A fairly common assignment for a commercial real estate appraiser is
valuing a large tract of land proposed for development as smaller
parcels. Subdivision development, the general term covering this type of
activity, entails splitting a large land tract into an appropriate
number of user-size lots that are more easily and profitably sold. The
value of the subdivision land tract, in advance of the actual
subdividing, is dependent on a number of property characteristics and
financial assumptions, including the number of lots that can be created
in the subdivision; the sales price of the individual lots; the timing
and cost of developing the streets and other infrastructure required to
ready the lots for sale; the timing of the lot sales; the timing and
cost of the various sale expenses; and the degree of uncertainty
associated with these assumptions.
A primary task of an appraiser working with this type of assignment
is to discover what drives the local market for this type of property.
Specifically, when faced with a subdivision assignment, the appraiser
should converse with local developers and their bankers who are the
primary collaborators in most land development activity. In the process,
the appraiser hopefully gathers the necessary information to replicate
the reality of how local developers and their bankers analyze
subdivision opportunities. The appraiser can then document and support
appraisal report information, and, ideally, reach a defensible value
A major goal of this study was to point to areas where the literature
and the market do not appear to match, at least not in the market
surveyed. It can be argued that there is no such thing as the ideal
method for appraising subdivisions in all situations, especially when
considering the wide variety of potential markets and participants.
Still, an appraiser should be familiar with the major issues involved
and be able to query local participants intelligently on valuation
When valuing land for subdivision development, the appraiser should
estimate value in the same manner that a typical developer would. But
how does the typical developer analyze subdivision tracts for valuation
purposes? Opinions on how valuation is or should be performed vary
For example, Steven Kapplin suggests that entrepreneurial profit
should not be treated as a separate line item in the valuation process
but instead can be adequately addressed through the use of a required
rate of return within a present value calculation? At a minimum, in his
view, the discount rate used in a present value analysis should be a
risk-free rate if entrepreneurial profit is included as a line item
expense. He disagrees with the treatment of entrepreneurial profit for
subdivision analysis demonstrated in The Appraisal of Real Estate, which
includes this profit as both a line-item deduction and a consideration
in the discount rate used in the present value analysis.(2) Other
writers are split on the issue.(3)
Another area of disagreement is whether to incorporate financing into
the analysis, and if so, how the dollar amount of financing should be
determined. Steven Cole feels that subdivision land should be appraised
on an after-debt-service basis, although he suggests that appraisers
have traditionally appraised subdivision land on a before-debt-service
basis.(4) The only example in The Appraisal of Real Estate regarding
valuation of a subdivision parcel excludes financing,(5) whereas other
sources include financing in the examples presented.(6) For those
writers who prefer to incorporate financing into the valuation task,
there is also a lack of agreement regarding the dollar amount or
percentage of financing that is appropriate.
Whereas William Brueggeman and Jeffrey Fisher(7) suggest a variety of
options for determining the dollar amount of financing, the main example
in their text incorporates approximately 40% land acquisition financing
as well as the majority of financing for improvement costs, including
all direct development costs and interest on financing carried during
lot construction and sales.(8) In contrast, William Ted Anglyn, Robert
Moreyra, and John Putnam suggest that the initial loan balance be set at
a stated percentage of the property's value which, in turn,
necessitates an iterative, computer-generated solution to determine the
dollar amount of financing.(9)
In the book, Subdivision Analysis, a comprehensive treatment on
subdivision valuation published by the Appraisal Institute, the authors
presented a variety of valuation options, including several different
means of handling entrepreneurial profit and financing issues.(10)
There are additional issues that can create differences in how
valuation is handled. For example, how sales expenses should be computed
and incorporated into the analysis or, if financing is included, how
repayment of the loan should be addressed. In Subdivision Analysis, the
authors suggest that the choice of a particular form of subdivision
analysis should be based on three criteria: how well the method of
analysis replicates reality, how well the appraiser is able to document
and support the information used in the analysis, and how reliable the
resulting forecast is. Further, they suggest that ideally the form of
analysis chosen should be the one employed by typical purchasers in the
DETAILS SURROUNDING INFORMAL SURVEY
The questions raised in the literature are worthy of further
investigation in the marketplace, but how to proceed is not clear.
Specifically, some of the nomenclature in this area is not well
established, some of the questions would be confusing to at least some
market participants, some of the responses to the questions are
dependent on other responses, some of the questions are more appropriate
for developers while others are better directed to bankers, and so
forth. To provide some clarity in this area, the author conducted an
open-ended discussion of various subdivision issues with eight
experienced residential subdivision developers and three local land
development bankers who operate in the greater Springfield, Missouri,
market. Springfield is a mid-size, middle-America community with a
currently active and growing residential sector. The greater Springfield
area (40-mile radius) supports a population of approximately 500,000
The developers and bankers chosen were identified and selected from
recent news and business reports. A developer must have had several
years of experience developing residential land tracts as well as a
solid real estate development reputation in the community. To be
included, a banker must have had recent and substantive experience with
Much of the information gathered in the informal survey is consistent
with published literature on the topic of subdivision development.
However, some of the findings do not support the literature, especially
in the area of financial analysis. The reason may be that the developers
and bankers contacted do not work in one of the country's major
real estate markets where analysis methodology may well be more
sophisticated. Regardless, the information gathered is representative of
what might be discovered from a fact-gathering effort in many mid-size
communities across the country.
A topic emphasized by all the developers contacted involved the
unusually high risks that go with land development. Several mentioned
that the average person has difficulty grasping the many potential
problem areas. According to the developers, these risks are many and
varied and virtually impossible to fully anticipate. For example, three
common refrains were meeting governmental and utility regulations,
dealing with neighbor complaints, and correcting unforeseen
environmental problems. Of course, the developers pointed out the very
real market risk that the lots may be the wrong size, offered at the
wrong asking price, or in the wrong location to satisfy the customer.
Developers in the survey appeared to adjust for high development risks
with proportionately high expectations for profit.
One of the developers indicated that he is willing to buy subdivision
land contingent on preliminary engineering work, including soil
drilling, to make sure that the engineering costs are manageable and
predictable. He will thus spend up to $1,000 per acre for this
preliminary work, with the real possibility that he will lose these
funds, depending on the results. Other developers discussed the need for
competitive bidding on engineering work - with significant differences
in bid quotes not unusual - and for fixed-price contracts that shift
much of the risks to the contractor.
Another developer indicated that the next phase of his current
development would not be nearly as profitable as hoped because of
unanticipated storm water requirements. Another said that a retaining
wall at the entrance of a newly built 23-lot subdivision cost $11,000
more than anticipated. This added approximately $500 of cost to each
first-phase lot. Still another developer bemoaned how expensive storm
sewer costs were becoming, including piping and retention areas. He also
told of a developer who incurred $120,000 in unexpected costs to remove
limestone when developing a 20-lot subdivision. The developers were thus
well aware that profits, if any, were earned only after successfully
navigating through the multiple and often unanticipated risks of
NEED FOR A MARKET STUDY
The developers and bankers contacted were in general agreement that a
well-documented market survey was a key component of the
appraiser's report. One of the developers emphasized the need for
careful market research, including supportable retail sales prices for
the lots, proper sales absorption rates, a full review of the
attractiveness of the project compared to other projects, and so forth.
In fact, he indicated that the rest of the appraiser's work, on an
assignment such as this, pales in significance by comparison. Another
developer suggested that the key to residential development is providing
the right product at the right time in the right location, and that it
was therefore the appraiser's main job to assess a proposed
development project from this perspective.
Several developers said that it was critical to the success of a
development to have pre-sales, lots sold before the lot construction is
completed. Similarly, the nature of the lots can play a large role in
determining the speed of sellout. One developer listed the following
items, in order of priority, for determining lot desirability and hence
saleability: proximity to common areas, existing trees, potential for
walkout basement, and corner lot. He indicated that other factors are
important as well, such as the length of the front-of-house building
line, but this type of feature is generally reflected in the larger
issue of building lots that are correctly sized for the market.
Appraisers planning to expand their existing appraisal practice might
consider meeting what appears to be a significant need in the
marketplace for quality market analyses. This service could be used to
lower at least a portion of the development risk discussed in the
previous section. The key is to maintain an extensive history concerning
all aspects of successful and unsuccessful subdivision projects in the
area. This information, when appropriately presented and analyzed, can
be promoted as either supplementary or complementary to subdivision
DESIGN AND CONSTRUCTION ISSUES VERSUS SOPHISTICATED FINANCIAL
The developers contacted had varying opinions regarding the need and
level of sophistication required for the financial analysis of
subdivision tracts. For most of them, the price paid for the land and
how much money the subdivision will make are important, but not as
important as the creative side of the business which, from their
perspective, involves design and construction issues as well as issues
regarding saleability of lots and houses. One developer said that she
simply preferred to spend her time on the creative side of the business
and that, as far as she was concerned, this was the key to success in
the development business.
Surprisingly, all eight of the developers surveyed turned out to be
home builders. One of the developers indicated that he always built out
all the lots he developed. In another case, the developer said that he
generally tried to build out 80% of his lots. This can make a big
difference in the developer's attitude toward the overall risk of
developing lots. In other words, the risk of developing lots can be
mitigated to some extent by a developer who has a good track record in
building and selling houses.
Several of the developers contacted suggested that if the developer
can afford to build the first few houses in a new development, the
project could get started on the right foot. In turn, other builders are
more willing to start construction in the subdivision because of the
increased buyer traffic and positive image being presented. Also,
several of the developers surveyed have inhouse sales organizations,
sometimes employing family members. This also works to spread the risks
among several different components of real estate activity, likewise
lowering the absolute risk of land development.
ACCEPTABLE LEVELS OF PROFIT
Profit compensates a developer for the time, resources, and expertise
involved in creating a product that is favorably received in the
marketplace. The developers contacted presented a wide variety of
responses when asked about the acceptable dollar amount or percentage
profit. Most preferred an indirect response such as "as much as
possible" or "what the market will bear" or "is
difficult to predict." Clearly, all were interested in earning a
profit or would be spending their time doing something else. However,
pinning them down on how they plan to turn a profit proved somewhat
One developer indicated that he hopes to net 10% on house
construction and not less than 15%-20% on subdivision development due to
the higher risk. Another developer suggested 25%-40% as a reasonable
profit goal on land and other major development costs. A third developer
mentioned that he tries to double his "hard" development
costs, including land costs, on all land subdivisions. But he added that
this goal is becoming more and more difficult to accomplish. Still
another developer said that he is involved in all aspects of the
residential marketplace and seeks profit in four different areas: lot
development, house construction, house financing, and house sales.
Hence, his view of adequate profit for subdivision development is tied
to how well he is doing with his overall activity. Nevertheless, when
approaching his banker regarding a new subdivision loan, he would bring
estimates of the net profit per lot and information on the percentages
of the total construction costs and total retail (gross sales) value
that needed to be borrowed.
USE OF CASH FLOW SPREADSHEETS
Of the eight developers included in the survey, not one used a
multiperiod cash flow spreadsheet in preparing revenue and cost
estimates. Most of the subdivisions that these developers were building
included 60 lots or fewer and were anticipated to be built and sold out
within a year or two. In several cases, the developer currently owned or
controlled land at one site that was larger than one or two years of lot
sales. In these cases, land development was phased to reduce upfront
construction costs. Given the relatively short sales horizon anticipated
or construction divided into phases, the developers surveyed were simply
not interested in the extra refinement of cash flow spreadsheets.
The strong implication here is that subdivision land in the market
studied is generally valued on a simple residual basis, with little
emphasis on the discounting involved with cash flow spreadsheets. In
other words, land available for residential subdivision can be valued
with or without a loan, depending on individual preference, but is
basically valued by the survey participants by computing the residual
left after estimating total potential revenue and deducting estimates of
all associated costs of development, including site development costs,
operating expenses, and a healthy allowance for entrepreneurial reward.
Interestingly, the bankers contacted were looking for cash flow
spreadsheets in the appraisals required for loans, as pointed out by
several developers. In one case, the banker said that his bank takes the
appraiser's spreadsheets and performs in-house sensitivity analysis
on several of the critical assumptions. This, in turn, raises an
interesting question when the cash flow estimates in the banker's
spreadsheets are converted to value estimates. Specifically, how does
the appraiser or the banker set the appropriate discount rate needed to
obtain a value estimate? Ordinarily this type of assumption needs to be
extracted from the market (i.e., from local developers), but based on
the results of this informal survey developers simply do not spend much
time contemplating and discussing this topic, especially as it relates.
to multiperiod cash flow spreadsheets.
Based on the author's discussion with the three lenders
contacted, the percentage of total development costs that a bank will
lend varies considerably from one developer to the next. All of the
developers surveyed emphasized the importance of a dependable source of
loan funds. Conversely, each banker emphasized that the amount of the
loan that the bank was willing to lend depended on past dealings with
the developer and other considerations, such as how costs are defined
and when they are anticipated to occur.
One banker indicated that he would lend 100% of the land and
construction costs if the borrower had a significant financial position
and would fully guarantee the loan, but he said that this would be an
unusual situation. The bankers were split on which costs should be
incorporated into the loan, and if land is included, whether the land
should be included at original cost or current market value. The bankers
indicated that they desired that the loan be fully paid after 60%-75% of
the lots are sold, depending on the developer and the particular deal.
Residential developers and the bankers who lend to them are busy
people and, if the persons surveyed for this article are a fair
indication, are difficult to track down. However, with the surveyed
group, once the connection was made and the nature of the request
explained, they appeared to be truly interested in valuation issues.
This does not necessarily mean that the developers agree with how a
typical appraiser would value subdivision land or, for that matter, that
they talk the same language as an appraiser or a banker. In fact, this
limited research suggests that appraisers and bankers communicate at one
level and developers and bankers at another.
The three bankers surveyed appeared more interested in textbook
valuation approaches than were the eight developers surveyed. The reason
may be that bankers are pressured to have defensible appraisal reports
in their files as required by regulatory agencies. Also, although the
developers were generally cooperative in discussing general subdivision
issues and concerns, they were, for the most part, either unwilling or
unable to discuss profit expectations. This creates obvious problems for
the appraiser working on this type of assignment and for the banker
trying to validate the appraiser's work.
The questionnaires provided in the appendix are offered to assist
appraisers seeking developer and banker information for subdivision
appraisal. These questionnaires were developed from the literature
review as well as from the interviews conducted for this article. The
questionnaires are intended only as guides and can easily be shortened
or supplemented with other questions. based on the survey work for this
article, appraisers should not expect the typical developer or banker to
complete the entire questionnaire, regardless of whether administered in
person or over the telephone because (1) it takes too long; (2)
developers in particular will not relate to some of the questions or
will consider the questions not personally meaningful; (3) the
discussion will tend to digress to related problems and concerns of the
person being questioned, providing useful insight to the appraiser but
subtracting from the time devoted to answering the listed questions.
As a final suggestion, an appraiser should take the time to gather as
much of this type of information as possible from a client developer or
client banker at the time of the appraisal. While it is true that an
appraiser is seeking market information from a variety of sources, the
developer who owns or hopes to own the subdivision tract and the banker
who anticipates making the loan are part of the marketplace and should
not be ignored. In addition, this information can be gathered in a more
thorough manner when the developer or banker sees the immediate need to
help the appraiser. This information, when gathered and stored in an
organized manner, will thus enrich the appraiser's database for the
job at hand and for the next subdivision assignment that comes along.
1. Steven D. Kapplin, "Entrepreneurial Profit, Redux," The
Appraisal Journal (January 1992): 14-24.
2. Appraisal Institute, The Appraisal of Real Estate, 11th ed.
(Chicago, Illinois: Appraisal Institute, 1996), 328-331.
3. One source of support for Kapplin's position is a text by
William B. Brueggeman and Jeffrey D. Fisher, Real Estate Finance and
Investments, 9th ed. (Homewood, Illinois: Richard D. Irwin, Inc., 1993),
630. Support for the alternative position can be found in Tom J. Keith,
"Applying Discounted Cash Flow Analysis to Land in
Transition," The Appraisal Journal (October 1991): 458-470; and J.
R. Kimball, Barbara S. Bloomberg, and Steven A. Jones, "Subdivision
Analysis and Valuation," The Appraisal Journal (October 1986):
4. Steven R. Cole, "Estimating the Value of Proposed
Developments by Discounting Cash Flow," Real Estate Review (Summer
5. The Appraisal of Real Estate, 330.
6. For example, Brueggeman and Fisher, 628.
7. Ibid., 606.
8. Ibid., 617-618.
9. William Ted Anglyn, Robert Moreyra, and John C. Putnam,
"Subdivision Analysis - A Profit-Residual Model," The
Appraisal Journal (January 1988): 45-59.
10. Douglas D. Lovell and Robert S. Martin, Subdivision Analysis
(Chicago, Illinois: Appraisal Institute, 1993), 48-114.
11. Ibid., 49.
Chester, Brian A. "Estimating Entrepreneurial Reward," The
Appraisal Journal (April 1990): 254-261.
Guntermann, Karl L. "The Valuation of Undeveloped Land: A
Reconciliation of Methods," Journal of Real Estate Research (Spring
Ling, David, and Richard B. Peiser. "Choosing Among Alternative
Financing Structures: The Developer's Dilemma," Real Estate
Review (Summer 1987): 39-48.
Munson, Chuck. "Lender Residential Subdivision Evaluation Using
Discounted Cash Flow Analysis," The Appraisal Journal (October
Okoneski, R. Joe. "Present Values: A Useful Underwriting
Tool?," The Appraisal Journal (October 1994): 609-617.
Sharkawy, M. Atef, and Joseph S. Rabianski. "New Criteria for
Evaluating Development Loans," Real Estate Review (Fall 1991):
Questionnaire Directed to Property Developer
1. Do you subdivide undeveloped tracts of land into individual lots
for resale to builders and speculators? If so, what type of subdivisions
have you developed most recently and in the past, as described by size
of land area developed, number of lots in the subdivision, type of
property end-use (such as single-family residential), and so forth?
2. In general, how do you determine the dollar amount that you are
willing to pay for an undeveloped tract of land that you are considering
for subdivision? In particular, what do you view as the major risks of
subdividing land and what impact does the risk level have on the amount
of profit that needs to be earned? (Major risk considerations would
include such items as unanticipated construction requirements, unusual
weather delays, unexpected changes in governmental regulations,
performance problems with contractors and subcontractors, unforeseen
changes in market trends and patterns, and so forth.)
3. Do you perform some sort of market study or feasibility study
before making a bid on undeveloped land that you are considering for
subdivision? If so, what are the main questions that need to be
addressed in the study?
4. How do you estimate the size and number of lots to be subdivided
from the undeveloped tract? Stated differently, how do you estimate the
portion devoted to street (circulation) requirements and other land
set-asides and the portion devoted to lot construction? Then, based on
the land devoted to lot construction, how do you estimate the size and
number of individual lots to sell?
5. How are site development costs estimated? Do you estimate these on
an item-by-item basis, on a lump-sum basis, or on a per-lot basis? (Site
development costs would include such items as clearing, grading, storm
and sanitary sewer installation, paving, utility installation and
hookup, landscaping, common area costs, special property amenities,
engineering fees, public approvals, accounting and legal fees,
construction loan fees, construction interest, miscellaneous expenses,
6. How long does full site development typically take? Is development
typically done in phases?
7. If the construction of lots is phased, how do you determine the
number of phases? What determines when a new construction phase will be
initiated? Also, what costs (or percentage of costs) are incurred in the
first phase and in the subsequent phases?
8. When analyzing a tract of undeveloped land for possible
subdivision, how do you estimate the number or percentage of lots to be
subdivided that will be presold before the lots are completed?
9. How do you estimate the time required to sell the subdivided lots
after construction of the lots is completed? (This time period is
referred to as the project duration, the absorption period, the
marketing period, or the sellout period.)
10. How do you determine the asking price for the individual
subdivided lots? Do you typically estimate price increases to take
effect during the sellout period?
11. How are operating expenses estimated during the sellout period?
Do you estimate these on an item-by-item basis, a lump-sum basis, or a
per-lot basis? (Operating expenses would include such items as sale
commissions, lot closing costs, property taxes and insurance,
professional services, developer contributions to the owners
association, general and administrative expenses, advertising, and
miscellaneous marketing costs.)
12. In general, what percentage of the purchase price of undeveloped
land tracts do you anticipate borrowing from a bank or other financial
13. Do you also expect to borrow the interest-carry on the loan?
14. Do you gain the commitment for the site development
(construction) loan at the same time you secure the land purchase loan?
If not, how does the process work for securing the additional loan for
constructing the lots?
15. What are typical terms for the land purchase and lot construction
loans? (Loan terms would include such items as the interest rate, the
payback schedule or "lot release factor," the upfront fees and
points, the maximum loan-to-value ratio, and the maximum loan period.)
16. What does the bank require to support the land purchase price and
loan? (Examples would include such items as a list of site development
costs, a market value appraisal, a multiperiod spreadsheet of projected
sales and expenses, a list of comparable land sales, public approvals,
soil studies, environmental studies, a title report, personal financial
statements, and the land purchase contract.)
17. Regarding the appraisal, what point in time is the appraisal
requested? Stated more explicitly, is the property valued as of a
current date or as of the point in time that the lot construction is
completed? Also, does the bank require that a discounted cash flow
analysis be performed in valuing the land?
18. How is the equity portion of the undeveloped land purchase price
raised? If equity is provided by persons other than the developer, what
percentage return is promised to these equity holders and how is it
computed? If equity partners are distinct from the development partners,
how are the profits (entrepreneurial rewards) divided and what return
should the development partners expect?
19. How are the profits, or entrepreneurial rewards, estimated and at
what point are they assumed to be earned? (Profits might be estimated as
a fiat dollar amount per lot, a total dollar amount for the full
development, a percentage of total sales, or a percentage of costs.)
20. Do you use a discounted cash flow technique in your subdivision
analysis? If so, briefly describe the process used. Also, how is the
discount rate determined?
21. What other considerations regarding subdivision development have
been overlooked in the conversation up to this point?
Questionaire Directed to Lender
1. Do you require a market study or feasibility study before making a
loan on undeveloped land being considered for subdivision? If so, what
are the main questions that need to be addressed in the study?
2. In general what percentage of the purchase price of the
undeveloped land will you lend to the developer?
3. Do you also lend the interest-carry on the loan?
4. Will you also make the commitment for the site development
(construction) loan at the same time you commit for the land purchase
loan? If not, how does the process work for a developer securing an
additional loan for constructing lots?
5. What are typical terms for the land and lot construction loans? In
particular, what are typical terms for the interest rate, payback
schedule (also called the lot release factor), upfront fees and points,
legal fees, maximum loan-to-value ratio, and maximum loan period? Are
there any other terms that should be considered?
6. Which of the following items does the bank require to support the
land purchase price and the loan? A list of site development costs, a
market-value appraisal, a multiperiod spreadsheet of projected sales and
expenses, a list of comparable land sales, public approvals, soil
studies, environmental studies, a title report, personal financial
statements, and the land purchase contract. Are there any other items
that should be added to this list?
7. Regarding the appraisal, what point in time is the appraisal
requested (i.e., is the property valued as of a current date or as of
the point in time that the lot construction is completed)? Also, does
the bank require that a discounted cash flow analysis be performed in
valuing the land? If so, does it matter when the discounting is done
(beginning-of-period, mid-period, or end-of-period)? What would be a
reasonable estimate of the discount rate and how is it determined?
8. What other considerations regarding lending for subdivision
development have been overlooked in the conversation up to this point?
Robert W. Owens, PhD, is professor of finance and general business at
Southwest Missouri State University, Springfield, He received a BBA and
an MBA from Texas Tech University, Lubbock, and a PhD from the
University of Washington, Seattle. He currently teaches real estate
principles and appraisal as well as financial analysis. He has written
articles published in several real estate and financial journals,
including The Appraisal Journal.