What Does “Land Residual” Mean?
During the land acquisition process or in the financial analysis, “land residual” is a commonly heard term. In essence, the land residual is tantamount to meaning the as-is value of the land in its current condition. And consistent with the meaning of “residual”, the land residual is what is left to pay for the land after all revenue, costs, and profits are accounted for.
So let’s walk through the financial analysis, beginning with the revenue side. First, you need to make a projection as to how many homes will be built and sold. The total revenue will include the base home prices, lot premiums, options sales, and any other revenue generated by the project. The total revenue becomes the basis that will pay for all costs and hopefully have enough left over for a profit.
Next, we need to deduct all of the development costs (but not yet the land price) to develop the land and build out the project. These costs would include the grading, site improvements, city fees, vertical construction costs, site supervision, design consultants, marketing, interest expense, and all other soft costs associated with building out the project.
Now, let’s talk about profit. Obviously, most developers and builders want to earn as much profit as possible. But when competition exists for a land parcel, the thought process turns to “what is the minimum profit” needed to take on the project risk. I like to think of this minimum profit as another cost to be deducted from revenue. And if you can tighten your profit requirement, it leaves more money left over to pay for the land in these competitive situations.
So here’s the recap. We have total revenue, less all project costs, less the minimum profit. Whatever is left over to pay for the land is the land residual. During the land acquisition and financial analysis, pencils sometime need to be sharpened in terms of projecting maximum revenue and keeping cost estimates as lean as possible. The goal being to maximize the land residual, which is the best price you can offer in a competitive land offering. FYI, there are some cases where the land residual is negative, which means that the project doesn’t make financial sense even if the land is free. In this case, the total project costs and minimum profit requirement exceed the total revenue, leaving nothing to pay for the land.
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