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Subdivision development: bridging theory and practice.
Abstract:
This article shows a divergence between subdivision development theory (as provided in the current literature) and practice (as found in the marketplace). In this case, the market encompasses residential land development in a mid-size, middle-America community. Two questionnaires designed for gathering appraisal information are presented to help bridge the gap between theory and practice. Topics covered with market participants include development risks, market studies, financial analysis, profit levels, spreadsheets, and subdivision lending. (Reprinted by permission of the publisher.)

Subject:
Land subdivision (Analysis)
Real estate development (Analysis)
Author:
Owens, Robert W.
Pub Date:
07/01/1998
Publication:
Name: Appraisal Journal Publisher: The Appraisal Institute Audience: Trade Format: Magazine/Journal Subject: Business; Real estate industry Copyright: COPYRIGHT 1998 The Appraisal Institute ISSN: 0003-7087
Issue:
Date: July, 1998 Source Volume: v66 Source Issue: n3
Product:
Product Code: 6552000 Subdividers & Developers NAICS Code: 23311 Land Subdivision and Land Development SIC Code: 6550 Subdividers and Developers
Accession Number:
20991284
Full Text:
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 estimate.

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 issues.

LITERATURE REVIEW

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 widely.

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 marketplace.(11)

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 persons.

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 subdivision lending.

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.

DEVELOPMENT RISKS

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 development.

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 valuation work.

DESIGN AND CONSTRUCTION ISSUES VERSUS SOPHISTICATED FINANCIAL ANALYSIS

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 difficult.

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.

SUBDIVISION LENDING

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.

CONCLUSION

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): 493-503.

4. Steven R. Cole, "Estimating the Value of Proposed Developments by Discounting Cash Flow," Real Estate Review (Summer 1988): 32-37.

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.

REFERENCES

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 1994): 169-177.

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 1994): 572-579.

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): 34-38.

APPENDIX

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, and contingencies.)

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 institution?

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.
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