Don't Pay Too Much For Land

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When the housing market gets hot and stays that way for a long time, land appears to be scarce. Builders start to hoard it - bidding up land prices out of fear of diminishing supply. But remember, the profitability of any housing community starts with land acquisition. Carefully follow an economic model that combines the sales price the market dictates for the homes with your own profit objective for the community.

Plug in the direct cost of the homes (materials and labor) and the lot cost at builder retail (the price at which finished lots could be sold to another builder). You really must keep that combination at 70 percent to 72 percent of your average home sales price. Typically, a builder's operating expenses, which include indirect construction costs, financing, sales and marketing and general administrative expenses, represent 16 percent to 20 percent of the average sales price. Keep direct costs and land to 70 percent to 72 percent, and you have room for a profit margin of 10 percent to 12 percent.

If direct construction cost is 52 percent of the sale price, then you can only afford 18 percent to 20 percent for the land. For example, if you know from your market study that homes in the community should be priced at an average of $250,000 and that direct construction costs will average $130,000, then the finished lot cost has to be between $45,000 and $50,000. (These calculations should be made on the base sales prices, excluding options and lot premiums.)

Builders in the land development business need to carry the model further, to determine what they can pay for raw land. This calculation has to take into account the net lot yield per acre and costs for land planning, entitlements, development, financing the land carry and the land profit target (remember, land and home building are separate profit centers).

For example, in the $250,000 homes above, what can you pay for a 25-acre raw land parcel that will yield a net of four homes per acre (100 lots)? Let's assume you want to maintain a 20 percent finished lot ratio to the base sales price - so you have to hit a $50,000 finished lot cost. Entitlements are estimated at $700,000, development costs at $1.7 million and financing at $300,000. Here's how the model looks:

Based on this example, you can only afford to pay $750,000 for the raw land. Pay more and you will either undermine the project's profit or require a price increase to cover the land purchase price. And that could jeopardize your absorption rate and the return on investment for the whole project.

Here are some general rules of thumb to use in land acquisition: Keep finished lots costs at 20 percent of base home sales prices. We've seen this vary in local markets to a range of 16 percent to 25 percent, but the rule is still a good one. At 20 percent for finished lots, the price of raw land should be 3 percent of the home price, or 15 percent of the retail lot price.

In the $250,000 sale price example, if the finished lot gets up to 25 percent of that sale price, it would be $62,500, and the raw land would be 4.5 percent of the house sales price. That allows a raw land cost of $11,250 a lot, which is the most you should ever be willing to pay.