-only (not profits) interest in a new LLC that would acquire the property. The LLC would obtain a bridge loan for $1,300,000 to pay off existing mortgage and fund the repairs.

The Plan

Our investment plan was to complete the improvements over a six-month time frame, and then raise the rents to market levels. In the first year we planned to complete the improvements and raise the rents for upcoming leasing season. No occupancy increases were projected, but the combination of higher rents and lower expenses were projected to significantly increase the NOI and cash flow. In the next two years it was expected that the occupancy would also rise to an average 97%, excluding collection and vacancy loss, further increasing NOI and cash flow. In the third year the LLC would refinance the property based on the increased income, and use the proceeds to pay off the seller’s LLC interest. At that point we would own 100% of the LLC interests and could either hold the property or sell at will.

The Result

The improvements were completed and the rents were raised $50-$75 per unit in the 1st year. Annual increases of $20 per unit were implemented in following two years. The occupancy increased from 90% to 98%, raising the NOI to almost $190,000, and the cash flow to $80,000. Now it was time to turn on the money pump. The property was refinanced with a $1,500,000 loan based on the higher value. We used $200,000 of the proceeds to pay off the seller’s interest and the LLC kept about $50,000. The loan was at a lower rate and longer amortization, so the cash flow actually increased to about $90,000. We held the property for two more years, and then sold it at a 7.6% cap rate on the next year’s projected net operating income of $186,200, yielding a price of $2,450,000.

Over the five year hold period the investment produced:
3 years cash flow @ avg. $80,000 = $240,000
2 years cash flow @ avg. $90,000 = $180,000
Refinance proceeds– $250,000
Equity at sale– $1,050,000
Total cash and equity $1,670,000
Less seller’s interest –$200,000
Total Gain–equity and cash $1,470,000

If you were paying close attention, you realize now that the deal was done with no money out-of-pocket from the buyer, but with none of the risks of over-leverage. This is a real deal. The sale was completed in April 2005 as a 1031 exchange. We bought a $3,000,000 office building with $1,000,000 equity, which also had upside potential, and from which we extracted $300,000 of tax-free cash equity after closing. We are now (2007) ready to exchange the office building for a $5,000,000 retail property from which we will extract over $1,000,000 of the equity in tax-free cash. This was an out-of-the-box solution that solved all the problems, produced significant upside, and created a money pump that keeps on going. This is how to build wealth in commercial real estate.

You may have heard all the buzz about the newest type of vacation home investment—condo hotels. These are condominiums located in four- and five-star hotels in cities like Miami and Las Vegas. Owners use their condos when they’d like. When not using their unit, they can place it in the hotel’s rental program and receive a percentage of the revenue it generates.

How do you choose a condo hotel unit that meets your desire for a vacation home and is also likely to produce a healthy revenue and appreciate down the road? Consider the following seven questions when evaluating a condo hotels:

1. Is a Condo Hotel Right For You?
Condo hotels are not your typical second homes. They are fabulously-furnished condominium suites in some of the most famous hotels and resorts around the country. The properties are usually large, high-rise, luxury hotels and come with premium amenities like valet, concierge and maid service. Prices can range from $250,000 to over $1 million for prime properties.

2. Is the Condo Hotel Well-Located?
Consider whether the property is located in a popular vacation destination, one that is likely to do a healthy tourist or business trade regardless of economic factors.

Also, you must be sure you yourself like the location. Does it offer you the ocean view or golf course access you always dreamed about for your vacation home? If you’ll be flying to this vacation home, how close is it to a major airport?

3.Does the Condo Hotel Have a Major Franchise?
The key to a successful condo hotel investment is the hotel operator. The better the operator and the franchise, the more likely the success of the property. A condo hotel with a name brand like Ritz-Carlton, Hilton, Starwood or Trump is likely to generate more revenue than a non-brand because it can charge higher room rates and benefit from international advertising and a centralized reservation system.

4. Will the Condo Hotel Receive Traffic From Any Nearby Attractions or Entertainment Venues?
A condo hotel that is near a convention center, a theme park or cruise port will benefit from proximity to these high-traffic venues.

5.Does the Condo Hotel Have Any On-Site Amenities That Will Draw Guests?
Such as a well-known health club, spa, fine dining restaurant or golf course? You’ll want to choose a condo hotel that has amenities you’ll enjoy using and also are a draw to attract hotel guests.

6. Does the Individual Unit That You’re Considering In a Condo Hotel Meet Your Needs?
Does it have enough bedrooms, enough square footage? Does it have a kitchen? (Some do, some don’t.) Does it offer an appealing view? Is it furnished to meet your tastes? Does it offer any owner storage?

7.Will the Condo Hotel Unit Appreciate?
While personal enjoyment should be your primary reason for considering a condo hotel purchase, it’s certainly worth thinking about whether the property you want has good appreciation potential.

Look at surrounding properties and area appreciation rates. Does the condo hotel have lots of competition? Is it different or better than area properties? How has the demand been since the property first came on the market? A realtor who is familiar with condo hotels and the area in which you’re looking can often help you determine if the condo hotel your considering has good appreciation potential.

If you understand how residential developers and builders make their buying decisions, you will be likelier to achieve success in buying or selling land. Some builders search for property strictly by geographic area. Others search for parcels that would enable them to reach particular buyer submarkets, such as housing type, price range, lifestyle and age group. Either way, they begin by casting the net into their areas or markets of choice and sifting through potential acquisition candidates. They often have to pick through dozens of properties before they find one they think they can develop profitably and frequently spend varying amounts of time, effort and money collecting information before they even know if the parcel will work. Their due diligence focuses on obtaining answers to five fundamental but critical questions:

What can I build?
How many can I build?
What can I sell them for?
How long will it take to sell them?
What are the costs?

These questions collectively define economic feasibility and influence every decision developers and builders make – from their initial contact with the property, during negotiation of the contract with the seller, through subdivision approval, to the day of closing and beyond.

How do you estimate the value of land for residential development? For starters, you should never price it by the acre or even think of it in terms of X$/acre. Raw land value is not derived from the number of acres but rather from what the property could yield, how it can be used, and the projected sale value of the total package end product (the new home on its lot). Its value is also related to the hard costs (i.e., costs for installing “horizontal improvements” to the site, such as streets, curbing, sidewalks, utility lines, and house construction costs or “vertical improvements”) and soft costs (expenses that will be incurred during the approval process). Accordingly, residential builders and developers do their income and expense projections for properties on a per-lot and not a per-acre basis. For all practical purposes, the parcel’s overall size is a meaningless number in the developer’s determination of property value.

Here’s an illustration:

Suppose there are two vacant 50 acre parcels you’re thinking about buying in the same municipality. Zoning for Parcel A requires a minimum lot size of 40,000 SF and width of 200 feet; Parcel B zoning requires 30,000 SF lots and 150 ft. widths. On average, the new homes would sell for $300,000 on Parcel A and $350,000 on Parcel B. Each parcel is fairly level with no remarkable physical constraints. Suppose per-lot improvement costs are ball parked at $56,000 for A and $43,500 for B.

In this scenario, Parcel A would probably be worth around $760,000 (or $19,000 per lot raw) to a builder who was buying fully-contingent. Parcel B, however, would command a price of over $2.3 mil ($44,000/lot). The reason that there’s a big difference in the bottom-line value of these parcels is that there are differences in the lot yield, end product value and horizontal improvement costs. In this example, if Parcel A were for sale at $19,000/acre, it would be for sale for a long time because it was significantly overpriced. On the other hand, if Parcel B were for sale at $44,000/acre, it would sell in a heartbeat because it was greatly underpriced.