|
Land as an Investment?by David L. Guglielmi
Metropolitan Investment Group, LLC
December 12, 2009
An email from a website visitor prompted this article which I guess I should have written from the very start. The question was alarmingly simple.
"Why invest in vacant land instead of improved real estate like single family homes, apartment buildings, commercial real estate or other forms of income producing property?"
My experience over the last seventeen years as a developer and an investor is very clear and convincing. Investing in land is a far superior strategy than buying improved real estate for four reasons:
Higher profits
Larger cash flow
Simple investment management
Greater flexibility for maximizing value
Let me explain what I mean.
Land offers higher profits because you take something in its most pure form (raw vacant undeveloped land) and be part of the process that creates substantial value from it, raising the land dramatically towards the ultimate real estate improvement goal of a "higher and better use."
Think of it in these terms.
I've always been a huge fan of William Nickerson's famous book, HOW I TURNED $1,000 INTO ONE MILLION IN REAL ESTATE IN MY SPARE TIME, and I got my start in residential real estate "Nickersoning" properties, which is finding quality real estate in need of modernization, improvement, repair, or cosmetic enhancement and doing the work to raise the value of the property and then pyramiding the equity by trading up. This is the most effective way of making money with improved real estate by far.
But what is Nickerson's method really doing? Making MARGINAL improvements to real estate properties. Adding a new bathroom to a house. Putting in a bay window and planting shrubs. Adding a skylight to a dark room. These repairs and improvements add value but these efforts create small jumps in value, from say $100,000 to $120,000 on a single family home. Great in percentage terms but not in real terms.
Investing in land allows you to be part of the development process that makes SUBSTANTIAL improvement to real estate properties, taking them from $10,000 building lots to $200,000 homes. The jump in value is enormous for the effort put in, often little more than filing paperwork with the County Clerk's office, but certainly not as labor, capital, or time intensive as Nickerson's method which is THE BEST way to make money with improved properties.
Land investment offers larger cash flow on a dollar-for-invested dollar basis for the same reason as it offers higher yields. If you buy and develop land or sell your land to another end-user (like a home builder or real estate developer) you are truly buying at wholesale prices and selling at retail prices. This significant spread when capitalized in the form of a mortgage or Deed of Trust note, land lease, project participation agreement, land contract, or other form of cash flow-based debt instrument is far superior than trying to raise rents while owning real estate after making improvements.
A simple illustration makes this point clear.
Assume you have $10,000 cash and want to invest this cash in a land or improved real estate venture.
With the $10,000 as a down payment in my area, I can buy a $100,000 piece of land and subdivide this parcel into four building lots, which I can sell on a land contract for $30,000 each, meaning I will be receiving monthly payments capitalized at $120,000 ($30,000 x four lots). I am now earning interest at a rate higher than exists on the original $90,000 mortgage (meaning my cost of capital on this transaction is ZERO) and the principal is now double my initial investment. Technically my rate-of-return on this transaction is infinite since my cost of capital is zero and my original principal investment has been returned----TWICE!
With that same $10,000 I could buy a small home and add a bathroom or some landscaping, but would I earn anywhere the
same cash flow? Most investors would have a hard time in this situation just getting a positive cash flow on the property.
The reason for the discrepancy in returns between the two scenarios is that the house investor is tying up a huge amount of capital in a depreciating asset (the physical home and all the windows, 2x4s, plywood, and pipes which make up a house) while buying only a small amount of land which is the real investment vehicle that allows for high cash flow returns.
Land offers ridiculously simple investment management since you do not have tenants and do not have any improvements which need to be repaired. Anyone who has been part of a real estate management company knows the litany of tenant headaches from frivolous lawsuits to eviction proceedings to the deadbeats that damage your property and then skip town in the middle of the night. You do not have hot water pipes that burst, roofs that leak, foundations that crack, or parking lots that need repaving.
Investing in land is simple.
You buy land. You improve the land to add value. You subdivide the land (if you want). You sell or lease the land to someone else. Done!
Land offers the greatest potential for investment flexibility so you can always maximize the value of your investment since land is literally an empty palate and is whatever you make it into for others. Raw land is like the concept of Potential Energy in physics. Land is "stored profits" which you can release any way you choose, and most investors choose to release this kinetic force in the way that guarantees them the highest rates-of-return over the quickest time.
The legendary New York City real estate developer William Zeckendorf recognized the importance of investment flexibility when he bought the Empire State Building and divided up the structure into various investment parcels, each providing their lucky buyers with a specific cash flow, rate-of-return, and rate of capital return, but always providing Zeckendorf with the maximum profit on the entire purchase. He knew that "the sum of the parts would always be greater than the whole" and this concept is always true with land. Ten five acre building lots are always worth more than a 50 acre tract of land.
But this flexibility is very difficult to apply towards improved real estate. It is easy to do with land.
A recent transaction I was associated with illustrates my point very well.
A partner and I recently purchased a 32 acre piece of land which we quickly subdivided into six home building lots. We financed this purchase using an interest-only seller financed mortgage with a balloon payment due in three years.
We had six prime building lots and tons of flexibility as to how we maximize our profits on this deal.
Ultimately, we sold the two best lots for cash, and since they were the most expensive we were able to pay off the existing purchase money first mortgage. We now owned the remaining four lots free-and-clear.
My partner, a local home builder, took his profit on the deal in the form of two building lots, one of which he received directly because of his participation in this deal and the other which I gave him in return for building a home for me on one of the remaining sites. (I pay only for the materials, he does the labor for the site.) This worked perfectly for him as well since he was going to build a home to sell on his lot anyway and building two houses simultaneously reduced his subcontractor and construction materials costs through an economy of scale at adjacent building lots.
I sold one of the lots on "soft" terms and financed the purchase myself with a 95% loan to the buyer, getting an above market price for the lot and collecting a nice check every month on the note. I will build a house on the other lot which I will sell or keep as a rental, I haven't decided which yet. The down payment received for this lot sold plus the monthly income on this note means that the material portion of the construction purchase is essentially free to me. (What I actually did was transfer the down payment plus assign four years of payments under the note to my builder/partner to cover the cost of the construction materials he ordered to build both our homes.)
The bottom line here is obvious. By maintaining maximum investment flexibility I:
- Received four prime building lots at no cost to me or my partner
- Created a mortgage note that will provide me with a monthly cash flow for ten years----six years of which I will receive in my own pocket
- And literally earned a single family home on a private five acre lot for free since each of the component parts of the home (the land, the construction materials, and the labor costs of construction) were generated from the profits of this transaction.
Try doing this with an apartment building or a strip mall. The process with developed properties is very similar to condominium conversion, taking an existing structure, dividing it into retail components, and then selling each to investors but anyone who has ever attempted a condo conversion (especially of a commercial property like an office building) knows how difficult it really is today.
With land, it is so simple since land is like clay, you can mold it into whatever you like----and I like profits. |
