Land Buy Sets Profit Potential

Look closely at the target financial ratios in the table that accompanies this column. The key to profitable building is to keep cost of sales at 70% of the base home sales price. That's the combination of the lot and direct construction costs of a house, before options muddy the water. It's easy to see that if you pay too much for land, you're in a hole that's hard to build your way out of — especially if the goal is double-digit profit.

Most builders have a hard time getting direct costs to 50%, much less below it. Usually you pay too much for land, which forces you to build too much house. Then you try to get your targeted margin by marking up costs instead of sticking to pricing dictated by the market. When prices are too high, velocity goes down. To get some sales, you discount houses — and there goes your margin.

Builders who develop land need to carry this model further to determine what they can pay for raw land. Calculate the net lot yield and planning, entitlement and carrying costs. Remember to include land profit. Don't mingle land and home building in one profit center. Keep them separate and transfer the developed lot to the building operation at retail.

Keep your emotions out of land acquisitions. Instead, use this model, based on a sales price the market wants. If the direct cost of building a house projects at 52% of sale price, shoot to spend 18% on the lot — and don't go over 20%, or you're asking for trouble.